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The Bernanke (Ka)put


Now that we have peeked behind the curtain, we can see that "money creation" by the Fed is really loans at near-zero rates funded by hapless investors attempting to avoid risk.

MINYANVILLE ORIGINAL The title of this article does not contain a typo. According to the Merriam-Webster dictionary:

ka·put adj k?-?pu?t, kä-, -?püt
Definition of KAPUT
1: utterly finished, defeated, or destroyed
2: unable to function
3: hopelessly outmoded

Somehow, the "Bernanke Put" has become an article of faith, at least among more than a few investors. The idea that the Fed can "print money" into infinity seems to be a central theme of the inflationist camp. Let it be known in no uncertain terms that the Fed does not print money into existence. It lends money into existence. As with all loans, it must be paid back…with interest.

Since the fall of 2008, due to the heightened risk in equities, money has been pouring out of the stock market in unprecedented amounts, flooding the money markets and reducing interest rates to near zero. This has been a gift to the Fed, since it can turn around and lend money to banks at a near-zero rate. The Fed has enshrined this practice into policy, calling it Zero Interest Rate Policy (ZIRP). However, this can only last as long as the market allows it. Historically, the federal funds rate has lagged the 90-day T-bill discount rate. This is especially evident in rising or falling interest rate environments. The following chart shows the actual fed funds rate juxtaposed against the 90-day T-bill discount rate.

Now that we have peeked behind the curtain, we can see that this "money creation" by the Fed is really loans at near-zero rates funded by hapless investors attempting to avoid risk. Today's 90-day T-bill discount rate hovers between .08% and .10%. Little wonder that the Fed can lend this money at "giveaway" rates averaging .25%.

And now for the other side of the equation. Since 2008, the Fed has turned around and lent this money to the banks in an effort to jump-start the economy. However, the banks were just as risk-averse as our hapless investors mentioned above. Rather than lending money to risky businesses in a floundering economy, banks took the easy way out. Thus, the bond carry trade was born.

The banks could take Fed money at .13%, invest in 30-year T-bonds with a yield as high as 5.066% and pocket the spread, when the going was good. However, good things don't last. The gravy train has left the station and all that is left is a crowded trade. In fact, to counteract this new development, banks took on more leverage: 25- and 30-to-1 leverage is now 50-to-1 and possibly more.

One offsetting factor to reduced yields in bonds is capital appreciation. This allows the banks to re-lever as often as their net asset value (or NAV) continues to rise. This is similar to the homeowner who refinanced his mortgage or took out a home equity loan as the perceived value of the home rose. Unlike the homeowner, the bond market is not dictated by a friendly appraiser and a lot of fudge. The market will tell you what your bonds are worth down to the minute. This may already be setting up a massive squeeze on bondholders.

The exodus from bonds is just beginning. Banks in the carry trade are being squeezed from both directions. In the past month, yields have risen from 2.45% to 2.91% while NAVs in the 30-year US Treasury bonds have declined by 4.55%, causing nearly a 2-year loss of interest income. Banks that bought or re-levered T-bonds in July are in a very dicey position. This may be the reason why the Fed re-started its repo operations two weeks ago and injected $810 million in to the banking system to increase reserves.

There are three technical reasons why the 31-year bond market rally may be over.
  1. The Triangle formation straddling the New Year is often seen as the next-to-last formation before a major reversal.
  2. The Elliott Wave analysis shows 5 waves indicating a completion of trend to at least two degrees.
  3. The Broadening (Megaphone) formation is often associated with market tops.
If these technical indicators prove correct, the reversal may be swift and deep. The Bernanke put may be kaput if it is:

1. utterly finished, defeated, or destroyed
2. unable to function
3. hopelessly outmoded
4. all of the above.

See more from Anthony M. Cherniawski at The Practical Investor, and more from Janice Dorn, M.D., Ph.D. at Trading With Art and Science.
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