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Analyzing the QE Meltdown, Ex-Ante


Correlation does not imply causation.


Late Friday, Egan Jones exhibited ex ante analysis and downgraded US Treasury debt by one notch to AA- due to the inflation risk as a result of QE III. Many in the street brushed this off as irrelevant, but I think Egan Jones raised a valid point and his reasoning is in line with a risk we addressed in The Bond Market's China Syndrome in early August.
Today... the conditions are in place for a similar rise in yields. In addition, with long duration coupons substantially below their level in 2010, a move just back to where yields were before last year's August equity market crash would produce a massacre in the bond market, potentially leading to a dangerous self-fulfilling meltdown.

The US fiscal situation is no different than Europe, and you can bet that if our yields start rising, our credit condition will rapidly deteriorate. This will feed on itself. Suddenly sentiment will shift and our reliance on foreign financing will be at risk as the reserve currency status is called into question.

So we have a situation here where there is a tradeoff between inflation, employment, and interest rates. It's not clear to the market what level of inflation is acceptable to Bernanke to bring down unemployment, but it is clear that the market is prepared to respond and there is an interest rate limit that would threaten US solvency. What is max pain for the US Treasury? I don't want to find out, but maybe Bernanke does.

The ex post analysis of QE III has been focused on the Federal Reserve keeping interest rates low for a very long time, concluding that bond yields will also remain low. The ex ante analysis has been focused on the implications of the inflationary discount in the long end of the curve and concluding that the conditions are in place for a nasty spike in interest rates that could manifest itself into a full blown meltdown.

I'm not calling for a bond market crash and maybe Bernanke can hold it together, but last week was a shot across the bow. I've said it many times before: Bernanke is prone to blowing up his own trade -- and if he's not careful, he may blow up the biggest one of all.

Twitter: @exantefactor
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