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**GRG55** · January 25, 2013, 11:43 AM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

The Fed was explicit that it will maintain a loose monetary policy until unemployment is down to 6.5%. Yes, the US Department of Labour could fudge the stats, but even in that scenario 6.5% would appear to be some ways out...

**dcarrigg** · January 25, 2013, 12:27 PM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

Originally posted by GRG55 View Post

The Fed was explicit that it will maintain a loose monetary policy until unemployment is down to 6.5%. Yes, the US Department of Labour could fudge the stats, but even in that scenario 6.5% would appear to be some ways out...

Exactly. Probably not before 2015 at the earliest. I sort of explained my thinking here (which Ash later commented on).

**FRED** · January 25, 2013, 01:34 PM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

Originally posted by dcarrigg View Post

Exactly. Probably not before 2015 at the earliest. I sort of explained my thinking here (which Ash later commented on).

Excerpt from Sept. 24, 2012 On Track for a Bond Market Crash - Part II: What will collapse the U.S. Treasury Bond market? - Eric Janszen, article written by EJ after a Boston Economics Club meeting held at the Boston Federal Reserve where he spoke with Janet Yellen:

What events may finally trigger a UST market crash?

Crisis antecedents in summary:

• The slow growing U.S. economy shows no credible trajectory for recovery before a new recession
• Dependence on two foreign lenders -- China and Japan -- to sustain the economy, who are themselves experiencing economic crises as well as political difficulties with each other
• An unknown threshold of UST debt on the Fed's balance sheet that is higher than 5% of GDP where it is today but lower than the Bank of Japan's current 15%
• Dependence on stable oil prices to prevent destabilizing price shocks, requiring careful geo-political management of the 1% of the global oil supply that determines prices as supplies dwindle and conflicts escalate in the region of the world from which the U.S. imports 18% of its oil
• Fed faced with the challenge of transitioning a $37.5 trillion bond market from government managed to market-based interest rates

Note that all of these antecedents to crisis have been with us for years. They may continue for years longer but some are more self-limiting than others. The Fed's ongoing efforts to create inflation is one. Bernanke and Yellen have both expressed concern that the NAIRU may have shifted due to a process they refer to as hysteresis. If the bond market decides that 8% unemployment not 5% as Fed models presume is the new NAIRU, then inflation expectations will begin to rise even with an output gap at 5% of GDP. That may be happening now but we can't know because the usual mechanism to communicate this change in inflation expectations, bond yields, is being manipulated.

The key problem with the Fed's bond price fixing operation is that no one wants to bet against the Fed by trying to bid up yields even if the odds without the Fed's intervention appear to be good. Rising default and inflation expectations that have not expressed in bond prices for years. All of the bets that market participants want to make based on a rational assessment of risks will be made once the herd believes that the bets will not be raked off the table by the Fed. This increases the likelihood of a disorderly exit of the herd from the bond market once the market is allowed to operate again as a market.

The UST bond market crisis corollary to my 2006 warning about credit risk pollution in the private credit markets is unexpressed and pent up inflation and default risk that has accumulated in the bond markets during three years of bond price manipulation since 2009 when $8.9 trillion in new UST bonds were issued and $26 trillion in new bonds in total.

Considering the antecedents, the UST market is vulnerable to shocks and accidents.

The mostly likely triggers of a UST bond market crash are errors due to incompetence, miscalculation, or both. Of all of the possible triggers, I see three as the most likely.

In one scenario the U.S. fails to pay 100% of its debt obligations in full and on time. I call it Le Petit Default and the Herd Stampedes. In the second scenario the Fed tries to wean the bond market off ZIRP and discovers that each and every one of the investors in the herd that is collectively holding $10.5 trillion in UST want to be the ones to sell during the first 10 basis point rise out of 100 or 200 or 300 not the ones who sell during the final 10 point rise. I call this one The Fed Whispers and the Herd Stampedes. In the third scenario the world experiences a second Peak Cheap Oil crisis like the one in 2008 but this time colliding with an over-priced UST market rather than an over-priced securitized debt market.

