Trouble with a Committed Extended Period of Time

Published by clickbroker.blogspot.com.

Bill Gross is developing a chorus in calling for Federal Reserve Chairman Bernanke to commit a time frame on extraordinary accommodative rates for an extended period of time. The longer the commitment, the better. The theory they are selling is that investors will start absorbing toxic assets if they are assured of low cost funding for a specific time frame.

This argument has many flaws. In fact, a Fed commitment to lower rates for a specific period of time actually reduces the risk in the carry trade of the world’s safest assets. The greatest risk in a leveraged position in Treasuries is changes in the cost of funding, not credit quality. Therefore, guaranteeing the cost of funding would actually move more money to the risk-free trade and away from productive capitalism.

The committed period of time being called for does not eliminate the collateral paradigm of finance. Speaking of small business lending, Bernanke said small businesses with good cash flow have lost access to credit because their collateral has lost value. The typical collateral for a small business is commercial real estate or the owners’ personal residences. The same principal has locked home buyers out of financing and homeowners out of refinancing.

Committed low cost funding will not bring bad assets into the pool of desirable collateral. It might add to the pool of willing investors, but not to the pool of able investors. In this economic downturn able is far more important than willing.

The real harm comes from the bubble being formed in so called risk-free assets such as gold (GLD), Treasuries and the few growth companies remaining on the stock exchanges. The bulls tell us they should be valued based on current interest rates; in essence no carrying cost. To a more limited extend the recent stabilization in residential real estate is also sitting on the shaky foundation of extraordinary low interest rates.

Yes it’s true housing is starting to form a mini bubble. The bubblelet will not be apparent until interest rates start to rise. And once the gold and Treasury bubbles start to pop, the world financial system trouble will brew again.

Gold, Treasuries and real estate are no ordinary assets. Together they form the collateral basis for most financial transactions. So artificially propping those up creates insatiable demand for the Fed never stopping.

Politically, Bernanke’s hands are tied. The public is unwilling to tolerate more Fed programs or quantitative easing. Gross and friends know this, so their creative genius is asking for the next best thing.

No disclosure.

Sphere: Related Content