Inflation Debacle Is Approaching Metaphysical Proportions.

This morning I saw this article from Jesse Eisinger about Paul Singer and other hedgies paranoid fantasies about encroaching inflation.

His argument can be summed up as: just because we don’t really see inflation it doesn’t mean that the inflation bugs’ paranoia isn’t justified. It’s just that they simply observed that every time Fed gets involved with its monetary policy it ends up inflating some kind of bubble. As an extension of that thought, he argues, all those bank-saving maneuvers and stress-tests were really for the show, to restore public confidence, but really did nothing to improve banks’ balance sheets.

Krugman weighed in on this, of course.

Sorry, but I don’t buy that.

For one thing, if you want to claim that the stress tests were all fake and the banks were truly insolvent, shouldn’t we have seen a reckoning by now? I’d say that in retrospect it’s clear that many assets really were temporarily underpriced thanks to the market panic, and that once the panic subsided the big banks were revealed to be in better shape than many people (including me) believed.

Which really brings entire discussion into the metaphysical. Does something exist if we don’t observe it? Even if you have to contort yourself to find inflation in the Hamptons and in Aspen, it doesn’t mean it exists. Not the way Paul Singer and the hedgies would like it to exist.

They almost remind of people who see Jesus on every piece of toast. They see it because they want to see it.

Bill Gross’s Come To Jesus Moment.

Bill Gross, the rock-star bond manager of Pimco (and now of Janus Capital), whom I frequently criticized on my blog for being wrong on Treasuries and the Fed, does a complete 180 in his recent letter to investors.

In short, after he dispenses with philosophical ruminations, he comes to conclusion that monetary policy isn’t evil. It simply isn’t enough to get us out of subpar growth and should be combined with fiscal policy (you know, like, spending by the government).

The real economy needs money printing, yes, but money spending more so, and that must come from the fiscal side – from the dreaded government side – where deficits are anathema and balanced budgets are increasingly in vogue.


Rick Santelli Gets Schooled.

I don’t know if those of you who follow this whole Fed/QE/inflation debacle saw this yesterday, but this is a must see. Inflation hawk, but really an approval-seeking, hissy-fit throwing man-child Rick Santelli got finally taken to school by other CNBC talking heads. I wonder how he didn’t end up rolling on the floor, stomping his feet on the ground.

Here’s a detailed article on Business Insider with a longer video (worth 10 min of your time) with excerpts.

Steve Liesman delivers the knockout punch in the end:

It’s impossible for you to have been more wrong, Rick. Your call for inflation, the destruction of the dollar, the failure of the U.S. economy to rebound. Rick, it’s impossible for you to have been more wrong. Every single bit of advice you gave would’ve lost people money, Rick.

As you might know I have been in Bernanke/Yellen camp for a long time. It’s hard for me to believe that some people are angry at the Fed for merely following its mandate. I think that anger is stemming from theirs missing the rally. The rally shouldn’t have happened because they were supposed to be right and Bernanke was supposed to be wrong. But that’s not how things turned out. And instead of acknowledging their mistake and moving on they are stuck in the assigning blame page and screaming “I was right” as if we’re not hearing them. We hear you just fine, it’s just that you don’t have a case.

A nice description of brief history of the conflict is here.



Bond Vigilantes’ Rage is Misplaced

As many of you know I always wondered about how the supposedly brilliant “bond vigilantes” have missed the biggest gorilla in the room – Bernanke. Well, they did and it bugs them BIG TIME. It wasn’t supposed to be that way, but that’s what happened. So rather than being a little introspective, they blame a guy who had access to certain tools and, gasp(!), decided to use them. Now they’ve reached a point of such ideological fervor that they would rather bet against their positions, just to make a statement.

Why are the bond vigilantes purposely driving down the market value of their stock-in-trade, anyway? Part of the reason is ideological. They hate Bernanke as an interloper, and Obama for the same reason, so they are reluctant to believe that the economy is actually recovering under the leadership of those two faculty-lounge geeks.

The vigilantes are like the hedge fund guys who share the same ideological hates and have been (wrongly) shorting the stock market for several years. Now both the bond vigilantes and the hedgies see a chance to “get theirs” back — notice how the friends of hedge funds have quickly used the bond rate spikes to renew their cable TV calls for a deep stock price “correction” that will bail out the hedge funds and give them a chance to get back into the market on the cheap.


About Those Rising Interest Rates

I’m in a bit of a wonkish mood today. Last week bond yields have risen to the highest levels in about a year, thus making market participants nervous, thinking “is this it?”. Some in the “inflation is bad and imminent” camp are probably ready to pop Champaign bottles open to celebrate the long (very long indeed) awaited arrival of inflation and a vindication of their self-imposed black-and-white view of the world. But let’s examine two obvious questions: 1. Is inflation indeed already here? and 2. Is it as bad as they say?

First, the whole purpose of the much-derided Bernanke’s QE exercise is to spur growth: that’s what the Fed does when the economy is slow – cuts and keeps the interests rate as low as possible for as long as the economy is weak. The widely used indicator that the growth is back is inflation: if we begin to spot rising prices it means the economy is recovering (people find employment, consumers back in the stores, driving prices up). This is a far cry from Zimbabwe or Weimar Republic hyperinflation which is what alarmists have in mind when they say “inflation”.