Le Petit Default and the Herd Stampedes

The last time the U.S. missed a federal government debt payment was April 1979 when the Treasury technically defaulted on a single payment on $120 million in Treasury bills out of a total of $800 billion of U.S. government debt outstanding. It didn't happen because the U.S. couldn't meet the obligation. It happened for technical reasons relating to how accounts were managed and payments were not made during a debt ceiling stand-off in Congress.

The result of that small error that affected 0.015% of total government debt was a sudden 60 basis point jump in rates across the entire yield curve. That increase subjected investors to an estimated $28 billion loss and added $9 billion to the interest expense on government debt in 1980. That rate reaction didn't go away as soon as the payments were made. It stayed with the market until the early 1980s. The incident was quickly forgotten as inflation swallowed that 60 basis point blip by pushing interest rates up another 600 basis points over the following year as inflation ran amok before the Volcker Fed's monetary sledgehammer fell.

This is why Geithner talks about a default today as a cataclysmic event. If the U.S. failed to make payments on only $1 billion of the $10.5 trillion UST outstanding we calculate an immediate 100 basis point rate rise versus the 60 basis point rise that occurred in 1979. Financial losses to bond market investors for a 100 basis point rise can be estimated using a rule of thumb: if interest rates increase 1 percentage point, a bond’s (or fund’s) value will drop by approximately the bond’s (or the fund’s weighted average) duration in years. The average duration of outstanding UST is now 5.3 years so for each 100 basis point rise UST holders will lose approximately 5.3%. For $10.5 trillion in UST outstanding that represents a $556 billion loss for all investors on a 1% rise.

Calculating potential losses for the entire $37.5 trillion debt market is more difficult. We estimate an average duration of 4.6 years for all bonds. That implies a $1.7 trillion loss for an immediate 100 basis point rate rise across the yield curve. If rates then rise over a year by another 200 basis points as they did in 1994, as discussed below, the additional loss to bond investors can be estimated at $3.4 trillion. At the same time annual interest costs will rise by $750 billion.

Needless to say this will not improve the housing market nor reflect well on the economic health and credit-worthiness of the United States, which will tend to re-enforce the desire of the herd that lives outside the U.S. to step up UST bond sales.

As for timing, the period of highest risk is early 2013 during a frantic post-election lame-duck session of Congress when the usual partisan brawl over the debt ceiling will be complicated by fiscal cliff theatrics. If a Petit Default and bond market crash were to happen, January 2013 is the month to watch.

The Fed Whispers and the Herd Stampedes

The Fed cannot purchase all of the bonds issued by the Treasury in perpetuity but can purchase enough of each issuance to convince markets to accept the securities at the offered price and interest rate. This method of price-fixing works because the U.S. economy is still stuck in an output gap that creates a deflationary bias on prices due to weak demand, as it has in Japan since 1992. Inflation expectations remain low from the old days when the Fed kept inflation low on purpose.

I know from personal contacts that the Fed is deeply concerned about the transition from low deflationary to higher inflation expectations as the output gap disappears, they hope. They think our current situation is similar to 1993.

It's odd because the institutional memory appears to be that the bond market over-reacted to a Fed tightening decision that was based on policy metrics. What really happened is that Greenspan's experiment at popping an equity bubble failed. He blew up the bond market instead.

The UST market fell 30% in a year.

What if the UST yields rose proportionally to the 1994 crash and added 250 basis points starting in October 2012? It might look like this.

But 2012 isn't 1993. UST outstanding was much lower then and interest rates much higher.

Federal public debt is 3.7 times larger today than in 1993 while GDP has increased only 2.4 times. The economy is far more leveraged.

But while Federal public debt as a percent of GDP has increased 100% since 2001, annual interest on Federal public debt has increased only 22%, from $350 billion to $450 billion and held steady near 3% of GDP throughout.

How is that possible?

Falling interest rates, thanks to the Fed and Treasury. Between 2001 and 2011 the average interest rate on all Federal debt fell from 6.6% to 2.5%. That represents a major savings in government debt interest expense.

But remember, all bond rates follow risk-free Treasury rates. At risk of a bond repricing event is not only the $10.5 trillion in UST outstanding but the total $37.5 trillion in outstanding munis, corporate bonds, agency debt, Fannie and Freddie bonds, and so on.

