Page 1 of 2 When money refuses to flow uphill
By Antal E Fekete
For some nine years I have been predicting that the economy is going into a
recession morphing into a depression, using a purely theoretical argument.
The essence of my argument is that the open market operations of the US Federal
Reserve cause a protracted decline in interest rates, which is responsible for
the hard-to-detect capital destruction affecting the financial sector no less
than the productive sector. The immediate cause of the depression is the
destruction of capital. The ultimate cause is the monetary policy of open
market operations. The chain of causation is as follows:
1.
Open market operations (in effect, net purchases of Treasury bills) by the
Fed are predictable. They invite bond speculators to
take risk-free profits offered by this fact of predictability.
2.
Bond speculators buy the long-dated Treasuries and sell the short-dated
ones, to pocket the difference in yields. These straddles represent borrowing
short and lending long. As such, they are inherently risky. However,
Quantitative Easing takes the risk out by making the odds, that the normal
yield curve will invert, negligible.
3.
The bond speculator faces the problem of having to roll forward the
fast-expiring short leg of his straddle by selling T-bills. The extraordinary
funding and refunding requirements the Treasury is facing, and the
extraordinary pressure on the Fed to increase the money supply combine to make
it ultra-easy for the bond speculator to move both the short and the long leg
of his straddles as he sees fit.
4.
The upshot is that interest rates keep falling along the entire yield
curve. Regardless how many long-dated issues the Treasury offers, bond
speculators snap them up even before the ink is dry on them. Here we have the
solution to the Greenspan-conundrum: the sky is the limit to the bond
speculators' appetite for Treasury paper. They are all right as long as they
can sell T-bills against them. But as the sky is the limit to the Fed's
appetite for T-bills, both flanks of the speculators are secure.
In my other writings I have explained how a prolonged fall in interest rates
along the yield curve brings about depression through the indiscriminate
destruction of capital in the productive as well as financial sector.
There is a vicious spiral: the more currency the Fed creates, the more
risk-free profits bond speculators will reap, contributing to a further fall of
interest rates.
This outcome is the exact opposite of the one monetarism predicts. The new
money created by the Fed will flow to the commodity market bidding up prices
there, to nip recession in the bud, monetarism predicts. Bernanke & Co
fully expects this to happen. This is not what is happening, however. The new
money refuses to flow uphill to the commodity market. It flows downhill to the
bond market where the fun is. Why take risks in the commodity market, the
speculators ask, when you can gamble risk free in the bond market? So grab the
money, buy more bonds and sell an equal amount of bills. As a consequence of
bullish bond speculation interest rates fall, prices fall, employment falls,
and firms fail. The squeeze is on, bankrupting the entire economy.
Official check-kiting
Some might object that the Fed could short-circuit the process and undercut the
bond speculators' lucrative business. All it has to do is to buy the
short-dated paper directly from the Treasury. Inverting the yield curve will
shake off the parasites.
My answer is that there is no danger of this happening. The Treasury and the
Fed know that bond-vigilantes watch what they are doing like hawks. Any
hanky-panky of direct sales of T-bills by the Treasury to the Fed would make
them cry "foul play!" As indeed it would be: direct sales of Treasury paper to
the Fed would degrade the dollar from irredeemable currency to fiat currency.
There is a subtle difference, realized only by the few.
Fiat currency is worse. Its arbitrary augmenting is decided behind closed
doors. It does not need the endorsement of the open market. Fiat currencies
have a short life span as they readily succumb to the sudden-death syndrome.
Irredeemable currencies are different from fiat in that they are created
openly, using collateral purchased in the open market. They have a more
respectable life span. As long as the official check-kiting conspiracy between
the Treasury and the Fed remains hidden from the general public, irredeemable
currency may even prosper. Direct sale of T-bills by the Treasury to the Fed
would tear down the curtain that hides the fact of check-kiting.
The mechanism of check-kiting is as follows. The Treasury issues debt that it
has neither the intention nor the means ever to repay. This debt is used as
"backing" for Federal Reserve notes and deposits, which the Fed has neither the
intention nor the means ever to redeem. When the Treasury debt matures, it is
paid in Federal Reserve credit issued on the collateral security of new
Treasury debt. When Federal Reserve credit is presented for redemption, the Fed
offers interest-bearing Treasury debt in exchange. This is a shell game and it
exhausts the definition of check-kiting. Neither the Treasury debt, nor the
Federal Reserve credit is issued in good faith. Neither is redeemable any more
than Charles Ponzi's tickets were. They are both issued in order to mesmerize a
gullible public, much the same way as Ponzi did.
Treasury and Fed officials know their history. They are familiar with the fate
of the assignat, the mandat, the Reichsmark, not to mention the Continental.
They know that no fiat money ever survived "the slings and arrows of an
outrageous fortune". Their only hope is that the fate of the irredeemable
dollar, as predicted by Friedman, would be different. They would not embark
upon an adventure in monetary policy involving direct sales of T-bills by the
Treasury to the Fed. If they did, surely this would be the end of their
experiment. Foreigners as well as Americans would dump the dollar
unceremoniously, and buy anything they can lay their hands on. This is
variously known as flight into real goods, Flucht in die Sachwerte,
crack-up boom, Katastrophenhausse. I purposely avoid using the term
hyperinflation as it connotes with the Quantity Theory of Money, which is not
really a theory. It is a linear model trying to explain non-linear phenomena.
