The Monetization Of America

J.P. Morgan suggested that the Fed would account for 90% of all new US debt issuance

By Mark J. Grant

In the piece I wrote over the weekend and subsequently published as an “Out of the Box” yesterday I touched upon the Fed’s buying and what it will mean for the bond markets. Today I wish to concentrate on the implications of what the Quantitative Easing will do to the fixed income markets and, to a lesser extent, to the equity markets. Many people, and erroneously, think that all of the purchasing by the Fed will go to both markets in equal amounts but this is not the case.

More money for the stock markets would have to come from asset reallocations by money management firms, insurance companies, pension funds and the like and this is not going to happen anytime soon given the 2008/2009 experience. Consequently the greatest flows generated by the Fed’s recent and forward actions will affect the bond markets much more than the equity markets.  What this means is a massive compression of available securities against Treasuries which continues what has been underway since early last year. The demand for Treasuries will also push down absolute yields so that my springtime prediction of a 1.25% ten year Treasury yield, the actuality is 1.38% so far so I was close enough, will be breached in 2013 as the Fed takes in and monetizes somewhere between 80-100% of all new Treasury issuance.
J.P. Morgan, in a recent piece, suggested that between the MBS purchases and the next upcoming stimulus push that the Fed would account for 90% of all new debt issuance and I then calculated a demand imbalance between $400 billion to almost $2 Trillion depending upon the actual Fed announcements. However you cut it though it means that the Fed will be purchaser of securities and that what is left is insufficient to meet demand so that compression and lower yields for anything/everything are on the horizon. There are many problems here and significant problems that will face the markets in the years ahead as the Fed will balloon its purchases so that they singularly support the financial markets. 

The Fed currently holds about 18% of the U.S. GDP on its books and it could bulge to 23-28% a few years out depending upon the continuation or increase in current programs. There are academic arguments to all of this and very real dangers when the Fed, if the Fed, ever turns and stops their purchasing but in the meantime we play the game to win and the strategy is simple enough. Buy every bond that is long where you can deal with the credit risk and take advantage of the compression. For those of you that do not watch the institutional bond markets like I do I can tell you that now, not off in the distance but now, there are almost no discount bonds left in the long end of the market as compression and the absolute decline in yields will push bonds to yet unseen levels and institutions are already or will be soon setting up to take advantage of these conditions.

This all works, by the way, only because all of the world’s central banks are working in concert so that there is no imbalance and money cannot be invested off-world. In effect, we are stuck but that is the way of it these days. There is no use arguing with what is and neither wishful hope nor predictions of crash will help you in the short run. One day there may well be the question of valuation and the worth of currencies but it will not be now so that betting upon doomsday scenarios is not a good play but never close your eyes to fact of the monster that has been created. It looms out there like the great silent beast that it is and it is only the ring of nothing else to buy on this planet that curtails his rampage. The beast is currently kept in his pen but if the gate of the worth of currencies is ever opened then not even Katie will be able to bar the door.

The world will continue to operate on relative value in the meantime and the Fed, as the buyer, will destroy what absolute value there is because their intentions and goals are vastly different from investors. Yields will not make sense empirically because of the actions of the Fed but it will make no difference; lower yields and greater compression will be the rulers of this part of the drama. The “Fear Factor” will come and go but the trend will be as I have predicted because the most fundamental of laws apply; demand will vastly be greater than the supply. The Mad Hatter rules and the Red Queen has installed a new croquet court!