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Central Bank Policies And Market Distortions On US Treasuries, S&P500 And US Dollar

Sebastião Buck Tocalino,
March 19, 2015

  • Recurrent countercyclical monetary policies have given way to several distortions in the economy.
  • It is believed that printed dollars have inflated both stocks and bonds in the US, but that is a misunderstanding!
  • Still attractive, US Treasury Bonds may provide the basis for a sustained appreciation of the US dollar against foreign currencies.
  • Once more, the widely anticipated interest rate hike by the FOMC may get postponed... further into oblivion!
  • Our mothers have taught us that sugar, if scattered on the floor, gets sticky and may attract pests like ants and cockroaches. Some of our parents also educated us on finance, teaching that easy money and plenty of credit do not encourage responsible lifestyles. Good lessons for those that learned them!

    The intervening behavior of central banks, mostly led by the minds of neoclassical economists and the Keynesian panacea (alongside mainstream academia), by launching recurrent countercyclical monetary policies, has given way to several distortions in the economy.

    The most recent one, about which I had written a few times before red lights started flashing everywhere, was the price of oil. On August 30, 2014, as I published an article on this commodity, WTI barrels were trading at US$ 97.86 and Brent at US$ 101.12. Disgusted by that first ISIS videotaped execution (of American photographer James Foley), I put together some data on oil consumption and gasoline sales (as well as some discomforting facts on the political, historical, social and religious aspects of major oil nations). The original article was first published in Brazil, and later on, a more succinct edition was published in the US, despite some editorial concerns with the political and religious overtones. In a nutshell, I was emphasizing the clear and detrimental relationship between central bank policies and oil prices. There were coincidences between the 1970's scene and the last ten years or so. Today, seven months later, West Texas Intermediate is at US$ 46.45 and Brent at US$ 55.20. The retractions since that text already amount to 53% and 45% respectively.

    The oil mania had started with the FOMC lowering Fed Funds rates below the level of inflation. Those negative real rates were supposed to counteract the economic effects of the busted tech bubble (of 2000) and the attack that brought down the WTC twin towers in NYC (on 9/11/2001). The oil speculative mood reached its peak with the anticipation of even more extraordinary stimulus from the FED to help yet another bubble, this time a highly contagious one, involving mortgage backed securities and the housing market. At the climax of the subprime crisis, oil prices showed a sharp but short-lived correction. But the second phase of that oil craze got kicked in soon after QE1 was introduced. It then seemed a result of: (1) the search to invest one's capital in a somewhat more tangible asset or product; (2) the fear that an abusive monetary policy would erode the value of fiduciary currencies and inflation could eat away any returns and part of the principal invested in bonds; and specially, (3) the revival of cheap credit availability to leverage more bold speculative bets on the market. The environment was benefiting not only oil, but also the precious metals.

    real interest rates, oil prices and new house sales

    A less known fact is that NASDAQ's tech bubble had also inflated expectations in Europe for the auction of 3G band among mobile telecommunication companies. Germans had raised and committed a huge sum of money in their bid. Since no participant knew how much the competition was offering in sealed envelopes, the bids were very high to avoid losing any opportunity in the new technology. Too high indeed! The Germans bid some US$ 50 Billion dollars (£ 30 Billion in British pounds at the beginning of the year 2000). Only later the exorbitance was recognized. That episode contributed to lower interest rates across Europe at that early stage of the 21st Century and the adoption of the common currency by different countries. Those more attractive loan costs enticed other European governments into more debt.

    Cheap credit did nothing to favor financial discipline in some economies. Excesses and the late hangover became obvious once crisis became unleashed in the five PIIGS (an indelicate acronym for Portugal, Italy, Ireland, Greece and Spain).

    In the last few years, I have repeatedly heard town-criers claiming that there's a more serious and looming bubble ready to blow: the US Treasury Bond market. Allegedly, the Federal Reserve, printing US$ 3.7 Trillion Dollars, propped up the prices of these bonds as they bought public debt and mortgage backed securities. It all makes perfect sense... Theoretically! It is widely believed that the printed money fuelled both stocks and bonds in the US.

