Rates of Interest
The following is excerpted from this week's Notes From the Rabbit Hole, NFTRH 247.
As the 10-year to T-bill yield curve chart makes clear, we are not in Kansas anymore. We are in Wonderland and as you can see, in Wonderland interest rates and their interrelationships are at the center of events.
Last week the bullish case reasserted itself across financial markets, but to argue that policy makers are doing anything better than pumping future distortions into the system is crazy talk along the lines of 'the world is flat' or... 'the above chart is flat'.
Last week Ben Bernanke clarified for people that yes indeed the Fed will eventually taper its QE bond buying operation while making clear that Zero Interest Rate Policy (ZIRP) will remain as is. I think that the average market participant is starting to settle in and get comfortable with the terms of our 'Taper to Carry' (T2C) plan, which sees the banks benefiting from borrowing short and lending longer.
Free market interest rates are rising, the Fed is apparently going to stand aside but keep an inflation mechanism in place with open-ended ZIRP. It is yet another stroke of genius by the Fed because after all, most people - professionals, retail, media - have been absolutely obsessed with the 'will they or won't they?' question surrounding a QE taper.
It's a diversion. Global T bond supply and demand fundamentals will decide the rates of interest on bonds throughout the yield curve. But ZIRP has been so taken for granted, so deemphasized by the media, mainstream financial professionals and policy makers themselves that it seems as though the Fed is considering tightening with the 'taper' talk when in reality, it is laying the groundwork for the next phase of the ongoing inflation operation.
T-Bonds, Gold & Lunatics
The 10-year Treasury bond has made a big picture (monthly) signal the likes of which we saw when gold broke down in Euros for example.
Noted on 12.19.12 at the site 'What's Wrong With Gold?' http://is.gd/MWUVuR
"I am not going to pretend I like the chart of gold in euros. I do not care for it. But gold will be broken below the weekly EMA 100 and the green dotted line and not until."
The weekly chart of Gold-Euro below had just breached the first important moving average and put us on alert, despite the outwardly apparent inflationary macro backdrop as a media bull horned "currency war" was heating up.
Here is the same chart today...
Moral of the story? Respect big picture chart signals despite what we think we know.
So the 10-year bond is now making a bearish signal with very important implications on the macro backdrop. That is because a bearish bond means bullish long-term yields. Meanwhile, the Fed commits to hold ZIRP against this rising yield tide.
In other words, the Fed is committing to maintain an unnatural and inflationary dynamic in a brave new world of financial system micro management. Call the Fed the Red Queen, the Wizard of Oz or...
Call the Fed a dispenser of blue pills if you want:
"Never send a human to do a machine's job." - Agent Smith, the Matrix
So with longer term yields naturally rising vs. ZIRP-pinned T bills, this measure of the yield curve is rising (daily chart above), which promotes an inflationary interpretation. Why is this important? Well, take the monetary metal for example, with its correlation to TNX-IRX using a monthly log scale chart:
Gold bugs did not do much complaining when the correlation broke in the second half of last decade and gold kept rising despite a declining curve (as Alan Greenspan tightened policy on the Fed Funds).
Ultimately, gold (monetary insurance) was forecasting deep troubles ahead for the financial system as the yield curve finally caught most people by surprise when it became widely known that the system could not be allowed to deleverage.
Hence the coming of ZIRP, which blue pill poppers far and wide would believe is the fix, and a normal economic input. 'It'll all be okay' dream the Kool-Aid drinkers as they click the heels of their red ruby shoes (man, this segment just won't quit with the metaphors, mixed or otherwise).
'If only Greenspan had held ZIRP, we would never have had to endure the crisis of 2007-2009' think happy people who approve of current policy.
"Well, if you want to believe that story you can" said Roky Erickson in Creature With the Atom Brain.
Interest rates are being manipulated if you define manipulation as an artificial pressure exerted upon something toward desired ends. Per my Mac's dashboard dictionary:
Manipulation: "handle or control (a tool, mechanism, etc.), typically in a skillful manner"
The key word is control. Control freaks dominate today's Federal Reserve. I know that there are people who would brand this as the ranting of a lunatic doom and gloomer. But this is the same type of ranting that was publicly uttered by this particular lunatic from his first public utterances in 2004 right into the 2008 crisis. The lunacy continues to the current day because my view is that things have not been repaired through policy. On the contrary, distortions have been intensified most notably by the duration of ZIRP, especially now, against a rising yield tide out along the curve.
So just for the sake of argument, I am a lunatic. As I write this segment on Saturday morning a good friend of mine sent me a link to this gold-bearish view http://is.gd/Qrqbns along with a note: "Another mainstream opinion? I hope he is wrong!" to which I ask 'why'? Should we not wish for Mr. Edelman http://is.gd/L54Uwd to be 100% correct in his gold bubble assertion?
Unless you are a gold cult member, you do not want to live in a world where gold is so popular or necessary in helping insure one's financial situation. You want to live in a world where markets perform in accordance with natural laws of supply and demand, rewards for productivity and penalties for waste and misallocation. Oh and maybe you want to live in a world where savers are not so harshly penalized. ZIRP targets little old Grandmas and forces them into the risk pool, after all.