Every 100 basis points rise will increase the annual interest cost of all bonds by $375 billion. If Treasury bond rates rise back to the 2001 pre-managed level of 6.5% the annual interest cost on all bonds will rise from $936 billion today to $2.5 trillion or from 6% of GDP to 16% of GDP.

Mixing metaphors, in 1993 the Fed was holding a tennis ball underwater. It popped out of the water in 1994 the instant the Fed took it's hand off the ball.

In 2001, the Fed held a basketball underwater and never let go, instead making it bigger and bigger and creating the housing, private equity, and other bubbles in the process while working ever more furiously to hold it down.

By 2012 the Fed is now holding a weather balloon underwater.

What caused the tennis ball to leap out of the water in 1994? It's worth reviewing the incident in detail. Below is a Forbes article from October 1994 with my comments in red.

THE GREAT BOND MARKET MASSACRE

In a year of low inflation, bondholders have suffered more than $1 trillion in losses. Here's why it happened, and could happen again.

October 17, 1994

(FORTUNE Magazine) – WASN'T THIS supposed to be the year Alan Greenspan got to triumphantly parade down Wall Street to the cheers of bondholders big and small? In many ways the circumstances seemed right. In January 1994, the 34th month of economic expansion, bond yields were historically low and inflation seemed negligible: Wages were going nowhere, and companies dared not raise prices. But within seven short months of that promising start, something fairly unusual happened: 1994 became the year of the worst bond market loss in history. Since the Federal Reserve began nudging short-term interest rates higher in early February, the bond market has inflicted heavy damage on financial companies, hedge funds, and bond mutual funds. Fortune estimates that the rise in 30-year Treasury rates from 6.2% at the start of the year to 7.75% in mid- September has knocked more than $600 billion off the value of U.S. bonds (some of the losers are shown below). And with long-term rates rising in every major country, the worldwide decline in bond values this year figures to be on the order of $1.5 trillion. That's assuming that rates rise no further from here, hardly a certainty.(Comment: the 30-year Treasury rate peaked at 8.16% in October 1994.)

Part of the reason for such staggering losses is the sheer size of today's bond market. As corporations and financial institutions "securitize" an increasingly larger share of the American financial pie, everything from home mortgages to credit card receivables and aircraft leases winds up as bondlike securities available to investors and speculators alike. In 1981, according to Securities Data Co., new public issues of bonds and notes (excluding Treasury securities) totaled $96 billion. Last year public offerings came to $1.27 trillion.

(Comment: Bond market issuance was large at $1.27 trillion in 1993. In 2011 it was $6.2 trillion. In 2012 we estimate it at $7 trillion.)

The bond business isn't just bigger. It has also become mystifyingly complex as Wall Street's financial wizards use high-powered technology, even an occasional Cray supercomputer, to devise new ways to hedge risks or speculate on minute changes in interest rates. The growth of financial derivatives, which basically are side bets on the future course of interest rates, exchange rates, and commodities prices, has not only magnified the financial consequences of a market move but also thwarted traditional analysis of interest rate movements, which tends to focus more on economics than on internal market dynamics. Combine these recent developments with the new technological capability to hurl billions of investment dollars across oceans electronically, and you suddenly have a global bazaar where events in Chiapas, Mexico, can lead to huge gains or losses in New York, London, and Frankfurt. Not only do these markets react to one another, but they react faster than ever before. Says one veteran trader: "A move in the long bond that used to take six weeks now happens in six days." (Comment: Today six seconds.) But none of these changes can fully explain the surprising losses of recent months, a setback that has confounded virtually every major bond investor on Wall Street. To understand what happened, one has to take all these factors -- a bigger, global market; derivatives; greater speed -- and magnify them tenfold. That would begin to take account of the dramatic leverage that has been injected into the financial markets by traders, the professional speculators who run hedge funds, and others in recent years. Even that multiplier might not capture the full effect of forces at work on this market. Indeed, as recently as last fall, some hedge funds -- and a few wealthy individuals -- were buying bonds on margin for as little as 1 or 2 cents on the dollar (banks and securities dealers put up the rest). When the market cooperates, such leverage can greatly magnify the gains, as it did last year, when some hedge funds enjoyed total returns of 50% or more. When it doesn't, losses can be staggering. (Comment: No one knows how much leverage exists today.)

