A Ponzi Scheme That Makes Bernie Madoff Look Like a Piker

The Fed indicated last week that it's going to start buying long-term Treasury securities. Since it's out of room to lower rates any further, the idea is that it'll keep rates low by maintaining a strong bid for long-term Treasuries. But that's not the real reason for the plan. Here's the truth.

Treasury needs to issue a huge amount of debt securities to fund all this failout frenzy. The UK, Europe, Japan and Latin America will be doing the same thing, effectively flooding the market with bonds, all competing for the same pool of bond investors (as the investor universe will not increase, cet. par.).

At the same time, the perceived credit quality of the issuing sovereigns will decline due to the massive increase in indebtedness (see Greece and Spain). The supply and demand factor noted above, as well as the credit issue, will drive interest rates higher, making mortgages, car loans, etc. more expensive, at the worst possible time.

The Fed desires the opposite: to keep rates as low as possible. But long-term lending rates won't move with the Fed funds target, which the Fed held steady last week at 0-.25% (don't get me started on how stupid it is to use a range rather than a single rate). Those rates will instead move with market interest rates - in other words, Treasury yields, which will go up.

So the Fed will simply buy those Treasuries and hold them themselves, effectively solving the supply and demand problem, and ignoring the credit risk problem.

Am I the only person who's following which shell the ball is under?

A. Treasury issues bonds.
B. Fed buys bonds.
C. Treasury issues special bonds to fund Fed.

Lather, rinse and repeat. Hello, inflation!

It won't work, in any event - evidenced by the fact that since the FOMC meeting, the long bond yield has moved higher. And there are two other factors that will come into play as the government starts throwing trillions around (this morning I read that there's likely to be a second bank bailout, on top of the TARP, which will cost $1-2 trillion, in addition to the "economic recovery plan" whose price tag will hit a trillion before Congress is through with it - but more on those topics in a post to come).

First, all that money-printing will devalue the dollar. There aren't enough US investors to absorb all the debt (unless the Fed just buys 100% of the issuance, in which instance the half-life of the US economy is maybe a year). Foreign investors will demand higher yields on dollar-denominated assets, since they'll see the value of their dollar-denominated investments fall in terms of their own currency - except maybe the UK, but they can't afford to buy our bonds anyway. So they'll bid the yield up.

Second, China's not going to be buying our bonds anymore. Not only have they soured on the US and its macroeconomic and fiscal policies, but it has its own massive slowdown to contend with. The Chinese slowdown has been caused by global demand - particularly that in the US - going into the crapper, so they can't fuel their output by sending massive amounts of cheap money to the US to keep rates artificially low so that Americans can afford to buy all their stuff. No matter what rates do here, banks aren't lending and people aren't spending.

So the Chinese central bank rightfully figures that the best way to stimulate the Chinese economy is to keep its money at home, and invest its reserves (yes, China actually still has reserves) in its own infrastructure. Without China in the game, again, the bid weakens and yields rise.

How sure am I that in spite of the Fed's efforts, long Treasury yields will rise? On January 20 - the day stocks hit their lows of the new year, with the Dow closing below 8,000 - I cashed in half of my leveraged bets against the NASDAQ and the S&P. Two days later, I invested the proceeds in another leveraged inverse bet - this one on the 30-year Treasury bond. Thus far, the return is about 3%, which is about 160%, annualized.