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Economics / Economic Theory Feb 12, 2010 - 04:54 AM GMT

By: Gary_North


Best Financial Markets Analysis ArticleAntal Fekete has published an article, "There Is No Business Like Bond Business." It was published on the 24hgold site, which my site links to (my gold price chart). Some of you may have read it. Some of you may be confused. Let me de-confuse you.

First, he is a deflationist. This is the central fact. He thinks there will be two money supplies, and the dominant one is deflationary. If you think this sounds nutty, wait until you read what he says about the bond market.

He begins with a summary of a nine-year forecast that has not come true. This, I must admit, is a unique way to begin an article that once again forecasts the same non-event. But this is what deflationists do.

For some nine years I have been predicting that the economy is going to a recession morphing into a depression, using a purely theoretical argument.

He summarizes his argument: the Federal Reserve's policy of buying assets with fiat money causes a decline in interest rates. This decline destroys capital.

Odd; falling bond rates raise the market value of bonds. But he says this destroys capital. Our journey into Wonderland begins. Everything is backward in Wonderland.

"The immediate cause of the depression is the destruction of capital." But why do falling long-term interest rates destroy capital? That is the issue he must deal with. Let me show you how he deals with it.

The FED lowers interest rates for the assets it buys with fiat money. But as long as the money is not sterilized by banks that refuse to lend -- which the FED can force to lend by charging a fee on excess reserves -- the money raises prices.

At that point, there will be an added rate of interest tacked onto all long-term loans. Lenders want protection against a depreciating currency unit. They charge higher interest rates. This is discussed by Murray Rothbard, who called this factor an inflation premium. Rothbard wrote:

Thus, if someone grants a loan at five percent for one year, and there is seven percent inflation for that year, the creditor loses, not gains. He loses two percent, since he gets paid back in dollars that are now worth seven percent less in purchasing power. Correspondingly, the debtor gains by inflation. As creditors begin to catch on, they place an inflation premium on the interest rate, and debtors will be willing to pay it. Hence, in the long-run anything which fuels the expectations of inflation will raise inflation premiums on interest rates; and anything which dampens those expectations will lower those premiums. Therefore, a Fed tightening will now tend to dampen inflationary expectations and lower interest rates; a Fed expansion will whip up those expectations again and raise them.

This is simple. Fekete does not address this obvious issue.

Fekete argues that the FED's purchase of T-bills will lower short-term rates. Agreed. This will create a carry trade. Maybe. Banks will borrow the money and buy bonds. This will lower bond rates: increased demand. He writes:

(2) Bond speculators buy the long-dated Treasurys and sell the short-dated ones, to pocket the difference in yields. These straddles represent borrowing short and lending long. As such, they are inherently risky. However, Quantitative Easing takes the risk out by making the odds, that the normal yield curve will invert, negligible.

A yellow light should have on. You should be thinking: "I am about to get rolled, intellectually speaking."

Can you spot the error? Probably not, unless you are a well-read Austrian economist or a professional investor.

Fekete limits his discussion to T-bonds. He never mentions corporate bonds.

This is the pea under the shell. "Keep your eye on T-bonds. Don't look at corporate bonds."

The corporate bond market is the 800-pound gorilla in the world of finance. It is where companies raise capital. In the first quarter of 2009, the U.S. corporate bond market amounted to $6.7 trillion.

(3) The bond speculator faces the problem of having to roll forward the fast-expiring short leg of his straddle by selling T-bills. The extraordinary funding and refunding requirements the Treasury is facing, and the extraordinary pressure on the Fed to increase the money supply combine to make it ultra-easy for the bond speculator to move both the short and the long leg of his straddles as he sees fit.

I have warned readers not to short T-bonds, for just this reason. It is not a free market. I have said that shorting corporate bonds is a legitimate crap-shoot. It is risky, but it is a relatively free market. Rising price inflation will raise corporate bond rates. The bonds will fall in value. Why? Because the existing bonds locked in a lower rate. That rate is now a money-loser.

Fekete never mentions municipal bonds, either.

Corporations can be wiped out by inflation. Capital costs rise. Labor costs rise. The risk of corporate default rises. So, corporate bond rates are hit by a second factor, beyond the inflation premium: the risk premium. Companies may default.

Fekete ignores this. He goes on:

(4) The upshot is that interest rates keep falling along the entire yield curve. Regardless how many long-dated issues the Treasury offers, bond speculators snap them up even before the ink is dry on them.

See the trick? He says "bond speculators." But he is talking only about Treasury bond speculators.

Can he be this blind? Yes. He is a deflationist.

In my other writings I have explained how a prolonged fall in interest rates along the yield curve brings about depression through the indiscriminate destruction of capital in the productive as well as financial sector.

A fall in the yield curve -- the Treasury's yield curve -- that results from mass inflation of money brings an economic boom, rising gold and silver prices, and asset bubbles. The money flows into the economy, creating a boom. See Mises, Human Action, chapter XX. Fekete is wrong again -- in theory and in terms of economic history.

There is a vicious spiral: the more currency the Fed creates, the more risk-free profits bond speculators will reap, contributing to a further fall of interest rates.

He is talking about T-bond speculators, not corporate bond speculators.

This outcome is the exact opposite of the one predicted by monetarism. The latter predicts that the new money created by the Fed will flow to the commodity market bidding up prices there, to nip depression in the bud. Bernanke & Co. fully expects this to happen. This is not what is happening, however.

Is he blind? This is exactly what has happened! The recession was reversed by massive FED spending that saved the housing market: over $1 trillion.

"The new money refuses to flow uphill to the commodity market. It flows downhill to the bond market where the fun is. Why take risks in the commodity market, the speculators ask, when you can gamble risk free in the bond market?

Remember: he has not yet discussed corporate bonds. He never does.

The corporate bond market fell for 34 years, 1947 to 1981, because of Federal Reserve inflation. It reversed only after Volcker's policies tightened money. Bond rates came down after 1982.

In October of 1946, Truman removed the wartime price and wage controls. So, 1947 was the first year of a free market since World War II began. In 1947, AAA corporate bonds paid 2.57% at the beginning of the year. In September 1981, at the peak of 34 years of price inflation, they paid 15.49%. The data are here, courtesy of Economagic.

Bond prices move inversely to bond rates/yields. This was the longest bear market in corporate bonds in U.S. history. Anyone who bought and held AAA corporate bonds got killed financially.

Fekete wants us to believe that monetary inflation will not raise bond rates. On the contrary, it will lower bond rates, he insists. To make his case, he limits his discussion to T-bonds. This is simply intellectual trickery. This is putting the shuck on the rubes.

An honest mistake is one thing. But this is a mistake so inconceivably huge that it calls into question the man's ability to deal with reality. At the heart of his argument is an error that destroys his argument. He concludes:

So grab the money, buy more bonds and sell an equal amount of bills. As a consequence of bullish bond speculation interest rates fall, prices fall, employment falls, firms fall. The squeeze is on, bankrupting the entire economy.

This is Antal in Wonderland.

You can read the entire, preposterous, misleading article here.

This sort of thing passes for serious analysis: bad theory, deliberate deception (or huge ignorance), and a refusal to look at the historical data.

For background on Fekete's theories, begin here:

    Gary North [send him mail ] is the author of Mises on Money . Visit . He is also the author of a free 20-volume series, An Economic Commentary on the Bible .

    © 2010 Copyright Gary North / - All Rights Reserved
    Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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