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The Inevitable Market Deleveraging Will Occur, Whether the Fed Wants It or Not

Phoenix Capital Research's picture




 

 

By engaging in QE, the Fed alters the very structure of risk in the financial system. Traders on Wall Street, knowing full well that the Fed would be soaking up Treasuries, rushed into new debt issuance with the intention of flipping over these assets to the Fed in the near future.

 

This became a self-fulfilling prophecy as the “front-running the Fed” trade became a dominant theme for Wall Street. By piling into bonds, traders forced prices higher and yields lower: precisely what the Fed wanted.

 

It is critical to note that a significant percentage of these investors had no interest in actually owning US debt as an asset class in the long run. They were simply looking for an easy trade that made money. As a result, interest rates were driven even lower by the “investment herd”.

 

All risk in the financial world ultimately traces its pricing back the yield on US Treasuries. US Treasuries are considered to be “risk free” because they are backed by the full faith and credit of the US Government.

 

All other, riskier assets (corporate bonds, municipal bonds, emerging markets bonds, then stocks and emerging market stocks) trade based on their perceived riskiness relative to Treasuries yields. By manipulating interest rates lower, both directly (cutting rates) and indirectly (by broadcasting its intention in buying Treasuries, thereby incentivizing traders to front run it) the Fed altered the capital market landscape in ways that few investors understand.

 

By maintaining artificially low interest rates, the Fed was hoping to drive investors away from bonds and into stocks and other, more risky assets. The Crash of 2008, combined with a retiring or soon to retire Baby Boomer population that is more interested in income than capital gains, resulted in a mass exodus away from stocks in the 2009-2013 period.

 

By keeping interest rates near zero, the Fed has been hoping to push investors into the stock market. The hope here was that as stock prices rose, investors would feel wealthier (the “wealth effect”) and would be more inclined to start spending more, thereby jump-starting the economy.

 

This has not been the case. Instead the entire capital market structure has become mispriced.

 

Individual investors have been fleeing stocks for the perceived safety (and more consistent returns) of bonds. Since 2007, investors have pulled over $405 billion out of stock based mutual funds. The pace did not slow throughout this period either with investors pulling $90 billion out of stock based mutual funds in 2012: the largest withdrawal since 2008.

 

In contrast, over the same time period, investors have put over $1.14 trillion into bond funds. They brought in $317 billion in 2012, the most since 20008.

 

This had the effect of pushing yields even lower (precisely what the Fed wanted).

 

 

As you can see, today rates are the lowest they’ve been in over fifty years. This is not a sustainable trajectory. Real estate and all other assets that have been financed via cheap debt have been pushed higher due to excess leverage. This includes GDP.

 

In the 1960s every new $1 in debt bought nearly $1 in GDP growth. In the 70s it began to fall as the debt climbed. By the time we hit the ‘80s and ‘90s, each new $1 in debt bought only $0.30-$0.50 in GDP growth. And today, each new $1 in debt buys only $0.10 in GDP growth at best.

 

Put another way, the growth of the last three decades, but especially of the last 5-10 years, has been driven by a greater and greater amount of debt. This is why the Fed has been so concerned about interest rates. It’s also why ultimately the Fed’s efforts to reflate the system will fail on some level with the inevitable market deleveraging occurring one way or another.

 

Be prepared.

 

For a FREE Special Report outlining how to protect your portfolio a market collapse, swing by: http://phoenixcapitalmarketing.com/special-reports.html

 

Best

Phoenix Capital Research

 

 

 

 

 

 

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Fri, 10/25/2013 - 17:13 | 4091412 max2205
max2205's picture

Again, GFO!

Fri, 10/25/2013 - 16:01 | 4091203 Deo vindice
Deo vindice's picture

"In contrast, over the same time period, investors have put over $1.14 trillion into bond funds. They brought in $317 billion in 2012, the most since 20008."

Wow! Zeros do count. We just skipped by 18,000 years of history in no time at all.

Fri, 10/25/2013 - 18:20 | 4091550 U4 eee aaa
U4 eee aaa's picture

That tends to happen as you get older

Fri, 10/25/2013 - 18:02 | 4091516 SKY85hawk
SKY85hawk's picture

It's decent profit as long as yields go down, prices go up!

Betc'ha not one person in a hundred understands this.

Perhaps that's part of China's and Bill Gross's strategy?

 

Fri, 10/25/2013 - 15:21 | 4091054 Fuh Querada
Fuh Querada's picture

Ny dog craps better stuff than this post.

Fri, 10/25/2013 - 14:56 | 4090948 SheepDog-One
SheepDog-One's picture

The FED created the new massive bubble, and implode it when they want to, that's all.

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