Are Bonds (Fixed Income) at a Tipping Point? Part Duo

The first of November, my Market Update asked if bonds were at a tipping point because they were not responding as Fed Chairman Bernanke wanted (lower interest rates, lower dollar and increased commodity prices.) I also said that we would know more within the next few months.

Since then, the 10 year Treasury has moved down very slightly or about 20 basis points (0.20). However, the yield curve has steepened (short rates down and long rates higher.) Not what Bernanke wanted (unless he wanted to make the environment for bank profits better.)

The dollar has been rising not falling. But the problem is that other countries are not going to simply sit back and let the U.S. devalue the dollar (to improve exports), so they have responded by devaluing their currency in order to compete. This currency war can’t go on forever, but in the meantime, it is destructive.

Commodity prices are about the same.

It seems that there is no definitive answer yet, but there is a lot of new money going into the banking system and the banks have three choices of what to do with the money:

1.Sit on these new assets and collect the overnight interest rate from the Federal Reserve, or
2.Lend this money out to companies and individuals who want to borrow money. There is not much of this going on because banks are sitting on nearly a trillion dollars of excess assets, (maybe banks don’t want to lend or maybe borrowers don’t want to borrow.) or
3.Buy assets with this money (bonds, stocks, commodities, foreign investments, etc.) Contrary to what many people think, banks do not need to lend money to borrowers to make profits, they can invest the money here and abroad, wherever they can make the most money.

Another thing that seems to be going on here is that we have not seen much inflation (by government statistics) in spite of all the new money that’s been created. The reason many people think is that inflation will not happen until those trillions of dollars in excess assets get turned into trillions of dollars of credit.

So, think about this, if the economy does turn around or people think it has turned around; and suddenly want to use credit, would those trillions of dollars of credit turn into instant inflation? If so, that may not be good for the bond (fixed income) market as investors will want to be paid for the inflation risk.

What are banks going to do with their 1+ trillion dollars in excess reserves?

If you follow the money, you know that banks (after bailouts, Fed purchases of toxic assets, guarantees, etc.) now have over $1 trillion in excess reserves per the Federal Reserve. Banks normally lend this money out and with over $1 trillion of reserves; they could create over $80 trillion in new credit. But is this a reality in today’s environment?

The housing problem is still not solved and will require banks to write off billions more in “bank assets.” They could loan this money to businesses, but few of them really want to take on additional loans with the economy in such bad shape. They could lend to consumers but they can’t afford more debt and their FICO scores have dropped making them less “qualified.” Anyway, consumers have decided to become more frugal.

If banks were to pump out trillions of dollars in new credit that went directly into the economy (to companies producing goods and services and consumers buying goods and services), it would certainly cause GDP to spike up and maybe we would be off to another bubble. But, adding that much credit into the economy would significantly reduce the value of the dollar and thereby cause serious inflation.

Yet, this is what a lot of people think will happen. The government continues to spend money hoping to fill the demand gap in the economy. The Federal Reserve keeps “printing money” for the government to spend; and at the same time, keeps interest rates low to encourage spending and to help prop up the housing market. Once everything becomes perfect again, the government can cut spending and the Federal Reserve can contract the money supply eliminating the threat of inflation. Bingo! Utopia.

Since we know this is a fairy tale, how about another alternative for all those “excess reserves” the bank has. What if this “excess” money in the banking system simply gets re-circulated. Banks could put all that money back into the financial system rather than back into the economy (the goods and service producing segments.) For example, they could buy assets like stocks, bonds, gold, real estate, etc. (GDP wouldn’t go up much.) They could buy these assets around the world (reducing the inflation potential here) and they could finance real things like factories, but overseas (Oh, darn, they couldn’t bring the profits home because of taxes.)

Is it possible? I don’t know. I am not a conspiracy theorist but we have to keep our critical thinking skills sharp and keep looking for possible alternative futures.