The Fed is Cornering Itself

Andy Waldock |

The government shutdown has passed and the markets are still here. The stopgap measures that kicked the can into early next year merely provided a buying opportunity in the interest rate sector for the top 1% while providing the catalyst for the final leg up in a bubble that makes the housing issue of ’07 look like an appetizer. Recent reports suggest that two separate papers presented at the International Monetary Fund meeting this week highlight the potential for a serious revision and extension of the fiscal stimulus plans already in place. Given the current nature of our markets, it’s hard to see how this doesn’t turn sour in the long run.

The Federal Reserve Board has two primary objectives; fostering full employment and stabilizing market prices. Historically, market prices referred to those things in life, which affect all of us like, milk, gasoline and farmland. This perspective has increasingly shifted towards the stabilization of more esoteric prices like the stock markets and interest rates. This shift in focus was originally designed to prop up a swooning stock market as well as getting capital flowing again during the heart of the economic collapse of ’08. The markets came roaring back with equities more than doubling and reaching all time highs this year and interest rates have bumped along at historic lows ever since.

The Fed achieved their goal of stabilizing prices ages ago and it has been proven that each additional increase in Quantitative Easing has been exponentially less effective than the previous one. This path will be followed for the next four years as Janet Yellen is handed the reins of the Fed next year. Why would the smartest minds ignore the data that so clearly illustrates these points? The simple answer is that, “and in other news, the Dow Jones Industrial Average reached another new high today,” sounds like a win to the average John Doe. The truth is that the average John Doe has never participated less in a stock market rally. Furthermore, the headline unemployment rate of 7.2% does not take into account that the labor participation rate is at a 35 year low. Therefore, the unemployment rate as published fails to include 90 million Americans who’ve simply given up looking for work and are drawing no unemployment assistance, thus no longer counting as unemployed.

Recent talk of tapering off the $85 billion per month Fed bond buying programs spooked the equity markets and sent the bond market plummeting, and rightly so. There’s no question that the excess capital created by the Fed must end up somewhere. We’ve seen a full rotation out of stocks and interest rates and into commodities and gold. Now, it’s out of commodities and back into interest rates and equities. The government shutdown created the mother of all buying opportunities in the interest rate sector and I believe this could lead to the final phase of an interest rate bubble that dwarfs the housing bubble because the big money knows the Fed is too scared to take their foot off of the accelerator and has backed themselves into a corner due to their willingness to manipulate prices on the open market.

We’ve already seen some of the smartest bond money in the world step aside with Bill Gross of Pimco choosing to exit the 30-year bond bull. However, like most smart money, he’s probably early on the way out and will probably miss the last leg up. Although, he was recently quoted about buying the bottom of the shutdown that it was like, “picking up pennies on the street. Somehow, I think he’ll survive. His pennies are not the same as my copper pennies. Banking analyst Dick Bove said on CNBC that the US balance sheet shows us at $16 TRILLION in the hole. Most of this is coming due between 2018 and 2020 as the Fed has taken advantage of lower yields across the board to increase the average length of maturity from 4.1 to 5.4 years since 2009.

Finally, the two papers presented this week will suggest that we EXTEND the length of the QE programs from the original goal of 6.5% unemployment and 2.5% inflation to perhaps 6% or even 5.5% unemployment as inflation is yet to rear its head. The Fed has increased its monetary base from less than $1 trillion prior to the economic implosion to more than $3.6 trillion. If the economic stimulus is the cause of the decline in unemployment from 10% to 7.2%, not counting a quarter of the US population who’ve quit looking for work, then a linear equation suggests that another $1 trillion would get us to 6% unemployment.

Current bond market expectations suggest the 10-year Treasury Note may close the year near 2.25%. That’s approximately 60 basis points above our current price of 126^27. The market would have to reach a new all time high of 133^13 for yields to decline this far. This represents a $6,500 rally per contract in the 10-year Note futures. Given the nature of the bond market, I expect to be able to get this market bought around the 125^00 level and would risk the trade to the 16-day government shutdown low around 122^00. This would provide a risk to reward of $3,000 to $8,400. While we fully intend to trade the bond rally, our primary concern remains focused on what happens once it’s over. The big question remains, “How can the Fed weasel its way out of a situation that they created for themselves while continuing to suggest not only its continuation but, its continuation beyond the original scope of its design?”

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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