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Is the Bond Market a Bull Trap?


Banks have exited the Treasury market, leaving speculative money and a lot of risk. There is more speculative money in the 10-Year US Treasury Note than there was in March 2008.

MINYANVILLE ORIGINAL In August, we published an article entitled The Bernanke (Ka)put. In it, we posited that the Fed cannot "print money" without certain unintended consequences. In fact, the phrase "print money" is a misnomer because the Fed actually lends money into existence. All loans must be paid back with interest.

Since the fall of 2008, 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 because it can then lend money to banks at a near-zero rate. They have enshrined this practice into policy, calling it zero interest rate policy (ZIRP). However, this can only last as long as the market allows it.

The Bond Carry Trade

Historically, the federal funds rate has lagged the 90-day T-bill discount rate. The federal funds rate may last only as long as the T-bill rate remains near zero.

Since 2008, the Fed has been able to lend money to the banks at the discount window in order to bail them out of their risky mortgages and loans. From 2009 through April 2011, the banks were able to borrow at near zero percent and invest in Treasury notes yielding up to 4%. This was a bonanza for banks. But the demand for these notes was such that the party couldn't last. Yields were dropping, cutting the profit margins on this so-called "risk-free" investment.

As yields faltered, the asset values in Treasuries increased, offsetting the loss of income. However, each marginal new unit of investment produced lower yields and smaller increases in asset value. In addition, bond volatility became an important factor for institutional investors.
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