Falsecarding by the Fed
There is also a second method by means of which bond speculators are making
risk-free profits. They "front-run" the Fed in the bill market. This means
that, through inside information or otherwise, they divine when the Fed has to
answer "nature's call" and must make the next trip to the open market in order
to buy the collateral without which it cannot issue more money.
Bond speculators forestall the Fed by purchasing the bills beforehand, thus
driving up the price. Then they turn around and dump the paper into the lap of
the Fed at the enhanced price, making a risk-free profit. This process is
called "scalping", after the kindred activities of small-time speculators in
tickets for the World Series and other popular sporting events.
The objection that the Fed knows how to throw bond speculators off scent by
various stratagems - for example, through falsecarding, say, by selling when
speculators would expect it to buy - can be safely dismissed. There is no
question that every year the Fed is a big buyer of bills on a net basis. If it
sells, it has to buy that much more later on. Fiddling means that the Fed may
miss its target. Falsecarding may backfire.
The speculators are a smart lot, thanks to "natural selection'' culling the
rank and file. They risk their own capital, which they stand to lose if they
place the wrong bet. Once their capital is gone they are out, and smarter guys
will take over. Hired hands at the Fed are no match for them as far as
brightness and adroitness is concerned. The latter work for salaries. If they
make the wrong bet, losses will be replenished by dipping into the public
purse.
Think of the losses the Bank of England suffered at the hand of a lonely bond
speculator, one George Soros. The British public was forced to swallow the
loss, and Soros was allowed to run with the loot and boast in his book that he
has busted the Bank of England single-handedly. Recently Soros said in
Davos that he is bearish on gold. In his opinion gold is in a bubble. Of
course. He knows that he couldn't bust the Bank of England again, once it is
back on the gold standard!
Cheating in Las Vegas
My voice has remained a cry in the wilderness. Nobody paid attention to the
mumblings of this armchair economist. My idle theorizing got an unexpected
boost last month from the website Jesse's Cafe Americain [1] . On January 22,
Jesse posted a story with the title "Front-Running the Fed in the Treasury
Market'' from which the following quotation is taken.
Attached is some information from a reader. I cannot assess its
validity, not being in the bond trading business. But it does sound like
someone has tapped into the Fed's buying plans to monetize the public debt and
is front-running those purchases, essentially "stealing'' money from the
public. It's what they call a "sure thing''.
To try and figure out who might be doing it, I would look for some big player
who is showing extraordinary returns on their trading, with consistent profit
that is not statistically "normal'', but is consistently "too good''. The
problem with cheaters is that they sometimes get greedy and call attention to
themselves. In Las Vegas the bigger cheats at the casino were often taken to
the desert for further questioning and final disposal. On Wall Street they are
more arrogant and persistent, defying resolution with that ultimate defiance,
"We'll just have to figure out other ways to cheat, and come back again.'' Time
for a trip to the desert?
Here are my reader's observations from the bond market:
"I used to work for a BB on a prop desk until the financial crisis took hold
and they fired the less senior guys. I now trade US Treasuries for a small prop
firm, to scalp basis trades in most on-the-run securities. Occasionally, I will
also take position in the repo markets for off-the-runs if I see something
'mis-priced'. Your recent article piqued my interest because we, too, have
noticed 'shenanigans' of a sort in the Quantitative Easing program involving US
Treasuries.
"What we have noticed, especially in smaller issues like the 7 Year Cash, is
that before a Fed buy-back would be announced, the price would pop
significantly as if buyers would run through all the offers on the two major
electronic exchanges (BGC Espeed and ICAP Broker Tec). This has occurred more
than several times as the 7 Year Cash would be overvalued both by its BNOC, by
as much as 20-30 ticks, as well as by its value relative to similar
off-the-runs. These buyers would lift every offer they could, driving the price
substantially above its 'value', sometimes for as long as a week at a time.
After this buying occurred, the Fed would announce the purchase of that
security, sometimes a handle above its approximate value. This 'luck' has
occurred not just in the on-the-run 7 Year sector, but also in the 30 Year
Cash, 3 Year Cash, and in several other off-the-runs. Again, it was especially
prevalent in the less liquid Treasury products. Often the 'appetite' for these
securities would begin two weeks before the official Fed announcement. The
buying was well-orchestrated and done in such a way as to throw it out of
kilter with the like cash Treasuries and the CME Ten Year Contract. If you
examine the charts of some of the selected buy-backs before the official
announcement, you will see a similar occurrence.
"While I haven't broken this down into a paper to prove it (and I see nothing
positive coming out of contacting the ESS-EEE-SFE about this issue), I can
assure you that it was occurring on a consistent basis across the entire curve.
A certain issue would be bid up substantially above market value (as determined
by several metrics), only to be gobbled up later by the Fed at an unreasonably
high price. These players must have substantial pockets as we, the small guys
(but with a decent capital base), would take the other side of what seemed to
be an obvious fade. While this did not occur in every issue of the Quantitative
Easing program, it occurred often enough to be obvious to any knowledgeable
observer.
"While I am not sure that this can be attributed to a purposeful Fed policy or
someone at the Fed talking to his pals, I am certain that it transpired."
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