Bonds and the Fading Recovery

Recently by Gary North: The Fable of the Bees (UPDATED)

Some commentators on the U.S. economy and the European economy are predicting that there will be “quantitative easing” soon. This is a euphemism for central bank inflation.

I have been reporting for months that the present policy of the Federal Reserve System is to deflate the money supply. The chart of the adjusted monetary base since early March indicates this. Similarly, consumer prices have remained flat or close to it this year.

I believe that, at some point, the FED will begin to inflate. But, for now, there is no need. The economy is not falling sharply. There are increases in factory production. Consumer optimism, while falling this month, is still above 50. The unemployment figures remain high. But there is no visible increase in the figures. The FED is not getting blamed for anything objectionable. When the FED gets no criticism, this is good news at the FED. “If it ain’t broke, don’t fix it.” The FED is not inflating.

The FED can expand M1 with no trouble. It can impose a fee on excess reserves held by commercial banks at the FED. The FED pays the federal funds rate to banks. This is under 0.25% most of the time. The risk to the FED of imposing a fee is that this will send a signal to the bond market: “Sell!” Why should this be a “sell” signal? Because fund managers will perceive this as a reversal of policy: quantitative easing.

Quantitative easing was the FED’s policy in October 2008, when it doubled the monetary base. That was to prevent a meltdown of the capital markets, especially big banks. This was the largest increase in the base money supply in one month in American history. The FED got no criticism.

So, the FED expanded the monetary base. As it has turned out, “So what?” was the correct question. That is because commercial banks did not lend these funds. They increased their holdings of bank reserves at the FED instead. They offset the increase in the monetary base. This kept M1 from doubling. It kept prices from doubling. This saved the FED from the worst crisis in its history.

The policy of the commercial banks to forego lending for the sake of guaranteed reserves indicates that bankers do not trust their banks’ balance sheets. They do not want to be subject to withdrawals by other banks. This is why they have excess reserves. They can point to these reserves as proof of their solvency, which is in fact the case.

Because the banks are not borrowing from each other to meet their reserve requirements, the federal funds rate is at the lowest in history. This decrease in demand, not Federal Reserve policy, is holding down the FedFunds rate, which is the only rate that the FED controls directly through its purchases of Treasury bills.

The media attribute the low FedFunds rate to intervention by the FED. Bernanke does not give a speech to some bankers’ group or testify to Congress regarding the actual cause of the low rates. He does not hand out a copy of his speech that says this:

There has been considerable confusion in recent months regarding the cause of a federal funds rate barely above zero since late 2008. The financial media attribute this to Federal Reserve expansion. This explanation is incorrect.

The Federal Reserve has maintained its balance sheet’s gross asset base ever since the crisis of October, 2008, when it doubled the monetary base. For almost two years, the FED has been selling off its liquid Treasury debt. We had to do this in order to buy the otherwise illiquid bonds of Fannie Mae and Freddie Mac. Without the FED’s purchases, there would have been a crisis in financing for mortgages.

In April, the Federal Reserve ceased buying F/F debt. Today, the People’s Bank of China is the major purchaser of agency debt, meaning Fannie and Freddie Mac mortgage debt bonds. We can see this reported monthly in the Treasury’s “Treasury International Capital” report, the report with the infelicitous acronym TIC. When people hear “TIC,” they immediately think “TOC.” Nobody in the financial world wants to think about TOC, whatever it may be.

The Federal Reserve has adopted a slightly deflationary policy since late February. This may or not be part of our promised policy of unwinding. I’m not going to say here. If I say it is, there might be a sell-off of the stock market and a mad rush to buy Treasury bonds. The Treasury would like that, of course, since it would lower T-bond rates. But that would hit the profits of the largest U.S. banks, which are making a killing on the spread between the Federal funds rate and the T-bond rate.

Let’s face it: the large banks are sticking it to their depositors big time. The depositors get almost nothing, and the banks get guaranteed money from the Treasury on its AAA-rated bonds. Yes, I know: the credit-rating agencies have taken a lot of criticism for giving AAA-ratings to the illiquid leveraged debt contracts that the banks swapped with the Federal Reserve at face value for liquid Treasury debt in late 2008 and early 2009. But if it were not for the AAA rating, who would buy U.S. Treasury debt today? Not the Federal Reserve’s fully vested pension fund, let me tell you! Anyway, the present cause of the historically low FedFunds rate is the fact that banks are not borrowing overnight to cover the paper-thin margins between their reserve requirements and the money they have loaned out. No one is loaned out anywhere near the maximum allowed by Federal Reserve policy.

Why not? Because the bankers are scared out of their wits over their own balance sheets, whose assets are listed at face value, according to the Financial Accounting Standard Board’s reversal in 2009 on FAS #157, which required banks to list assets at market value. What if the rule gets changed back? With commercial real estate assets down 40% and likely to fall a lot more over the next two years, what banker wouldn’t be scared? We here at the Federal Reserve are not about to rock the boat. We sit here, as good stewards of the legal monopoly over the money supply that was granted to us by the government in 1913. We are not sure what the commercial banks would do if we started charging interest on excess reserves. So, we just keep paying them next to nothing and cross our fingers. So far, so good.

For the latest report on the Treasury’s TIC report, click here.

China has been buying agency debt, which at least pays above the T-bond rate.