LEVERAGE not only has magnified the swing in bonds but also has given the fixed-income market some new personality twists. In recent years bonds have become less of a pure barometer of inflation expectations and more of a slave to the tactics of speculators looking to capitalize on short-term opportunities. Indeed, it was leveraged speculation that produced much of the great bond rally last year, a rally that brought long-term Treasury rates as low as 5.8% last October, and it played an equally important role in the market melee this year. (Comment: This time it is the Fed's forcing of investors into high risk, low yield investments with ZIRP policies.) That ugly chapter began in February, when the Federal Reserve began boosting short-term rates in response to signs of a strengthening economy, as well as rising prices in the commodity markets.(Comment: As we know now from the Fed minutes, the Fed raised rates because the Fed consciously tried to prick an equity bubble.) In a normal, unleveraged environment, the rise might have calmed inflation worries and even brought long-term rates down a bit. But instead the initial increase of 25 basis points, from 3% to 3.25%, in the overnight federal funds rate triggered an immediate 40-basis- point increase in the 30-year Treasury rate as leveraged bondholders were forced to quickly liquidate their positions to curtail mounting losses on their bond portfolios. (Comment: This time because of the size of the market and degree of distortion created by the Fed, the immediate increase may be 100 basis points.) By early May of this year, when the Fed had raised the federal funds rate 75 basis points, bond prices had plummeted and bond rates had jumped 140 basis points, or nearly 1.5 percentage points. The $1.4 trillion mortgage market followed Treasuries into the tank, declining in value, and at the same time European bonds and those from emerging markets were falling too. Losses for hedge funds, insurance companies, securities houses, mutual funds, and everyone else with investments in the fixed-income markets began to mount. Among the hardest hit in the bond debacle have been the big hedge funds that gambled on a continuing decline in European bond rates. Steinhardt Partners, one of those buying on whisper-thin margin, reportedly had amassed a $30 billion position in Eurobonds before the market turned. Its holdings were so large and so leveraged that Steinhardt was losing $4 million for each basis- point rise in European rates. By May the fund's losses amounted to about a third of the $4.6 billion it had under management. Steinhardt, which had blessed its investors with gains of better than 60% in each of the past three years, was still down more than 30% at the beginning of September.

The Fed's plan to prevent an epic bond market blowup is to keep announcing its policy approach so that the bond market isn't surprised when it finally acts. For example, the Fed published this chart in June. It was highly unusual move. As far as I know it is the first time that the Fed has ever published such a forward-looking chart.

How will the Fed know when it's time to raise rates? Not the Taylor rule. Maybe the Balanced-approach or
the Optimal control? That gives the Fed a year of wiggle room between 2014 and 2015.

Looks good in theory, but the IMF thinks that the U.S. will be in an output gap until 2016. The only time a central bank has ever raised rates when an economy was in an output gap was the Bank of Japan inauspicious decision to try to end ZIRP with a rate hike in August 2000. How many times does the Fed get to change its mind and publish revised charts? Once you put a line to paper like this, it has a funny way of sticking. It's doubtful that the Fed will get to implement the smooth series of rate hikes that will raise the Fed funds rate from zero to 4% as shown. More likely we will get a dislocation like in 1994 but more severe.

Above is one of 30 models we have built to try to get our heads around the various scenarios for a bond market crisis.
This one is based on a combination of the IMF's forecast for a U.S. output gap exit by 2018 and the Fed's Optimal Control
rate hike model. It assumes that the Fed begins to communicate a change in policy as the gap closes around a higher
NAIRU of 6% unemployment.

As you can see from the above, modeling any of these scenarios cannot produce the kind of accurate long range forecast we were able to produce to forecast the financial crisis and its impact on stocks in December 2007. The models do, however, allow us to build a dashboard to see patterns in events that will give us lead time of, we hope, several days to perhaps a week before a major bond market event, give us an indication of a major bottom or top, and allow us to distinguish a bond market event from the bond market event.

