Bernanke Resurrects the Bond Vigilantes

By: Chris Temple | Sat, Oct 10, 2009
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At long last, enough of a scare has been put into policymakers to move them into a multi-pronged effort aimed at propping up the value of the U.S. dollar. Following its brief strengthening of a couple weeks ago, the greenback had suddenly begun to fall off a cliff again, threatening late this past week to hit yet new lows for 2009 (as measured by the U.S. Dollar Index.)

The first to take action was Japan's central bank, which sold yen and bought dollars as we slept in our beds Thursday night. That prompted a spike in the dollar's value against the yen in the currency market yesterday; a rally that the dollar enjoyed to a lesser extent against the euro and other currencies. That Japan took action to weaken the yen against the dollar makes sense from their perspective; even after two decades now of, usually, economic lethargy following the bursting of their financial bubbles, things are again worrisome. Most notably, deflation has worsened again in Japan, a consequence most directly of the strong yen. Economic growth there is under threat because Japan's exporters have a tougher time competing against those in China, given that the latter have the "benefit" of having a currency -- the yuan -- pegged to the U.S. dollar (in a recent issue of The National Investor, I explained to my subscribers the significance of China's RENEWED link to the dollar.)

On top of Japan's direct intervention in the currency market, key U.S. policymakers finally deemed it necessary to weigh in with some verbal support of the world's reserve currency yesterday. Federal Reserve Chairman Ben Bernanke has insisted anew that the central bank is ready to tighten monetary policy once the economy shows signs of improvement (naturally, that is left undefined.) White House chief economic advisor Larry Summers quickly weighed in with a "huzzah," adding that the Obama administration knows that devaluing a currency is not the road to prosperity. So, they wouldn't think of doing that!

For good measure -- and to show that it is not relying on mere words -- the Fed tossed out a press release telling us that it has begun small-scale tests of those "reverse repo" trades they announced were coming after the recently concluded Federal Open Market Committee meeting. These transactions -- though they have nothing to do with interest-rate policy -- would, over time, allow the central bank to drain some of the excess reserves from the financial system, ostensibly reducing inflation pressures. The extent to which they are engaging in such things is negligible; and will remain so for some time. After all, the economy is far sicker still than the Pollyannas on Wall Street think. And Bernanke knows this.

But a man who is supposed to be such a great student of history (in Helicopter Ben's case, an expert on the causes of the Great Depression) has ignored a far more recent history lesson; and that has just bought him a BIG headache. Quite apart from Japan's own motives and action, one event Thursday caused hearts to skip a beat or two at the Fed and at the Treasury; and it was not the fact that the U.S. Dollar index sank back to its lowest level of the year. Instead, it was the midday result of the Treasury's latest auction of 30-year bonds.

Now, subscribers to this newsletter know -- even as many others have been scratching their heads over the supposed contradiction of, chiefly, falling interest rates and a rising gold price -- the reasons why interest rates have been so low despite the Fed's massive monetary inflation. That yields have stayed so low even as the dollar weakened has been a veritable mystery to most. The Fed has been thrilled beyond description at this course of events; so much so that it has acted as though it is bulletproof. It had to have seemed like central banker heaven for the Treasury to be able to sell well in excess of $100 billion of paper (net) every month in a declining currency, at absurdly low interest rates and -- best of all -- with buyers tripping over one another in a rush to buy it!

The relatively paltry $12 billion auction of 30-year bonds Thursday, however, has violently shaken folks at the Treasury and the Federal Reserve out of their complacency and smugness. Though the market was pricing the 30-year's yield at 3.98% just prior to this auction, the bonds left at an effective yield of 4.01%. Though not a disaster on the surface, it could be -- and was -- taken as a signal that Uncle Sam's ability to sell his debt under the recent very favorable conditions is not unlimited after all; especially when there is such a lack of interest on his part to lift a finger to defend the currency that paper is denominated in.

Like rats leaving a sinking ship, holders of the longest-term Treasury paper began selling. In a mere 24 hours, through yesterday afternoon, long-term interest rates as measured by both the 10 and 30-year Treasury issues spiked a quarter of a point higher. This took at least some of the starch out of the continuing, gravity-defying rises on Wall Street, where stocks most likely would have closed at decisive new highs for this cyclical rally had rates not spiked and given the giddy bulls there a little pause.

Time will tell whether this initial (?) effort to finally give the U.S. dollar some support will pay off. The history of currency interventions shows that such forays are usually doomed if done from a defensive position, while a currency is falling. Had someone acted a mere week earlier -- as the dollar was on what proved to be a brief upswing -- we would be looking at a far different pictured today. The Dollar Index would still be rallying, stocks and commodities would have gone from boiling to simmering and -- most important of all -- a species thought extinct would not have been resurrected.

That species is known as the bond market vigilante. In times past, these investment managers and traders could be counted on as a reliable "check" on fiscal irresponsibility and currency neglect. If any government -- including that of the United States -- ran up its fiscal deficits or allowed its currency to depreciate, the vigilantes would sell its debt, causing rates to spike and enabling the markets to do what the government in question would not do.

Mark this last week down. Ben Bernanke (and, to be fair, the Obama Administration as well) had the best possible world, as I described earlier. Especially due to the dollar's enhanced reserve status as, now, the carry trade currency of choice, they might well have been able to go much longer in selling their debt at rock-bottom rates, had they shown just a little concern a little sooner over the dollar. They did not; and, now, they have brought the bond vigilantes back to life.

That Bernanke in particular did not recognize this (when, truth be told, has he EVER done anything right?) shows he's not such a great history student after all. For he may have just started in motion a chain reaction which -- though it will probably be a bit slow in developing -- will cause a repeat of what we saw in 1987.

In the current issue, I describe the events that led to the shocking Crash in the stock market of that October. All the same things were present: a Federal Reserve neglecting the dollar, followed by the bond market's rebellion against that policy. The resulting spike in interest rates was, for a while, ignored by the stock market. But finally -- just like Wile E. Coyote hanging in mid-air when his Acme rocket boosters ran out of fuel -- the stock market had to crash.

If he's fortunate, Bernanke will get some help in the near term as the economic news is actually deteriorating anew. That might finally serve to bring about overdue and needed corrections in stocks and commodities, which themselves would lead to a firming of the dollar. All that will do is buy some time, however; and during this time, the now-awakened bond market vigilantes will be rubbing the sleepy bugs from their eyes and scrutinizing the whole situation.

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Chris Temple

Author: Chris Temple

Chris Temple, Editor
The National Investor

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