On Wall Street

October 29, 2010 7:20 pm

Fed set for higher stakes in the crisis casino

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Critics often denigrate financial markets saying they are nothing more than a casino.

For some time the US Treasury bond market has not been a free market where interest rates are determined by investors.

Having artificially, as it were, lowered Treasury yields with round one of quantitative easing, or QE last year, and resumed buying modest amounts of Treasuries in August, the Federal Reserve is set to fire up QE2.

The presence of such a “big buyer” means the game of hot potato in the bond market will only become further entrenched, as traders and savvy investors focus on holding specific bonds with the expectation of selling them at better prices to the central bank.

As the Fed’s presence assumes a larger scale in the bond market, so the more distorted Treasury prices will become, rippling through the rest of the US fixed-income market which is priced over government bond yields.

The ever growing presence of the Fed – when Treasury yields already sit at very low levels – is seen by many as setting the stage for an enormous bond bubble that promises to end badly for all investors who have pumped record sums of money into bonds and bond funds since the financial crisis.

No less an authority on bonds, Pimco’s Bill Gross, this week labelled QE2 a “Ponzi” scheme.

The rationale behind QE2 is to lower Treasury yields and force investors into riskier assets. It reflects the desire of some Fed officials, notably Ben Bernanke, the central bank chairman, for a higher rate of core inflation.

While Fed officials concede there is a risk that QE2 may not work, deploying extraordinary monetary policy is seen as being the sole weapon left for boosting the economy. Against the backdrop of massive fiscal deficits and the strong likelihood of political gridlock after next week’s Congressional elections, further government stimulus is not an option.

The anticipation of QE2 has boosted equities and commodity prices and sent future inflation expectations sharply higher as the dollar has slumped. Higher stock prices will help some consumers weather the downturn in housing and sluggish wage growth.

The hope is that this “wealth effect” feeds a virtuous cycle and breaks the shackles of a lacklustre recovery that is weighed down by the bursting of the mortgage bubble. It is certainly a scenario that bullish stock analysts and investors are shouting loud and clear across Wall Street.

Except there is a strong risk that the recent rally in risk assets is simply a case of the Fed pumping more money into the system and ultimately, like all “highs”, the initial rush will fade.

Then there’s the real problem with QE, namely that for it to work Treasury yields must be compressed to extremely low levels. But, once that has sparked a stronger recovery and presumably rising inflation, owning bonds paying low rates of interest would be ruinous for investors. Hence the charge of QE constituting a Ponzi scheme.

This is the corner the Fed has backed itself into and why Treasury yields have been rising recently. In a sense, the bond market is already “gaming” the Fed, pushing policymakers to make a serious commitment to QE.

No one doubts that the Fed will also try and game the market. But with the central bank itself divided as to the merits and likely consequences of QE, it is doubtful that it will unveil a massive programme of purchases or surprise the market and buy a chunk of 30-year bonds – which rose above 4 per cent this week for the first time since August – strongly reducing the already low chances of this policy gamble working.

Either way you cut it, QE2 looms as being nothing more than an exercise in temporarily boosting trading profits for bond dealers and their clients, while providing little stimulus for the economy.

That’s what you get with a central banker established as a house dealer in Treasuries. But unlike in an actual casino, bond traders are allowed to sit at the table and count the cards.

E-mail: michael.mackenzie@ft.com

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