Chances are the the Masters of the Universe will do no better at transitioning the herd from a managed bond yield curve environment to market-based bond pricing than they did in the early 1990s when the market was much smaller and less volatile. The transition point will be one that we will watch very carefully to identify it as a potential trigger for a petit default that triggers a full scale panic.

(continued... with additional potential bond crisis trigger Second Peak Cheap Oil Crisis Spikes Inflation and the Herd Stampedes)

**cobben** · January 27, 2013, 02:26 AM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

"The models do, however, allow us to build a dashboard to see patterns in events that will give us lead time of, we hope, several days to perhaps a week before a major bond market event, give us an indication of a major bottom or top, and allow us to distinguish a bond market event from the bond market event. "

Reasonable, now as it's difficult to predict both what and when, the various cycle analysts are worth looking at for a "when".

Martin Armstrong is I am assuming well-known here. He is as I recall looking for the sovereign debt crisis to reach the US first in a few years according to hs models, but has mentioned somewhere that if things accelerate out of control it could happen sooner. That is also reasonable, but not much help in pricking the turning point more exactly.

"Clearly, 2013 should be the year for the low in interest rates. Whatever these people do, they will do it like the perfect storm. . . . Unless we are going to sit down and really examine the whole process, we are standing on the threshold of a catastrophic rise in interest rates. Once those rates begin to rise, small increases are now a huge potential fueling the fire that will make the debt rise faster now than it ever has in history going into 2016."

__________________________________________________ ________________________________________

Here is something curious, from John Needham down under, with his own peculiar proprietary cycle system.
As he is not looking here directly at the US bond market, yet everything is so connected these days, perhaps he is on to something that may even affect the debt mother ship.
He rarely makes this type of sweeping prediction.

The Words that Dare Not be Spoke Down Under!-The Best Currency Trades for 2013

"AUD-USD has been sensitive to the more common Danielcode time cycles which we typically see as resistance at the 59 and support at the 62 DC week cycle where a DC week is 6 trading days. Financial markets including currencies have strong fractal patterns with the time cycles repeating as Daniel recorded, “It is for time, times and an half”, and on the 6 day timing chart above we see an interesting overlap of different time fractals in mid February 2013. I fancy that may be an opportune time for chaos in US or European financial affairs and it’s a likely time for a significant change in trend for the Aussie and Kiwi.

As a firm believer in mean reversion I think that AUD-USD and AUD-EUR are likely to present the outstanding trading opportunities of 2013, with the Aussie Dollar on the short side. Australia is New Zealand’s dominant trading partner and historically these two currencies have traded in a well defined range, so the same thoughts apply. The likely trigger for this reversion is financial drama in US or Europe or even Japan. Aussie is dependent on all of them for funding. And of course Australia’s Iron and Coal boom is directly levered against China, and any significant slowdown in China’s infrastructure (Steel) plans will impact mightily on Aussie miners as the recent correction of the Ore price from $187 to $90 and bounce back to $120 has demonstrated with both BHP and Rio Tinto mothballing major projects.

So there is an interesting proposition. A host of countries with well publicised problems supporting the most leveraged property markets on earth; largely through a currency with a propensity for high volatility as it reacts to events elsewhere.

What could possibly go wrong?"

__________________________________________________ ________________

Oh, and the Swedish Riksbank decided late last fall to significantly increase the currency reserves, no particular reason given, "just to be on the safe side".
This has, uncharacteristically for Sweden, drawn a lot of flack as being unnecessary, even from the very experienced out-going head of the Swedish Debt Office (= Treasury, which will have to float the foreign currency bonds).
The Riksbank just hit back, saying essentially better to do it now while we still can easily get those bonds out the door.
There is only one possible use for these extra foreign currency reserves, and that is to bail out the Swedish banks if/when the real estate market crashes.
The Swedish banks namely fund most of their retail mortgage loans with - you guessed it - foreign currency denominated mortgage bonds, so called covered bonds.

What could possibly go wrong?

**cobben** · January 27, 2013, 05:15 AM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

". . . .to distinguish a bond market event from the bond market event. "

Two pieces by Howard Simons.
Note he is not US-centric/biased, he gives the bunds a work-over in the second one.

