Saturday, January 3, 2009

The Treasury Bond Bubble: Yet Another Ponzi Scheme by the Fed

US Treasury BuildingImage by Scorpions and Centaurs via FlickrThe chart below represents the iShares Barclay's 20-year Treasury ETF (symbol: TLT) which invests in long term US treasury bonds (20 years to 30 years). The price of this normally stable ETF rose nearly 30% from November 2008 to the beginning of 2009.

This explosion in value was due to the Federal Reserve's decesion to lower interest rates to a "range" of 0 to 0.25%. This action was taken in concert with large-scale buying of long term Treasury Bonds.

The Fed is essentially doing the largest refinance in history. The government is borrowing at 0% for three to six months and using the money to buy its own longer dated debt. This has the effect of raising long bond prices and lowering their yield (since in bonds, price and yield are inversely related). This lowers the government's long term borrowing costs. It all looks very good on paper.

The problem is that this strategy makes the Federal Reserve, US Treasury, and entire US gov't vulnerable to the same risks that brought down investment banks Bear Stearns and Lehman Bro's. These companies met their ends in large part because they relied on funding which had to be "rolled over" every three to six months. Sound familiar?

The government is doing the exact same thing. By relying on huge auctions of short term t-bills, the gov't is able to retire long term debt. But this short term debt comes due quickly, and thus must be paid back by selling new debt. This means that there has to be a long line of people willing to lend the government money at 0% for the forseeable future.

By relying on short term capital to fund the government, the Fed has begun the most desperate and risky stage of its intervention. This will either work a treat or lead to the comeplete unravelling of the financial system. There is no middle ground here, we stand on the pin-point of history. Either outcome will be spectacular.

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