FOMC Discusses Excessive Risk Taking

We always believe it’s good to hand out awards to people who deserve it. Whether it’s for doing good things or bad things, we believe they should receive an award to recognize their “achievement.”

In this instance, the newly inaugurated “No —- Sherlock Award” goes to the US Federal Reserve’s Federal Open Market Committee (FOMC). Like the board of the Reserve Bank of Australia (RBA), the FOMC is responsible for making interest rate decisions for the central bank.

And last night the FOMC released the minutes of its November 3-4 meeting, which contained the following, hehem, wonderful lines:

“Members noted the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period, including the possibility that such a policy stance could lead to excessive risk-taking in financial markets or an unanchoring [sic] of inflation expectations. While members currently saw the likelihood of such effects as relatively low, they would remain alert to these risks.”

Really? How surprising. Who would have thought that giving away free money would cause “excessive risk-taking”?

But it’s obviously a conclusion that any old newsletter writer, or anyone with an ounce of common sense could come to.

However, it seems to have taken the FOMC’s nine PhD’s more than a year to figure this out.

With quick minds like that in charge of interest rate policy it’s no wonder the US economy is being stuffed faster than a Christmas turkey.

The issue of excessive risk taking is something we’ve written about all year. Even as bankers and policy makers were talking about deleveraging we knew it was all a hoax.

Let’s set the record straight, there has been no deleveraging and there will be no deleveraging – well, not until the brains trusts at the central banks and in government have finished creating the next Great Depression.

In fact, from what we can see there is more leveraging than ever before.

So, seeing as it’s taken the FOMC twelve months to admit that low interest “could” lead to excessive risk taking, you should view their judgment about the “relatively low” likelihood of this becoming a problem as a genuine warning sign.

It’s this blinkered view from the so-called experts that makes investing in precious metals all the more compelling.

I touched on this yesterday when we considered whether a rising gold price was sustainable. Our conclusion was that it is, primarily due to the increasing money supply globally – including here in Australia.

But I’m going to have to break a promise I made yesterday to cover the Australian gold price today. Because it’s worth looking again at the zero effective yield being received by investors in US bonds.

Once I’ve got this out of the way I can then address the Australian dollar price of gold tomorrow.

Anyway, yesterday afternoon, the editorial team got together for a pow-wow. We were trying to figure out why on earth an investor would exchange cash for an investment that will provide no real return over a three month period.

When you think about it logically it just doesn’t make sense. If we think about this on an individual, small-scale level, what could be a reason for you taking cash out of the bank and giving it to someone in exchange for another piece of paper (a government bond) which will only guarantee you the return of your initial cash?

If we strip it back to the really basic level then arguably you would do it if you thought the government bond was more useful to you than cash.

So, what uses does a government bond have that cash doesn’t?

Well, if we take the theory back to the institutional level, for institutional investors in the US, a government bond is safer than holding cash in a bank. Bank deposits are only guaranteed by the Federal Deposit Insurance Corporation (FDIC) up to a maximum of $250,000.

So the only real alternative for an institution is for a ‘cash like’ asset which they assume to be even safer than cash. Surely the US government couldn’t possibly renege on its obligations to redeem the bonds for cash on maturity!

But what about inflation? Don’t forget that most of the Muppets in institutional investing have either been brainwashed into thinking inflation is a non-starter, or, well, they just don’t care – it’s not their money after all.

Besides, for the big banks trading cash doesn’t generate commissions whereas trading in and out of bonds does.

Do you remember the results from Goldman Sachs? Much of their ‘profits’ from 2009 were gained thanks to their trading desk.

And that’s the key to this. It links right back to the blinkered view of the FOMC and their belated non-warning about excessive risk taking.

US treasury bonds are being used as an instrument of excessive risk.

It would seem there are two ways they can do this. First, they can trade the bonds and the bond futures multiple times to generate big returns on even the smallest market movements.

Naturally, the smaller the movement in price, the bigger the exposure required to generate returns. And with interest rates being pushed lower and lower with no expectation of the Fed increasing rates, the movements on a daily basis are miniscule.

If you click here you can compare the movements of the Fed Funds Rate in recent months compared to movements over the longer term.

Don’t forget, this rate is the basis for all other interest rates. If the Fed Funds Rate is barely moving then interest rate traders have to leverage themselves up a whole lot more if they want to maintain their trading profit levels.

And that leads neatly onto the other reason for the appetite for US treasury bonds. Typically a treasury bond is afforded the status of being the least risky asset class by lenders.

Therefore if you want to leverage yourself up as much as possible it’s only natural that you’ll want to fill your balance sheet with as many “low risk” assets as possible.

The lower the risk, the more you’ll be able to borrow against them.

And even better, why not borrow against treasury bonds in order to buy more treasury bonds which you can then use as margin for even more treasury bonds.

After all, as far as the banks are concerned, what’s the odds of a big movement in treasury prices leading to a margin call compared to a big movement in the price of stocks?

For now it’s not very likely. But as with anything, the greater the perception of safety in an investment, the greater the demand for it becomes. And the greater the demand the further the price moves away from fair value – creating a bubble.

In other words, the paradox of investing safely is in this instance creating the mother of all asset bubbles.

The Fed’s standpoint that low interest rates “could” create excessive risk taking is akin to saying a 10 tonne weight “could” crush an egg.

Cheers.
Kris.

60-Second Market Round Up
by Shae Smith

The S&P/ASX200 ended the day in the red, closing at 4,685 down by 32 points. The Aussie market has had a flat start after an ordinary session in Wall Street overnight.

The Dow Jones Industrial Average finished down 17 points to 10,433.71. Stocks fell early in the session after the third quarter GDP report showed that the economies growth was weaker than expected. Read more here.

In the UK, the FTSE100 closed to 5,323.98, lower by 0.59%. The Footsie dropped on the open on the back of news that China’s central bank is tightening its lending policy.

The Nikkei closed at 9,401.58, down by 96 points.

The price of spot gold in Australian dollars is trading at $1,270.84, while in US Dollars it is trading at $1,168.66. The price of silver in Aussie dollars is $20.15 and in US Dollars it is $18.53.

The Aussie dollar versus the US dollar is trading at USD$0.9195, and against the Japanese Yen JPY81.38

Crude oil closed at USD$75.82

For the biggest movers on the market yesterday click here…

FOMC Discusses Excessive Risk Taking, 5.3 out of 10 based on 8 ratings

Tagged as: bankers, deleveraging, excessive risk taking, Fed Funds Rate, financial markets, FOMC, Goldman Sachs, government bond, great depression, inflation, interest rates, Open Market Committee, policy makers, reserve bank of australia, short-term interest rates, US economy, us federal reserve