Two Warning Signs for Treasuries

By Howard Simons Jan 14, 2013

Had the word "shmendrik" not been invented as a character name in 1877 by the Yiddish Theatre, it could have been invented to describe today's bond investors.

. . .

Please note in the chart above how the yield curve between two and ten years is starting to steepen. This is measured by the forward rate ratio between two and ten years, the rate at which we can lock in borrowing for eight years starting two years from now divided by the ten-year rate itself.

If short-term interest rates are kept near 0% and long-term lenders demand higher yields, the end result will be a much steeper yield curve. That will force all borrowers, the US Treasury included, to start shortening the maturity of their debt and to accept the greater rollover risk of doing so. In this extreme case, you wind up with overnight repo financing, the rollover risk that brought Bear Stearns and Lehman Brothers down back in 2008. If the Treasury tries to keep debt service costs down by moving in this direction, we will have another unholy mess on our hands.

Wait until they see what I charge them for my $1 trillion coin; I will even throw in the Cracker Jack box it came in as part of the deal.

__________________________________________________ ____________________________

Two Charts That Explain Why the Market Should Be Worried About Bunds

By Howard Simons Jan 22, 2013

A better name for the eurozone project? Alfred E. Newman's European Vacation.

. . .

The chart below shows a strong inversion in the term structure of swap spreads. Not only are shorter-dated spreads higher than longer-dated ones, but they moved higher more quickly when Mario Draghi announced recently he was not looking to become more stimulative.

Now let’s take a look at ten-year bund yields mapped against ten-year swap spreads. Yields have been rising since late July, right when the aforementioned Draghi pledged to do “whatever it takes” to save the euro. They are now 0.44% higher, a considerable jump off of a 1.167% starting point. Ten-year swap spreads have plunged from 52 to 19 basis points on the notion that “whatever it takes” will involve printing sufficient euros to keep sovereign yields low.

What would happen to the price of those ten-year bunds if yields crept back up to even the August 2010 pre-Jackson Hole level of 2.2%? The on-the-run bund is priced now at 99.02 at a 1.607% yield. At 2.20%, the price falls to 93.73. That is a 5.34% loss; it also wipes out about three and a half years of coupon income.

The risk/reward of such a trade is poor. Markets do not sell off when people are expecting them to sell off; they sell off when no one is insuring against the adverse event, and the continuation of unrealistic pricing depends on government and central bank policies capable of changing instantly and without warning.

**cobben** · February 01, 2013, 07:19 AM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

Originally posted by cobben View Post

Oh, and the Swedish Riksbank decided late last fall to significantly increase the currency reserves, no particular reason given, "just to be on the safe side".
This has, uncharacteristically for Sweden, drawn a lot of flack as being unnecessary, even from the very experienced out-going head of the Swedish Debt Office (= Treasury, which will have to float the foreign currency bonds).
The Riksbank just hit back, saying essentially better to do it now while we still can easily get those bonds out the door.
There is only one possible use for these extra foreign currency reserves, and that is to bail out the Swedish banks if/when the real estate market crashes.
The Swedish banks namely fund most of their retail mortgage loans with - you guessed it - foreign currency denominated mortgage bonds, so called covered bonds.

What could possibly go wrong?

Curiouser and curiouser . . .

Now Per Jansson of the Riksbanks claims that the Fed has repeatedly refused to renew the credit lines with the Riksbank after they expired in 2010.
(This does not seem to have made it into the English language news.)

A fresh proposal from an investigation ordered by the Riksdag over how the Riksbank's balance sheet should be reorganized (= capital requirement reduced) recommends some rather sweeping reforms, including a much smaller currency reserve which the banks should pay for, the currency risk to be moved to the Debt Office (which already does the currency speculation anyway), and buried in the proposal the suggestion that the Swedish gold reserve should be sold in its entirety. Yes, the Riksbank has not checked on its foreign held gold either.

(Swedish only it seems, google translated: "Riksbank's financial independence and balance sheet")
Riksbankens finansiella oberoende och balansräkning

**coolhand** · February 01, 2013, 02:10 PM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

I don't think Wall Street understands this game yet. Rates are not rising ever again under the current currency system - the only way they rise is if the US loses its reserve status...then they'll rise like you can't believe, and BAC will be a smoking crater...Bond vigilantes are gone until then.