Back on message, gold as a macro indicator (as opposed to heavily gamed cult idol) dutifully followed the more stable 10 year-2 year yield spread right up until the analysis I personally used went right out the window in late 2012 and gold began a negative correlation with the 10-2.
At first I thought that this was due to the man made pressures induced by the inflation-sanitizing effects of Operation Twist. Well, maybe that was the case and today gold is just experiencing what many an asset class has experienced under the heavy weight of the momentum-driven hedge fund community when it gets a bit in its mouth (like uranium into 2007, oil into 2008, copper into 2010 and going the other way, the Yen currently).
It all comes back to 'respect the charts', right?
Gold for whatever reason disconnected from a long-term indicator with which it had positive correlation. The daily chart above shows that the 10-2 turned down after gold did. The red dot could be a bottom in late June. If so, and if gold's current bottom 'W' attempt is something real, the two could again come into positive correlation and rise together. But as of now they are both in downtrends, though showing signs of getting back in alignment.
Our T2C theme is a very real plan that has done nothing but gain credibility, culminating last week when Bernanke himself did not dissuade the market's fears about a tapering of QE but did offer sweet words about ZIRP, which is the front end of inflation and which is now all but systemic and taken for granted.
The spread between the ZIRP-pinned T bill rate and freer Treasury notes throughout the rest of the curve is rising and due to rise further with the implications of a wind down of the yield dampening QE operation as the Fed submits to global bond supply and demand dynamics.
The US banking sector should benefit and the US housing sector... not so much as interest rates rise on the long end.
As for gold bulls, their fate should once again be tied to the relationships between the freer bonds (i.e. non-ZIRPed) on the yield curve. Here is the big picture of the 30 and 2 year yield spread and gold that we have reviewed so many times in the past. When the freer bond market drives up long-term yields (ex. 30) vs. short (2), one interpretation is that the bond market is starting to anticipate inflation. 30-2 is at a logical bounce point (blue arrow):
Currently the Fed is making noises about inflation being too low. This continues to be in my opinion the insane reality of a dysfunctional financial system. But the point is that the Fed is not currently gold's enemy. I would say that the Fed and large banks, which are not coincidently now coming out with some increasing inflation projections and positive views on commodities, are squarely pitted against the 'always taking things too far' hedge fund community and its penchant for milking a trend for all it is worth.
I believe we are on the right path in expecting the current inflation attempt that began with the coming of ZIRP in December of 2008 to morph into a profit motive for the banks, where they will be rewarded first and foremost if the effects of inflation start to become obvious and the rates of interest on their loans rise as the Fed holds indefinite ZIRP on their costs.
Beyond what could be a nearer term rebound in the economy and the broad inflation trade, I also believe that the manipulative distortions being hard wired into the economy will one day end in another major liquidation. I wonder if the most recent green ramp noted on the first chart in this segment starts the clock ticking.
I realize that this segment got a little weird and that I may not be doing a great job of clearly defining my points. But sometimes we should just throw the stuff up there and slug our way through it as a means of gaining perspective. I mean it sure beats the 'buy gold because the world is ending!' crap that carries little sound rationale. It also in my opinion is more valid than robotically repeated Buffett ideology per the above linked gold-bearish article:
"Why do we feel that gold is in a bubble? Simple: Its price is unsustainably high. Warren Buffett recently observed that, with enough money, you could buy all the gold in the entire world -- or, with the same money, you could buy 10 Exxon Mobils and still have a trillion dollars left over. The stock pays dividends, grows in value more or less in sync with company profits, and is in limited supply (there are a fixed number of shares available)."
Right now, the mainstream holds sway and this man is right. The whole point of arguing the value of gold however is not to argue the merits of dividends or value within a system. I'd take return, productive endeavor and value over a lump of metal any day. The point is in arguing the viability of the very system in which these debates take place.
Above I have tried to show that the manipulation of interest rates is a tool used to keep the system appearing viable. I have also tried to show that distortions are built into the system that will one day come to the surface... again. I promise to try to be more concise going forward, but this material is complicated. There is a reason that more and more respected financial professionals and commentators are throwing in the towel due to corrupted market signals. It's a Wonderland, not a normal environment.
I for one resolve to be invigorated by, not discouraged by, the complex situation. After all, if it was easy anybody could do it. Now, finally... let's get to the regular analysis... NFTRH 247 then proceeds to cover precious metals, commodities, stock markets, currencies and the sentiment backdrop.
If you would like analysis that is not afraid to get a little weird on occasion and always thinks for itself, give Notes From the Rabbit Hole a try. After all, this is not the linear and relatively free market of Peter Lynch and a younger Warren Buffett. We must be willing and able to check and re-check assumptions in the face of non-stop policy maker micro-management in an age where inflationary policy is cooked up in opposition to the market's natural need to correct previous excesses (i.e. deflationary pressure).