Signup for our free newsletter:

The Perverse World of Central Banking

Written By Geoffrey Pike

Posted August 10, 2015

ctrlbankAfter the job numbers came out last Friday, stocks went down significantly. The expectations for a Fed rate hike in September increased, which was negative news for stocks.

In our perverse world of central banking, stocks will often decline on good news and go up with bad news. If the economy looks like it is getting stronger, then this means there is a greater chance the Fed will seek higher rates and a tighter monetary policy. Most stock investors don’t like that.

We have been hearing about the possibility of the Fed hiking rates for a long time now. But the expectations of a Fed rate hike have not really seemed to affect the bond market. We are still in a situation of a 10-year yield that is just over 2%, and mortgage rates are still near 4%.

When the Fed raises its key interest rate – the rate for overnight borrowing between banks – it will do this by paying a higher rate on bank reserves. This could conceivably impact market interest rates, but it also does not automatically translate into higher market rates.

Bloomberg had a story last week reporting that the Wall Street banks have been accumulating Treasuries at their fastest pace since March 2014. The biggest bond dealers, including JPMorgan Chase and Citigroup, increased Treasury holdings for four straight weeks, making analysts wonder what is going on.

The Bloomberg story seemed to put a positive spin on it, saying that investors are optimistic about the Fed raising rates gradually. The increase in holdings is also being attributed to regulations that require banks to hold a larger percentage of high-quality assets.

There is also speculation that low inflation expectations are increasing demand for long-term government debt, but it could just as easily be the other way around. Maybe low yields are keeping inflation expectations down.

Regardless, it is interesting that the so-called smart money is actually buying longer-term Treasuries, despite the expectations of a Fed rate hike.

Maybe the Smart Money Really is Smart

All of the reasons stated above for big financial institutions demanding Treasuries are valid reasons. We don’t know just how much each reason factors into the increased demand.

But is there another potential reason that isn’t being widely reported? I stated that the smart money is buying Treasuries despite expectations of a Fed rate hike. What if the smart money is buying Treasuries because of expectations of a Fed rate hike?

Better yet, what if the big players are buying long-term Treasuries because of expectations for an economic downturn?

One of the classic indicators of a recession is an inverted yield curve. This is where longer-term rates fall below short-term rates. It indicates that there is higher demand to borrow short-term money. It also indicates a higher demand to lock in long-term interest rates.

When long-term rates fall below short-term rates, history shows an almost guarantee for a recession or some kind of economic downturn. When the recession becomes evident, it is likely that long-term interest rates will fall even more.

Unfortunately, we can’t rely on an inverted yield curve to predict a recession for us now. Short-term rates are near zero. A flattening yield curve will indicate a possible recession, but we are unlikely to see it invert. Short-term rates would really have to spike up.

If you look back to the fall of 2008, owning long-term U.S. bonds was one of the best investments you could have had at that time, unless you were shorting stocks. Again, we usually see falling long-term rates during recessions. The only exception to this is when price inflation is really high. Interest rates could go up, even in the face of a recession in this instance.

With oil prices and other commodities down, and with China and other parts of the world showing signs of major trouble, it would not be surprising to see some major economic trouble ahead, even in the U.S. All of that new money created by the Fed, along with the accumulating government debt, has misallocated resources to a great extent over the last 7 years. It is going to correct at some point.

The smart money is not always smart, but I don’t really like to bet against it. If you do bet against it, it should be done very carefully.

The so-called smart money is not saying why there is demand for Treasuries. But if it is because of a fear of recession, do you really think they are going to tell the public that?

The smart money may actually be smart on this occasion. I would not bet against it. This means hedging your bets if you are long on stocks. The smart money may be betting on a recession without others realizing it.