A Fed-Induced Speculative Blowoff

Courtesy of John P. Hussman, Ph.D., Hussman Funds

Why are Treasury yields rising despite hundreds of billions of Treasury purchases by the Federal Reserve? There are two possibilities in the current debate. One is that the Fed’s policy of purchasing Treasuries has scared the willies out of the bond market on fears of higher inflation, and that the policy is a failure. The other is that the policy has been such a success at boosting the prospects for economic growth that interest rates are rising on anticipation of a better economy.

From our standpoint, neither of these explanations hold much water. On the inflation front, the recent bond selloff has hit TIPS prices as well as straight Treasuries, which isn’t something you’d expect to see if inflation expectations were being destabilized. And although precious metals and other commodity prices have been pressed higher, the commodity run can be more accurately traced to negative real interest rates at the short-end of the maturity curve, coupled with a downward trend in long-term yields that has now reversed dramatically (more on that below). I’ve long argued that unproductive government spending and profligate fiscal policy are ultimately inflationary (regardless of how the spending is financed, and particularly if it is monetized), but I continue to view persistent inflation as a long-term, not near-term concern. A rise in T-bill yields of more than 15-25 basis points would change that assessment. Until then, velocity can be expected to collapse in direct proportion to changes in the monetary base, with little impact on prices.

As for the notion that the Fed’s targeted Treasury purchases have directly aided the economy, the argument requires bizarre logical gymnastics. It demands one to believe that although the purchases were intended to stimulate the economy by lowering rates, they have been successful without lowering them, and in fact by raising them, because the expectation of lower rates was so stimulative that it caused rates to rise, so that the higher rates can be taken as evidence that lowering rates without lowering them was a success. Oh, brother.

It’s clear that we’ve seen some firming in various indicators such as the Purchasing Managers Index, the ECRI Weekly Leading Index and weekly claims for unemployment. The question is whether these can be traced to lower yields and greater availability of liquidity. On the interest rate front, the answer is clearly no, as Treasury and mortgage rates are even higher than they were before QE2 was announced. On the "liquidity" front, the additional reserves have simply added to an existing pile of well over a trillion dollars of idle reserve balances in the banking system. And while we did see a pop in consumer credit in the latest report, it was entirely due to Federal loans to students (arguably people displaced from the labor force and seeking an alternative). Other forms of consumer credit have collapsed at an accelerating rate.