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June 12, 2009

The Conundrum
by Daniel Aaronson and Lee Markowitz

As per Merriam-Webster, the definition of a conundrum is:
1: a riddle whose answer is or involves a pun;
2 a: a question or problem having only a conjectural answer, b: an intricate and difficult problem.

As the housing bubble was going into overdrive, Alan Greenspan described the low long-term interest rates as a conundrum because long-term interest rates did not rise in concert with the ongoing economic expansion. What the Federal Reserve failed to see was that long-term rates were artificially low because foreign central bankers were aggressively buying US Dollars and Treasuries.

In Congressional testimony on February 16, 2005, Alan Greenspan said:

For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience.

Not realizing the effects of foreign capital flows on long-term interest rates, the Federal Reserve, by not taking action, incentivized Americans to bid up houses and consume beyond their means with borrowed money. The Federal Reserve should have been the know-all, be-all that markets came to believe.

Today, the foreign capital flows that led to Greenspan's use of the word conundrum are disappearing. This is clear as foreign governments cut back on Treasury holdings, largely explaining the rise of long-term government interest rates. In an effort to replace the foreign capital flows that once supported long-term government bond markets, the Federal Reserve is printing money to buy long-term Treasuries. In essence, the Federal Reserve is attempting to recreate the conundrum. Ironically, when the Federal Reserve wanted higher long-term interest rates, it could not achieve its goal. Now that it needs lower long-term interest rates it is also failing.

Daniel Aaronson
Lee Markowitz CFA
Continental Capital Advisors, LLC

Continental Capital Advisors, LLC was formed to offset the destruction of wealth caused by the global devaluation of currencies by central banks. The name Continental Capital symbolizes the 1775 US Currency, "the Continental", which was backed by nothing and quickly became devalued.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Comments within the text should not be construed as specific recommendations to buy or sell securities. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, and / or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Any action taken as a result of reading this is solely the responsibility of the reader.

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