Tick By Tick Research Email - Monetary Easing vs Treasury Yields

Ever since Captain Ben turned his printer off in March of last year, the world has been a wash with rumours of when the latest round of "easing", or more simply "fiat currency printing", will occur.  Seen as some form of financial saviour, the process of monetary printing has managed to successfully inflate markets and provide the appearance of policy success.  However, as we all know, not even the bearded superman can stop the impending global recession that will be started by debt of profligate European nations.  Not that the print-o-nomic society that we live in has realised this yet.  At this point, I think it would be unfair to point the finger solely at Dr Bernanke as the folks over at the Bank of England, the Bank of Japan, The Swiss National Bank, the ECB (oops!) and a old Zimbabwean man by the name of Robert Mugabe whose HP Laserjet has been pumping out fiat for almost two decades now should also be named.  

To digress for a second.  When there is a sell off in the global markets, the first activity that that we tend to see is the acquisition of vast quantities of US Treasury bonds.  Endorsed by Little Timmy, these bonds are seen as the safest asset out there despite there being over $15 trillion of them.  Strange if you ask me, but some things you just have to accept.  In troubled times, yields take a proverbial nose dive towards the pivotal zero real yield benchmark where, even then, some investors are still prepared to purchase the "super secure" instruments.  Its fine though, it's not like the US has a debt problem is it?  Anyway, back to printing.

When one evaluates how a fractional banking system works, it is clear that the currency of the nation in question will always become debased - or in lay terms, worth less than it was before.  Think of it this way.  I am the economy, there is only $1 in the whole system and the most expensive item is an elusive metal that costs 50cents.  If I print $1 more dollar (or double the money supply); would you, as the seller of the elusive metal, still accept 50 cents for the elusive metal?  (If you are even thinking about saying yes, please get in contact and I will explain why this would be a very bad move).  In reality, the elusive metal should eventually become worth $1.  This is the same process we are seeing with Gold - a metal traditionally worth the same value as one Dow Jones Industrial Average Index or $12 700 to you and I.  

Part of the design of fractional banking is to slowly print fiat currency so that money demand can be met with supply (M2), however what we experience during Central Bank easing is the rapid growth in supply designed to drive down the opportunity cost of lending between different counterparties.  An event that also accelerates the debasement process.  Moreover, similar to the rhetoric behind drug tolerance, the rate of printing required resembles an exponential curve to achieve the same effect as before which further accelerates the debasement process.  

If we take this concept back to the process of purchasing US Treasuries during times of market stress, the market reaction can only be described as counterintuitive.  Given the heightened probability of easing during these periods, the asset based return on investment is almost certainly going to be negative.  Moreover, if yields were to rise, the Federal Reserve would likely intervene in the market to reduce the yields using further easing programmes.  

Using this as a platform, it is my belief that once the European and Japanese smoke screens fade, this process will become further understood and eventually priced into the US treasury market with substantially higher yields than we have experienced in recent times.  Furthermore, during periods of currency expansion - and therefore asset price inflation - it will become natural for investors to question the validity of the single figure nominal yields that a wide variety of financial products and personnel are used to producing.  

After that short introduction, it is time to introduce this weeks articles and media for your viewing pleasure.  We start with a great interview with Bill Gross about the impending end game in Greece before moving onto an interesting graph showing how NYSE's Opex volume for January Expiry has fallen a mind blowing 27% in just 12 months.  Then we move onto the articles starting with a piece by Warwick professor Robert Skidelsky on whether debt matters followed by an interesting comment by Manmohan Singh as to why he thinks centralised clearing for OTC derivatives is avoiding the real issue of retaining risk.  Enjoy!

1)         David Kaufman of Westcourt Capital interviews Bill Gross on Greece (Click HERE [23])

2)         Option Volume for Opex 2011 - Zerohedge (Click HERE [24])

3)         Does Debt Matter? - Robert Skidelsky (Click HERE [25])

4)         The fallacy of moving the over-the-counter derivatives market to central counterparties - Manmohan Singh (Click HERE [26])