Risk On, Hate On

The most hated asset class, U.S. Treasuries, is under renewed assault – not only in word, but in deed.

Options traders are paying record prices to protect against swings in long-term U.S. Treasuries relative to stocks amid concern inflation will accelerate.

Implied volatility, the key gauge of options prices, for contracts with an exercise level closest to the iShares Barclays 20+ Year Treasury Bond Fund (TLT) has climbed to 16.65, compared with 13.85 for the SPDR S&P 500 ETF Trust (SPY), according to three-month data compiled by Bloomberg. The ratio between the two ETFs reached 1.24 on Sept. 14, the highest since at least 2005.

The Treasuries fund, which includes bonds maturing in 20 years or more, fell the most since July 2009 last week, while U.S. equities rallied after the Federal Reserve pledged to keep monetary policy accommodative even when the economy strengthens, increasing inflation concerns. The Fed’s preferred measure of the market’s expectation of price increases has risen to 2.8 percent, near the highest in 13 months.

“Treasuries don’t offer a whole lot of value here,” Bret Barker, a portfolio manager at Los Angeles-based TCW Group Inc., which manages about $128 billion, said in a Sept. 18 phone interview. “The Fed is going to be in ease mode even longer than the market expected, and as such inflation expectations are rising. The open-ended purchasing caught the market off guard.”

To derive inflation expectations from the Fed’s asset purchases is irrational. As much analysis by John Hussman and the following chart amply shows, money velocity drops to offset the increase in the monetary base.

In fact, the Fed’s actions are deflationary. It is true that the Fed’s purchases add to the base money supply, unlike debt sales by the Treasury which are settled by transfers from existing reserve accounts. But when the Fed buys the bonds, substituting cash for the bonds previously held by the sellers, it not only deprives them of the interest income from the bonds, but implicitly reduces the Federal deficit. The interest paid on the purchased bonds by the Treasury is remitted straight back from the Fed to the Treasury (after deduction for Ben’s private tennis court and so forth), thus reducing the Federal government’s net interest expense and therefore total spending. This reduction on Federal dis-saving implies an increase in private sector saving, in addition to the effects of the reduction of interest payments to the private sector. Given the present Fed balance sheet, this amounts to some $60 billion annually by my estimate.

Of course, the bond sellers now have cash to invest and the supply of investable securities is reduced by the quantity of withdrawn bonds. The Fed expects that securities prices will therefore be driven up, and yields reduced, although this is by no means a foregone conclusion in reality. And yes, to the extent that this cash is used to increase speculative positions in oil and other commodities, commodity prices will be increased leading to a perception of inflation. However, historically there is very little correlation between commodity prices and consumer prices, presumably as increased prices for necessary food and energy result in decreases in spending in other areas.

Fundamentals for the Treasury trade remain intact – powerful deflationary forces from private sector deleveraging are overcoming government attempts to reflate. Recession may well segue into depression in the coming months and years. We have never before seen such a simultaneous global slowdown, so there is little or no history to guide us. It is amusing to note that the BoJ has announced yet another round of QE. This is QE8, no less. Yet they still labor under the delusion that these repeated blows to the private sector’s return on capital are helpful. Economists!

One should be aware that, should economies around the world actually recover, massive inflation will quickly follow as liquidity preferences change. Interest costs will consume government budgets and central banks will rapidly become insolvent as their bond portfolios lose value from rising interest rates. Covering these expenses will require huge increases in government expenditure and the spiral will be off to the races. This doesn’t seem a likely scenario, given the pressures to reduce government deficits in Europe and the U.S. especially, but this is economics so you never know.

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