According to a recent report on Bloomberg, America’s bond dealers have begun to pull out of the market for Treasury bonds. “For the first time since the government started collecting the data, central banks, mutual funds and U.S. banks are buying more government securities at Treasury auctions than Wall Street’s bond dealers.”

Then who is buying the bonds directly at Treasury auctions this year? Foreign investors, mainly central banks, and individuals and fund managers. They have bought 57% of the bonds, compared with 45% at this time a year ago, and 32% in 2008.

What is going on? The reporter speculates that this is the result of a low rate of price inflation coupled with fear that the recovery has stalled. This has created demand for government bonds. The 10-year bond is paying below 3%.

There is no fear of inflation, one fund representative said. The bigger fear is deflation.

As to what kind of deflation, the article did not say. Deflation of stock indexes, perhaps. Why there should be fear about lower prices is a mystery to non-Keynesian economists. Shoppers want lower prices. So what?

The interest rate on 10-year notes fell to 2.9%. It has not been that low since December 2008, after the collapse of Lehman Brothers. There was a rush toward AAA safety then. It is happening again.

Then what of the recovery? Investors are investing as if they do not take it seriously.

On July 16, the rate on 2-year notes fell to just over a half of a percent, an all-time low in the post-War era.

Consumer confidence is down to 66.5, according to the Thomson Rutgers/U. of Michigan index. Retail sales (except for autos) have fallen for two consecutive months for the first time since 2008. New home sales fell to a record low in May, after the first-time home buyer tax credit was allowed to die.

The article parroted the line about Federal Reserve policy.

Even bond-market bears such as primary dealer Morgan Stanley have trimmed forecasts for U.S. yields to rise in the second half of the year, with slow growth likely to keep the Federal Reserve from increasing record low borrowing rates into 2011. The target for overnight loans between banks has been zero to 0.25 percent since December 2008.

The assumption is that the FED is keeping rates low, and is not expected to increase “record low borrowing.” The Federal Reserve has nothing to do with record low borrowing, except insofar that its deflationary policies are expected to tank the economy. Bankers do not like to lend money prior to a tanked economy.

Morgan Stanley of New York has lowered its estimate for the 10-year yield at the end of the 2010 to 3.5 percent from 5.5 percent at the start the year. The median projection of 55 forecasts in a Bloomberg survey is 3.36 percent, down from 3.80 percent in June.

This indicates that Morgan Stanley had its head in the clouds earlier in the year. If these analysts assumed 5.55, they assumed something like a boom economy. They must have assumed the hoped-for V recovery.

Primary dealers, which are required to bid in government auctions and act as the trading partner to the New York Fed, have won the lowest proportion of Treasuries in auctions since the government began releasing the data in 2003.

These dealers do not see any reason to compete with investors who are willing to bid down the bonds’ rate of interest.

Purchases by China in recent months have focused on longer-term debt, unlike in 2008, when most of the cash went into Treasury bills. While China has slashed its bill holdings by nine-tenths to $6.8 billion as the global credit crunch eased, total holdings are up 8.3 percent in the 12 months through May, with notes and bonds due in two years or more surging 46 percent, the Treasury said July 16.

This indicates a slowing economy. American companies on the S&P 500 have accumulated near-cash assets in the range of $2.3 trillion. They want liquidity, just in case there is a turndown.

Consumer credit has declined in 15 of the last 16 months. Factory orders fell by 1.6% in May from April.

The recovery, such as it is, has reversed.

So, companies are holding back on expansion. The report says that 87% of the 23 S&P 500 companies that reported earnings have beaten analysts’ projections for earnings per share. The question is this: Is this still being driven by cost-cutting? So it seems.

Who is buying Treasuries? Investment funds and U.S. banks. But increases have been marginal: up about 2% since December 31, 2009.

Banks have tightened their lending standards. Meanwhile, consumers’ credit ratings have fallen. So, banks are buying more Treasury debt, when they are investing in anything at all.

Company borrowing is down almost 30% in the first half. This indicates contraction, not recovery.

Globally, bond returns topped stock gains by the widest margin in nine years in the first half as optimism about the global economic recovery waned.

The bond market is forecasting slower growth worldwide in the second half of 2010.


Those who believe that the Federal Reserve is fearful of a flat price index, because this index reflects a stagnant economy, must believe that the FED is not the cause of today’s lack of price inflation. It is the cause, but only indirectly. It refuses to force banks to lend by imposing fees on excess reserves. The FED could reverse the stagnant M1 and stagnant M1 money multiplier in a matter of days.

We should conclude that the FED is content with the slowdown. Then what will change the minds of the FED’s policy-makers? A major recession would. I don’t think a mere slowdown in the rate of growth will.

If the FED senses a crisis brewing, it will inflate. Right now, it doesn’t sense this.

This gives us more time to allocate our capital in ways that will hedge against price inflation.

This could come at any time, but I do not see it yet. There are no signs of crisis in the American economy, just sluggish growth. For the FED, sluggish growth does not bring forth calls to audit the FED or reduce the FED’s authority. In a time of calm, the FED avoids bad publicity. Until the unemployment rate shoots upward, and the stock market falls sharply, the FED will bide its time.

When it starts to inflate, there will be time to react. If you can take steps now to hedge, do so. But shop. Wait for emergency sales.

July 21, 2010

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2010 Gary North