Lower Bond Yields by Any Means Necessary

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There are two contradictory ideas at work in today’s Daily Reckoning. The first is that even if you know something should and probably will happen, you don’t really know when it will happen. The second is that something can continue for far longer than you ever expected, only to fall apart more quickly than you imagined.

But before theory, let’s look at reality. The reality is that the Federal Reserve in the United States would like everyone to quit gaping at vanishingly small short-term interest rates. The Fed surprised stock buyers and bond traders when it cut the Fed funds rate from one percent to somewhere between zero and 0.25.

The S&P 500 hit a five-week high and the Dow was up over 340 points. The cut was the Fed’s ninth in the last fourteen months, on top of $1.4 trillion in new lending. But really, who does Ben Bernanke think he is? MacGyver? Is he going to fashion a miraculous recovery in the world economy using chewing gum, bailing wire, and raw oyster shells?

Maybe! Or maybe Bernanke is channelling Malcolm X. He’s going to reflate the housing bubble “by any means necessary.” Hot air, funny money, talk therapy…whatever it takes baby.

“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the Fed said in its statement accompanying the new rate. “In particular,” it continued, “the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

Short-term rates are low and they’re going to stay there for awhile. But the big news in the statement is that the Fed is taking the fight to longer-term interest rates as well. It aims to flatten the yield curve with brute force, or at least bucketfuls of cash. It will do this by buying more mortgage-backed assets and even U.S. Treasury bonds.

“As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.”

The benefits of merely mentioning the strategy started showing up right away. Yields were down and prices were up as traders loaded into U.S. bonds. All aboard the Fed’s Bond Yield Express! Destination Zero!

You can see below that the current yield curve is more of an on-ramp. And the only reason it looks moderately curvy is the scale on the y-axis. In truth, the curve is being flattened by the Fed’s weight-of-money strategy. Throw money at bonds. Crush the curve!

yieldcurve.gif

Source: Bloomberg

This policy is bound to have all sorts of unintended consequences. But the main intended consequence is to liberate the household balance sheet by lowering ten-year U.S. bond yields, which are roughly linked with 30-year U.S. mortgage rates. We talked about strategic indirection yesterday. Here you have it.

Forgive us for this digression into bond yields. But we’ll get to why it’s important in just a moment. Bear with us for just a few more data seconds. If you look here, you’ll find that the Fed HAS been effective in reducing yields on short-term notes and bills in December. The yield on the 1-month bill has fallen by 44%, on the 3-month by 42%, on the 6-month by 47%, on the one year by 44%.

By contrast, stubborn ten-year yields have fallen “just” 12.8% while thirty-year yields have gone down 11.1%. This is why the Fed will start buying bonds of longer maturities. In its attempt to reflate U.S. household balance sheets, it has to move ten-year yields down. So it’s rolling up its sleeves and getting to work.

But don’t think that just because the Fed works hard it will necessarily work well. Generally in life, we believe the quality of your effort counts for more than the results you achieve. Not because results don’t matter. They do. But outcomes are generally beyond your control in most things, and often they are just plain random.

But the Fed believes in hard work. So work it will. But as Bloomberg reports today, Japan’s central bank kept its main rate at zero from 2001 to 2006 while flooding the banking system with extra cash to encourage lending, spur growth and overcome deflation. The abundant funds failed to prompt lending by commercial banks, which expanded their reserves at the central bank almost nine times by early 2004.”

What can you expect to see then? First, look for rising gold prices. Gold was up again in New York trading by twelve bucks to $855. Diggers and Drillers editor Al Robinson has brought together some excellent Aussie gold analyst in his latest report, going out to subscribers later today. If you want to know the forecast for Aussie gold, you’ll want to take a look.

What else? Well, the commercial banks the Bloomberg article mentioned will stock pile cash and deposit it at the central bank. In the local market, Commonwealth Bank raised over $2 billion in a share placement to institutional investors. The Financial Review reports the price of the shares were at a 7.3% discount to CBA’s market price. Like other Aussie banks, CBA is beefing up its capital base to reassure investors that it’s positioned to ride out the crisis.

Need a laugh? Take a look at this. It’s an interview with Bernard Madoff at some sort of Wall Street roundtable in 2007. We listened to it this morning and jotted down some of the more ironic highlights.

“How do you make money?,” the moderator asks.

“Well today basically, the big money on Wall Street is made by taking risk,” Madoff replies. True enough. Wall Street made money trading its own capital. Or, in some cases, using other people’s money as collateral for big loans to trade. You can see, though, that taking on risk is not the same thing as entrepreneurial capitalism, especially when it’s not your capital at risk.

Here’s another gem from Madoff: “In today’s regulatory environment it’s virtually impossible to violate rules…And this is something the public doesn’t really understand…It’s impossible for a violation to do undetected, certainly not for a considerable period of time.”

The more interesting and less ironic part of the discussion is how Madoff describes his firm’s use of quantitative models and algorithms to replace human beings. Madoff told the public that using more models and fewer brains made for greater efficiency and reduced regulatory risk.

“Take the human being out of the equation. When you do that, there are two advantages in our industry. You solve your regulatory risk [because a computer can’t lie, cheat, or steal]…Because the nature of any human being and certainly anyone on Wall Street is that the better deal for your customers the worse deal for you. Because you’re on the other side of the transaction.”

Madoff then gave an example of a retailer who sells televisions. If he lowers prices, he said, he lowers profits. What’s good for the consumer is bad for the salesman and vice versa, he says.

“As honest as you try and get people to be,” he went on, “there’s this normal natural pull that you have to deal with.” That ‘pull,’ presumably, is to always act in your own interests when they are not in alignment with the customer’s interests. And in Madoff’s formulation of business, the businessman’s interests are never aligned with the customers, apparently.

“I guess you could also program a computer to violate the regulations, but we haven’t gotten there yet,” he joked. Maybe someday, when computers have consciousness too. But not yet.

Is Madoff correct? Well he’s probably plain wrong about the TV retailer. If the seller cuts prices, he sells more units. What’s good for the customer is good for that particular retailer (though perhaps not all retailers in the aggregate.) Just ask Wal-Mart.

But the real question is whether the interests of financial institutions ever really aligned with their customers. He pointed out that the decline in commissions that came in the late 1970s stripped away all the transactional profit on offer to brokers. They had to make money some way. So they traded their own capital and, ahem, leveraged their informational advantages.

But you sense a fundamental and perhaps cynical error in this conception of things. Madoff reveals the error when he says you should “take the human being out of the equation.” This reveals the belief that the economy is a machine, or a complex set of variables that are reducible with enough MBAs and quants, to equations.

As hard as hard as it is to figure out the delta in an options trade (the change in the options price for every change in the underlying) try figuring out how to quantify fear and greed. And besides, perfectly rational people are often quite happy to take opposite sides of a trade. Why? They think differently. They base their decisions on different experiences. They have different objectives. Maybe one of them had hot chilli for lunch. Who knows?

But you can never remove human beings from the equation. That is a new kind of fatal conceit of the model makers of the financial world. That everything can be reduced to variables and plugged in the right equation to be both explanatory and predictive. It’s really no more useful than financial astrology.

All you can really get from good models are probabilities, not certainties. The only certainties, other than death and taxes of course, are that human beings are enormously flawed and will repeatedly make stupid mistakes out of arrogance, and later, maybe in Madoff’s case, out of fear.

It’s kind of remarkable to hear a man talk about the virtue of his cutting edge models that take human beings out of the equation. Hardly. The core of his real business model was good old fashioned fraud. And it wasn’t a model based on an equation but on the psychology of the con.

Dan Denning
for The Daily Reckoning

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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