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Wednesday January 19, 2005 - 20:08:25 GMT
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Forex: Fed Official Notes Foreign Demand For US Bonds...Is It Distortionary? Desirable?

Fed Official Notes Foreign Demand For US Bonds...Is It Distortionary? Desirable?

Fed Governor Bernanke today sounded as if he was making an observation that long-term rates in the US are so low because of foreign demand. But I think there was more to it...the Fed Dec14 FOMC minutes noted that a long period of ultra low rates had created a distortion in risk taking...taking on too much risk. The spread between short and long rates is one measure of risk and they are very low. With Fed officials out on the road in the last two weeks since the Jan04 release of the Dec14 FOMC minutes promoting reasons to be worried about inflation, US spreads should be widening and they are not. Nearly every major money manager and bond trader has tried to short the long-end, or buy steepening trades and they have gone nowhere. On the face of it the market seems to be in disbelief about the Fed's rising concerns over inflation (more practically the Fed's fear that it took rates too low for too long and needs to correct the situation pronto or inflation will resurface down the road). So with all the drumbeats from the Fed since the Dec14 FOMC minutes the only logical reason for why bond yields are not rising is foreign buying. Does the Fed really want to go there? To me anyway foreign buying is a euphemism for foreign central bank buying...namely Asian central banks buying US Treasuries with intervention dollars. In other words the market is being prevented from functioning by distortions created by massive currency intervention or manipulation in the Far East (and to some extent the Middle East). I think one would have a hard time finding a period in US economic history with the US economy growing at 4% (consistently), unemployment rate under 6%, core CPI at 2.2% and the spread between the 2-yr and 10-yr notes under 100bps. Actually it is 94bps today and last time it was only 94bps was in May 2003 when Ben Deflation Bernanke was telling bond traders the Fed would drop money on the economy from low flying plans to prevent deflation if it had to, even with a zero Fed funds rate. And the time before that was never. So why is the US yield curve so flat so deep into the expansion and the same deflation mongers beating a new drum of inflation? My belief is that currency managers in Asia and the Middle East are creating a very distorted US yield curve that may well be fuelling malinvestments...distorted views of credit risk and increased leveraging. The Dec14 FOMC minutes noted speculation in some housing markets (one Fed official said recently that he would not want to be a new home buyer in the current housing market). So the efforts of Asian monetary authorities to protect export markets by slowing or preventing currencies from appreciating is coming home to roost in the US and seems increasingly uncomfortable for Fed officials. And what about the other side of the balance sheet? What about all the won, Taiwan dollar, Singapore dollar, Hong Kong dollar and Renminbi that officials sell to keep currencies in line against the almighty dollar? It should be boosting the money supply (if unsterilized)...which is inflationary. Or in some cases like Korea, the government issues bonds to finance currency intervention...crowding out, higher cost of borrowing and depresses investment. None of these policies are sustainable. And they all face huge exposure to one asset class and currency...US gvt bonds and the dollar. Greenspan in some respects got markets to focus on the unsustainable growth in the US current account deficit back in November. Perhaps now he will get markets and G7 to focus on unsustainable currency policies in Asia that have led to artificially low US interest rates that may be the seeds of a future US inflation problem or worse, financial market dislocations.

David Gilmore


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