I have never seen ANYONE write about how interest rate derivatives create artificial demand for low interest rate bonds. Knowing that JPM has over $90T in interest rate derivatives on their books alone, someone convince me that the bond vigilantes aren't dead.

Let's pretend I am JPM. The UST needs to issue 10-yr UST's at 2% or less (or else the gov't deficit spikes). They sell them to me. I borrow money from the Fed at basically zero to buy them, levered say 15-1, but but I don't like the interest rate risk I am taking on. The convexity on a 2%, 10-yr note is frigging enormous.

So I go to GS or the Fed or my own derivative desk (it doesn't really matter, it's all semantics b/c the Fed is back stopping it all anyway) and I buy interest rate swap protection on all those UST's. This means if rates rise, I am totally hedged...

Now I am long a risk free trade where I borrow at 0% to lever 15-1 to buy a bunch of 2% yielding bonds & have derivatives that protect me from interest rate rises, & I make 30% ROE, RISK FREE!!!!!

(Of course, the catch is if interest rates actually rise, those derivatives will quickly do to JPM & the whole system what they did to AIG...bye, bye!...which is why everyone knows a) the Fed will never let rates rise again, & b) if they do, the Fed will bail them out just like AIG.)

Rates are never rising again until we reset the currency system. If that is not the case, I challenge anyone to explain to me why there are $600+ Trillion in interest rate derivatives...who is the counterparty, & why did Larry Summers tell Brooksley Born "I have 13 bankers in my office that say you will crash the global financial system if you try to regulate interest rate derivatives." (from the book "13 Bankers", by Simon Johnson)

“ I have 13 bankers in my office, and they say if you go forward with this you will cause the worst financial crisis since World War II.” From a phone call from Lawrence H. Summers, deputy secretary in the Clinton Treasury, to Brooksley Born, then running the Commodity Futures Trading Commission, regarding Born’s efforts to regulate derivatives. Referenced in the title of Simon Johnson and James Kwak’s 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown

**cobben** · February 02, 2013, 05:46 AM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

Originally posted by coolhand View Post

Let's pretend I am JPM. The UST needs to issue 10-yr UST's at 2% or less (or else the gov't deficit spikes). They sell them to me. I borrow money from the Fed at basically zero to buy them, levered say 15-1, but but I don't like the interest rate risk I am taking on. The convexity on a 2%, 10-yr note is frigging enormous.

So I go to GS or the Fed or my own derivative desk (it doesn't really matter, it's all semantics b/c the Fed is back stopping it all anyway) and I buy interest rate swap protection on all those UST's. This means if rates rise, I am totally hedged...

Now I am long a risk free trade where I borrow at 0% to lever 15-1 to buy a bunch of 2% yielding bonds & have derivatives that protect me from interest rate rises, & I make 30% ROE, RISK FREE!!!!!

You are now the third eggman, together with China & Japan.
What happens if the $USD begins to lose value at a rate greater than 30%?
Did you just buy something similar to a corner on the Zimbabwe stock market?
You can't effectively hedge the currency risk, there is no other market sizeable enough to absorb that risk, although I am sure that GS and others would happily sell you the swaps anyway.

Oh, sorry, I forgot - you are probably not actually "JPM", rather the CEO of JPM, so it all makes good sense. The scheme will hold together for a year or too, during which time you pay yourself a humongous bonus.

**touchring** · February 02, 2013, 08:26 AM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

Rates appear to be rising, at least for the last 6 mths. Perhaps it has to rise for another 6 months to be a convincing trend. LOL

**coolhand** · February 04, 2013, 05:47 PM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

Originally posted by cobben View Post

You are now the third eggman, together with China & Japan.
What happens if the $USD begins to lose value at a rate greater than 30%?
Did you just buy something similar to a corner on the Zimbabwe stock market?
You can't effectively hedge the currency risk, there is no other market sizeable enough to absorb that risk, although I am sure that GS and others would happily sell you the swaps anyway.

Oh, sorry, I forgot - you are probably not actually "JPM", rather the CEO of JPM, so it all makes good sense. The scheme will hold together for a year or too, during which time you pay yourself a humongous bonus.