    I have discussed both these markets separately and in more detail in my previous articles (some in English) showing the actual differences and effects in their development.

    Stocks and Bonds were NOT responding in the same way to all those Dollars printed by the FED. To get a glimpse of what I mean, you may look into "A Plurisy of Madness" and "Gauging The Stock Market With The Tocalino Index" (on the subject of stocks) and "Fedspeak? Get A Load Of That BULL!" or "An Interest Rate Hike? Check Out Long Bonds, Yield Curves, US Dollar Index, Demographics And Money Multiplier" (relating to US Treasury Bonds).

    The chart bellow should help to illustrate the dissociation in these markets. We have a comparison between the S&P500, representing the stocks, and TLT (iShares 20+ Year Treasury Bond fund), which is BlackRock's ETF for long T-Bonds. The time axis stretches across 6 years of dollar printing, from the beginning of QE1 to a few weeks after the end of QE3.

    QE on T-Bonds X S&P500

    The trajectory was clearly divergent, showing the undeniable appreciation of US stocks and depreciation of long US bonds during all three editions of quantitative easing, except from the announcement of QE3 Tapering onward. T-Bonds only sustained some uptrend in the intervals between QEs and, more steadily, in 2014, after the FED started tapering its way out of QE3.

    After that FOMC meeting in December/2013, chairman Ben Bernanke officially stated that the Federal Reserve would gradually decrease its asset-buying monetary-stimulus until exiting the market in the fourth quarter of 2014. Bernanke's statement, given before Janet Yellen's term kicked off, was designed to avoid any doubts about the orientation of his substitute at the chair. Yellen's reputation was that of an even more dovish economist than Bernanke. Tapering meant that the FED was pulling the plug on its printers in slow-motion. But it was that FED attitude, buying less every month, which actually allowed T-Bond prices to climb.

    Though really counterintuitive, the fact of the matter is that it happened: long Treasuries became cheaper while most of the fresh dollars were minted to purchase them in the secondary market.

    If we base our thoughts on good old and down to earth commonsense, and forfeit a more pragmatic observation of what has really happened, we might indeed believe that the huge volume of new central bank dollars must have inflated bond prices into a bubble. But this logic may be ready to pull the rug on which many rational investors are standing!

    In the table below I show all editions of quantitative easing (1, 2 & 3 - so far!) along with the behavior of the yield curves from 1-month to 30-year Treasuries. One must understand that, within the same duration, higher yields mean cheaper Treasuries, and vice-versa, lower yields mean more expensive bonds. It is mind boggling that long yields got higher instead of lower with QE, but this is just another angle for viewing the same picture shown above. The FED, throughout most of its interventions in the market, has been lowering the prices of T-Bonds, and thus, it has effectively raised their yields!

    QE and long bond yields

    It is also important to realize that the long yields of US Treasuries remain very attractive in the actual global context. If we take into consideration four of those five nations in the PIIGS , leaving only Greece out, we can see that government debt from Portugal, Italy, Ireland and Spain are yielding actually less than US government debt! But certainly those economies present more risk than Uncle Sam.

    10-Year Global Bonds

    As odd as it may seem, the quantitative easing of new dollars chasing US Treasuries seems to have cooled the market's overall appetite for them. The results were cheaper T-Bonds and higher US yields in the global market for long bonds. That's not bad at all! While stocks have soared to more speculative levels, US public debt (against all expectations) is still attractive in the gruesome landscape of global economy.

    We all seem to agree that the USA is one of the cleanest garments in the swelling laundry basket of the world's current state of affairs. Therefore, by preserving their relative attractiveness amongst most international equivalents, US Treasury Bonds continue to be one of the safest havens for foreign capital. This may provide the basis for an even more sustained appreciation of the US dollar against most foreign currencies! It may also delay any widely expected interest rate hike from the FOMC further into oblivion!


    Disclosure: The author has no positions in any stocks or ETFs mentioned, but may initiate a long position in TLT and/or UUP ETF shares over the next few days. The author wrote this article himself, and it expresses his own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock or ETF is mentioned in this article.


    Copyright © Sebastião Buck Tocalino - All rights reserved.

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