Guest Post: QE And The “Crowding Out” Of The Bond Market Vigilante

Tyler Durden's picture

Submitted by Global Macro Monitor

QE and the “Crowding Out” of the Bond Market Vigilante

We’ve updated our chart of the sources of financing of the U.S. budget deficit from the Fed’s Flow of Funds data released on September 16th.   The chart illustrates how the Fed and foreign central banks have been indirectly fully funding the  massive U.S. budget deficit for the last three quarters.   It will be interesting to see the data for the quarter ending today as no doubt there will be less yellow with the end of Q2 on June 30 and more “flight to quality” blue (domestic) and red (rest of world).

Ronald McKinnon, professor of international finance at Stanford University, has an excellent piece in today’s Wall Street Journal about the damage the Fed’s zero interest rate policy (ZIRP) is doing to the U.S. and global economy.  One of his main points is the Fed and other central banks, who are not yield sensitive,  have been financing the U.S. budget deficit and crowding out the now extinct U.S. bond market vigilante.

As you know the Global Macro Monitor is not a fan of ZIRP and believes it one factor that ails the economy not what will cure it.  We take comfort to be the same company of such an intellectual heavyweight as Professor McKinnon.

The professor makes several excellent points in his piece,

Without the [bond market] vigilantes in 2011, the federal government faces no immediate market discipline for balancing its runaway fiscal deficits.


…the vigilantes have been crowded out by central banks the world over.  [see the yellow/red bars in the chart]


Central banks generally are not yield-sensitive.


True, in the last two months, this “bubble” of hot money into emerging markets and into primary commodities has suddenly burst with falls in their exchange rates and metal prices. But this bubble-like behavior can be traced to the Fed’s zero interest rates.


Beyond just undermining political discipline and creating bubbles, what further economic damage does the Fed’s policy of ultra-low interest rates portend for the American economy?


First, the counter-cyclical effect of reducing interest rates in recessions is dampened…


Second, financial intermediation within the banking system is disrupted…


Third, a prolonged period of very low interest rates will decapitalize defined-benefit pension funds—both private and public—throughout the country…


Perhaps Fed Chairman Ben Bernanke should think more about how the Fed’s near-zero interest rate policy has undermined fiscal discipline while corrupting the operation of the nation’s financial markets.


(click here if chart is not observable)

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props2009's picture

What is scary is yield expansion for Chinese bonds and chinese CDS and German CDS all of which has started to rise to 3year highs.

Motley Fool's picture

This is bullish for ink and paper. :P

achmachat's picture

and for everything "real" that has to be bought with an ever-expanding supply of Federal Reserve Notes!

Yesterday I was "reading" an old Duck Tales comic in which it is stated at least 5 times that only precious metals are real money. Incidently, that episode was about a stamp that's sooooo precious because there's only one of them in the world, that is until Donald finds an entire supply of it, hence making the stamp worthless. Perfect metaphor of the Federal Reserve Notes that keep losing value as they are printed and created out of thin air.

Nevertheless, today is an awesome day, as there's 165 troy ounces of beautiful shiny silver arriving in the afternoon to join the rest of the stash!

The Deleuzian's picture

I love those old Disney cartoons (way before my time but way ahead otherwise)...  There's many examples of this in modern numismatics...Morgan dollars that were $1000's of dollars in the 60's before the great Carson City and old school New Orleans Mint hordes were found... I personally know someone with a whole roll of the 1955 Double-Die Lincoln pennys ...Only goes to show.....

daily bread's picture

Let's see, roles of the FED:

1. Does it buy most of the country's mortgage debt?  CHECK

2. Does it buy most of the country's public debt?  CHECK

What else can a "poor" money printer to do? I forecast:

3. Buying the last big chunk of private debt -- it will start to issue credit cards, bearish for VISA/MASTERCARD.

4. Buying the last big chunk of public debt, i.e. states/municipals.

Motley Fool's picture

All your debt are belong to us?

Downtoolong's picture

Don't forget those student loans. Even living in your parent's basement won't pay those off if you can't get a job.

swissaustrian's picture

This chart has a weimarian character...

The Deleuzian's picture

Looks to me from the bar graph above that the Federal Reserve is the Bond Market...To be honest...I don't even know what that means!  The repercussions from this is dangerous...One of those 'unknown unknowns' I suppose

Sri's picture

I agree that is one scary chart but isn't the objective of any QE is to force money that would have gone into government debt to go into a more productive arena to generate economic growth (you lower government interest rates to 0 and send those looking for return into other areas that need investment).  It looks like that money just went to prop up equity markets. 

Bastiat's picture

Another objective of QE is to buy the UST debt at unrealistic yields to keep the UST from going broke.

kahunabear's picture

Liar loans had pretty good rates at one time too. Markets are easily manipulated and not always efficient.

sbenard's picture

Good article. Thank you!

It was interesting that Professor McKinnon makes the case that the Fed's ZIRP has suppressed the very economic activity it was intended to boost. I read his entire article, and it was very enlightening!

Bicycle Repairman's picture

"…the vigilantes have been crowded out by central banks the world over.  [see the yellow/red bars in the chart"

Bond vigilantes?  They were castrated long ago.

Belarus's picture

I have modeled it and the stock market needs to crash 14%, 22%, 32%, then 50% to fund our ongoing unfunded deficits in the years to come.

The other other place the kind of money our treasury will need in the Federal Reserve montezing our debt. 

The third option is if Super Congress or interest rates forced the government to plug the unfunded hole, Super Congress has no chance in hell of doing that while interest rates explosing north of 10% WILL get the job done.

Everything, queing Tepper's best voice, everything else is just noise. Europe just hastens the day.

malek's picture

-- (wrong thread)