Fed Weakness, Future Insatiable Bond Demand with Short Supply

 This article by me was originally published on Talkmarkets:

http://www.talkmarkets.com/content/us-markets/fed-weakness-future-insatiable-bond-demand-with-short-supply?post=74137

The Federal Reserve and many central bankers are sincere about saving America from negative interest rates caused by derivatives markets' demand for long bonds. But the Fed could not save us from the housing bubble of the last decade and won't likely save us from negative interest rates and a powerful push towards the cashless society.

Supply and demand are key to understanding the long bond market. And that supply and demand may result in profound changes in our economic system, not for the better.

Long bond markets are likely rarely manipulated, as stocks are when corporate buybacks reduce supply of stocks available. There has been an accusation made that banks are trying to push yield up and price down, because they want the best deal for their insatiable appetite for bonds.  Manipulation of auctions to raise yield seems counter intuitive. You would think that all those warnings of yields rising would make banks want to avoid doing illegal things to make them rise, if they are going to rise anyway.

I believe that the banks know otherwise, that the yields are headed downward, and that the price of bonds they want to buy will go inevitably higher. That is why, if the allegations are true, that banks seek to push prices for bonds down.

While I am not permitted to link to it, Blackrock has a study out which was not to be used by the retail investor, but only by institutions. I don't plan on using it, but clearly the demand for bonds in that study far exceed the supply through 2016. Blackrock estimates that in 2017, that would change, but it is only an estimate, and it is only for the regulated asset owners who often times are forced by their rules to keep buying.

In the section of the Blackrock pdf. report, titled After Liftoff, by Peter Fisher, there is a chart that shows demand from regulated asset owners to be 5 trillion dollars and supply to be 5.8 trillion dollars for 2017. So, for regulated asset owners there will be a .8 trillion dollar oversupply as an estimate only from Blackrock. Previous to that there is a huge under supply.

But regulated asset owners do not make the market themselves. They are central banks, insurance companies, pension funds and and banks. But many other parties are required to put up bonds as collateral in the derivatives markets. Hedge funds, businesses borrowing from banks, private investors, make up a huge market and they could make the supply and demand picture remain as it is now. The insatiable desire for bonds as collateral could continue for years, maybe decades. In the age of austerity, rising prices for bonds could be the new normal.

While I don't have figures on those non regulated asset owners, we do know that derivatives markets continue to grow. While the mortgage securitization and CDS markets have slowed, they never were the bigger markets anyway. Interest rate derivatives is by far the largest derivatives market. This market, as well as energy derivatives are growing like gangbusters. That means it is likely that treasury bonds will experience insatiable demand for as far as the eye can see.

As we saw back in 2009, collateral needs for derivatives were growing by leaps and bounds and non regulated asset owners were a huge part of the market. And this recent alert would make it seem as though more collateral will be needed than first thought.

Central bankers may want to save us from the abyss, and even Blackrock speaks of lift off. Bill Gross implores the Fed to raise rates. The fear is that the Fed won't get high enough above zero to prevent a testing of the effective lower bound in the next downturn.

But you have to wonder if the ones calling for a cashless society and negative nominal interest rates, like Larry Summers and his friends, are the ones reading things correctly. They wish to eliminate cash as the barrier to dropping interest rates below zero.

Truth is, the Fed will become even more powerful if cash is eliminated from the culture and the zero lower bound is eliminated with the elimination of cash. The Fed appears to be very weak right now in its efforts to raise rates and return to past memories of normalcy.

But that future Fed power to impose negative rates in the next downturn comes with a price. The elderly, the poor, those with failing eyesight, and travelers could be very vulnerable to a cashless society. We all could be vulnerable, but those groups would suffer the most.

For travelers, for example, cash is king. The travel industry could be destroyed if there is established a cashless society, and businesses dependent on travel will suffer greatly.

Disclaimer, I am not an investment counselor or attorney. This is not professional investment advice.

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