Second, and this is an extension of the previous point – inflation is not always bad, precisely because it indicates a growing economy. It’s all about the range: 2% inflation is too low, Bernanke and his Fed colleagues would probably like to see it in the 4-5% range, 7-8% would probably warrant a tightening action from the Fed (rising rates, this is what Paul Volcker famously did in the early 80s). Yes, the Fed wants to see real, consumer-driven inflation rising, which of course doesn’t mean it wants to see it rising forever. Fed’s actions at keeping interest rates low are intended for a pick-up in business activity (making it cheap to borrow and consume or start a business), thus inflation is not seen as a negative side-effect that everyone should fear, but instead an intended and positive consequence of QE.

This is where many people get confused: Bernanke is pushing down rates in order to see them rise? In a sense, yes. Here’s a good summary:

“In a nutshell, that’s the QE conundrum. Central banks argue that their bond purchases are meant to push down yields in order to make long term finance cheaper. But, at the same time, a sign that QE’s working is rising yields.”

10-year Treasury yields have risen to 2.25% recently, highest in a year, which many say is some kind of dangerous threshold. Bond traders are especially jittery and here’s why (now I’ll get really wonkish, but if you do read on I promise to make it exciting if you remember one thing: when bond prices rise, interest rates decrease; and vice versa, if bond prices fall the interest rates rise): Many of the bond portfolio managers are holding huge portfolios of agency mortgages. Those mortgages are primarily fixed-rate – they pay a fixed coupon. If interest rates rise, like they did in the past few weeks, it means that homeowners holding those mortgages suddenly pay a lesser (in relative terms) interest rates than the market and thus are less likely to refinance. Because those people are less likely to refinance, our bond managers are stuck with their portfolios of mortgages that pay less than they could get in the market today. On top of that, because people are not refinancing, it forces bond managers to hold those losing bonds longer (it’s what they call duration risk), and because the average maturities of those bonds are further into the future it also increases those bonds’ risks and volatility (one would much prefer to hold a 5-year bond as opposed to 10-year bond all other things being equal – you get your money back faster). So now, our bond managers who thought they were holding a 5-year bond find themselves holding a much “longer” bond that is risker and thus requires additional hedging. Now we come to this concept that they call “convexity vortex”. In order to hedge their exposure to rising interest rates the bond managers’ most widely used tool is to sell US Treasuries: because they’re losing money on their portfolios of mortgages due to rising rates, they want to at least make money on the other side of the trade – be short Treasuries and thus benefit from rising rates on this hedge. So as interest rates increase they begin to sell more and more US Treasuries to hedge their portfolios. This brings a self-perpetuating vicious circle: rates rise and makes them put on hedges by selling Treasuries that, in turn, make Treasury rates rise even higher.

But no matter how important bond traders fancy themselves to be (Master of the Universe, Bond Vigilantes), the real danger at this moment is not rising interest rates, but the premature slowing down of the QE. The state of the economy is much more important than the hurt feelings and reduced fees that will plague bond managers. Besides, according to Krugman, it’s hard to imagine scenario where these high bond valuations don’t take some kind of a haircut. Just look at this curious matrix that he put together:


It’s all about one’s perception of the economy: inflation hawks see inflation creeping on and will pick scenario 1; those who think Bernanke is on the verge of snatching the QE punch bowl will pick scenario 2; and those who see a recovery, but still subject to continued QE (I’m in this camp), will pick scenario 3.

I pray to monetary Gods that Bernanke is in my camp too.

Attention Hedge Funds! Bernanke is not exactly London Whale.

Brad Delong draws a nice picture of how hedge funds see the world.

Some in the industry like to draw parallels between the London Whale trade last year that cost JP Morgan $6bn and being short US sovereign debt: they think one day the trade has to be unwound in a quick and messy manner and then the shorts will cash in. There’s one big difference: JP Morgan can’t print money, Bernanke can. And then there’s a concern for inflation ( a strange concern for someone who’s supposedly short Treasuries).

But, the hedge fundies say: “What if the economy recovers and starts to boom? What if inflation shoots up? The Fed could loose $500 billion on its portfolio as it moves to control inflation! Why doesn’t that fear that?”

The Fed does not fear that. That is what it is aiming for.

Hedgies also upset that there’s no higher authority that can come in and right the imagined wrong done to them. Unlike London Whale (Bruno Iksil), Bernanke doesn’t have a boss who can force him to unwound this trade today. This fact really annoys the hedgies.

Who do the hedgies imagine are the Fed’s political masters who will tell it to shift and adopt policies that will bring on even massier unemployment? Rand Paul?

There is a reason that the trade of shorting the bonds of a sovereign issuer of a global reserve currency in a depressed economy is called “the widowmaker”.

Origins of Bernanke Hatred.

Oh, this is so good.

One trader explains what he thinks are the origins of such Bernanke hatred:

Some guys don’t understand monetary policy and think he’s doing wrong thing.

Others think it’s immoral that markets aren’t let to clear (meaning, collapse to a point where someone will swoop in and just by). Others are pissed because they missed rally so they blame Bernanke as the exogenous factor that made them wrong. Like “if not for this STUPID policy I’d be making money.”


And then here’s Krugman’s perspective:

I don’t really know, although at some level I’m not surprised: finance types just hate, hate easy money policies, although you would think that these policies are often good for their bottom lines. I do wonder in this case whether there’s extra hatred of Bernanke because he keeps proving them wrong: they keep predicting terrible things from QE, runaway inflation, and all that,and instead the bearded academic stuff keeps turning out right.

Again, and I know at this point I’m belaboring the point, but how did it happen that me, a nobody who just reads the generic news, could be so right and those pompous overpaid hedge fund managers could be so wrong?