Bernanke Conundrum

Overnight markets indicate that Treasury prices are lower and interest rates subsequently higher (remember the inverse relationship between bond prices and interest rates). 2yr Treasury notes are trading at 1.33% and 10yr Treasury notes are trading at 3.85% (both are .03% higher from Friday’s close).

If interest rates are higher, clearly that move must be an indication that economic activity is improving and equity markets should be higher overnight, correct? In “normal” economic times, perhaps that line of reasoning would hold water, but in the Uncle Sam economy, we need to go deeper.

Equity futures indicate our stock markets will open lower by approximately 1%. What’s going on? Welcome to the Bernanke conundrum! What is the riddle wrapped inside our economic enigma? How can Fed chair Ben Bernanke nurse our economy back to health while at the same time maintaining the necessary fiscal independence, integrity, and discipline of robust Fed policy?

Big Ben has used aggressive measures to backstop a wide swath of our markets. In the process, he has created a fair amount of stability but with an effective government guarantee “insurance” policy as the cost of stability. Some of these policies have lessened in size as certain sectors have normalized. However, the major Fed programs remain in place. What are these?

1. quantitative easing: commitment to buy $1.3 trillion in total of Treasury and mortgage-backed securities in an attempt to keep these rates down. Then why are rates rising? More on this in a second.

2. commitment to provide necessary liquidity as needed to support the “wards of the state” including Freddie Mac, Fannie Mae, GM, AIG, Citigroup.

These programs in conjunction with the massive deficit spending programs undertaken by the Obama administration have ballooned our expected funding needs in calendar 2009 to upwards of $3 trillion, a fourfold increase over prior years.

In my opinion, interest rates are moving up much less on any real signs of economic improvement than on these funding needs and very real signs of a monetary printing press malfunction. What’s that? With the Fed Funds rate at 0-.25%, the Fed is literally flooding the economy with cash. Where is that cash going? Is it flowing through to the economy? Not really.

The cash is pouring into the banking system to cushion and support financial institutions from the ongoing losses connected to rising defaults on credit cards, residential mortgages, commercial real estate, and corporate loans.

The market is now very clearly sending a signal to Bernanke, Geithner, Obama and team that if they want to continue their programs as designed (and they do and will), the price, that is the rate of interest, is going up. Why?

The market is very concerned that the flood of liquidity will lead to inflation if not rampant inflation and potentially hyperinflation. How does Bernanke head that off?

Withdraw the very liquidity that he has found so necessary to pour into the financial system. How does he do that?Two ways.

1. increase the Fed Funds rate: that is, make borrowing more expensive.

2. reverse the quantitative easing program so that the Fed actually sells Treasury and mortgage-backed securities into the market and takes liquidity out in the process. What are the impacts of both those maneuvers? Higher interest rates.

In fact, interest rates are moving higher already in anticipation of Bernanke being forced to make these moves. Can Bernanke “thread this needle?” What will happen if interest rates move higher?

Slow the economy, especially housing given higher mortgage rates, and lower earnings especially for financial institutions. To wit, our equity markets are lower overnight.

Nobody said this was going to be easy.

About Larry Doyle 522 Articles

Larry Doyle embarked on his Wall Street career in 1983 as a mortgage-backed securities trader for The First Boston Corporation. He was involved in the growth and development of the secondary mortgage market from its near infancy.

After close to 7 years at First Boston, Larry joined Bear Stearns in early 1990 as a mortgage trader. In 1993, Larry was named a Senior Managing Director at the firm. He left Bear to join Union Bank of Switzerland in late 1996 as Head of Mortgage Trading.

In 1998, after 15 years of trading and precipitated by Swiss Bank’s takeover of UBS, Larry moved from trading to sales as a senior salesperson at Bank of America. His move into sales led him to the role as National Sales Manager for Securitized Products at JP Morgan Chase in 2000. He was integrally involved in developing the department, hiring 40 salespeople, and generating $300 million in sales revenue. He left JP Morgan in 2006.

Throughout his career, Larry eagerly engaged clients and colleagues. He has mentored dozens of junior colleagues, recruited at a number of colleges and universities, and interviewed hundreds. He has also had extensive public speaking experience. Additionally, Larry served as Chair of the Mortgage Trading Committee for the Public Securities Association (PSA) in the mid-90s.

Larry graduated Cum Laude, Phi Beta Kappa in 1983 from the College of the Holy Cross.

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