Ahhh...not so fast my friend.

If I am JPM, i don't give a shit what happens to the currency as long as my assets & liabilities are both denominated in that currency, no?

In other words, if (per above, i would argue when) the US economy hyperinflates, the real economy will crumble as food & energy costs spike & employment levels plummet...so I, JPM, will then foreclose on their houses, and cars, & office buildings, etc.

Or, if I am JPM, once the USD collapses, the value of my gold bullion holdings will offset the currency losses (they are a bullion bank.)

See the beauty of it? The only way lenders lose is if their assets (bonds) are denominated in a different currency than their liabilities...in JPMs case, their assets & liabilities are in USD...except their assets give them claims to "hard assets" whose price will skyrocket in any currency crisis.

Now, in the case of Japan & China, yes they are screwed...which is why China has been on a "real asset buying spree" for the past 5+ yrs..."Here, Mr. Citgroup. Please finance our purchase of this [oil field/ag land/copper mine/gold mine/coal mine] for us. Our collateral will be these UST bonds - they are risk-free."

Mr. Citgroup: "Thank you China, we are happy to engage in this transaction with you. We earn an attractive interest margin on your loan & we are fully collateralized on the deal by these risk-free US Treasuries."

***T*** · February 05, 2013, 04:36 AM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

Spot on coolhand. Spot on.

**cobben** · February 05, 2013, 02:40 PM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

Originally posted by coolhand View Post

If I am JPM, i don't give a shit what happens to the currency as long as my assets & liabilities are both denominated in that currency, no?

That is true I suppose as long as the current system holds together, even if the value of the profits from your position should be reduced significantly by "very high" inflation.

The only thing that could hurt you is if you lose your favored connection to the Fed, e.g. if the Fed cuts off your free money just when treasuries go no-bid.

Anyone else than JPM would likely be thrown to the wolves at some point, I was forgetting about your "special" status.

**cobben** · February 19, 2013, 06:44 AM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

Originally posted by cobben View Post

That is true I suppose as long as the current system holds together, even if the value of the profits from your position should be reduced significantly by "very high" inflation.

The only thing that could hurt you is if you lose your favored connection to the Fed . . .

I assume this could never happen, now could it . . .

But if it did, I suppose it would be Sibleau's quasi-fiscal deficit come home to roost.

The Fed's D-Rate: 4.5% At Dec 31, 2013... And Dropping Fast

. . .

In other words, at Dec. 31, 2013, a 4.5% interest rate (or, as we call it, the D-Rate) is where the Fed starts losing money.

And then, if the Fed waits another year, the NIM breakeven is 3.5%... if the Fed then waits another year, the NIM breakeven drops to a minuscule 2.5%... and so on until year after year, the tiniest rise in rates will force the Fed approach Congress and explain why suddenly, not only is it not remitting interest income to the Treasury, but why just as suddenly, there is now a credit balance, that has to be funded by the Treasury (a move which monetarily will require the Fed to bail itself out, but which politically and economically will be an epic and final hit to the credibility of the Fed, as the Fed will be officially printing money just to print money).

Of course, the above analysis assumes the Fed delays and avoids exiting QE in 2013, and then 2014 (and so on) as this is the last instrument Bernanke and his successor have to push up the stock market, never mind the economy, the unemployment rate or inflation. Which the Fed will have no choice but do, and yet the longer it build the wall of QE worry, the greater the negative sensitivity to even the smallest increase in interest (and IOER) rates, if and when inflation picks up and Bernanke is taken to task with his "15 minutes" promise of eliminating hyperinflation.

In other words, while QE4EVA may be unlimited in the eye of the beholding Chairman, it is very much limited by the amount of reserves pumped into the system, and the amount of cash that Ben will have to pay banks as interest on their excess reserves.

. . .

**Chris Coles** · February 19, 2013, 07:06 AM

Re: Bank of America issues `bond crash' alert on Fed tightening fears

One aspect keeps coming into mind; if most of the QE is only being used to boost the stock markets; then surely the price of the stock is as much an illusion as the value of the QE? In which case, a collapse of the markets doubles the risk as then both sides of the account are written in red ink?