Sense on Cents

Everybody back in the pool!!! Turn that music up and let’s rock!!

Why so ebullient and energized to ‘party?’  Well, our host, Ben Bernanke, has promised to keep the ‘punch bowl’ filled. As the Wall Street Journal highlights in writing Bernanke Sheds Light on Exit Strategy:

Mr. Bernanke reiterated that despite recent improvements in the economy and financial markets, the federal-funds rate will likely remain near zero for an extended period of time.

That statement by the ‘grand and wonderful wizard’ Ben Bernanke is the equivalent of turning up the volume to some music by the J. Geils Band. How are the partygoers reacting? Filling up their cups, that being, buying bonds like there is no tomorrow.

On the day, the Treasury market has rallied by 10 to 15 basis points (recall lower rates means higher bond prices) as all the partygoers (market participants) reenter into a variety of ‘positive carry’ trades.  In layman’s terms, positive carry trades very simply are a vehicle to use cheap dollars (i.e Fed Funds borrowed between 0 and .25) to purchase higher yielding assets. Another commonly used term for this form of investing is utilizing increased ‘leverage.’ Yes, we have previously partied with increased leverage. That did not end well…

Why would traders or others utilize this approach in the midst of such economic uncertainty? Very simply, when the host tells you that the ‘punch bowl’ is going to remain filled for an extended period, he is compelling you to get involved. In fact, he is effectively forcing you into the pool. How so? The returns on the safest, shortest, and most liquid assets (T-bills, CDs, money markets) will also be kept low for an extended period.

As an investor, the Fed chair is literally forcing you to take greater risks in your investments. Those funds will be utilized by financial institutions to generate increased earnings and thus write off the loans on their books which are defaulting at an ever increasing rate.

What are the risks of keeping the ‘punch bowl’ filled too long?

> inflation, as too much “liquid”ity enters the system

> asset bubbles, as too many cheap dollars chase returns

> mispricing of risk, as market participants focus on the technical rally rather than fundamental analysis

The challenge for Bernanke is knowing when and how to pull that punch bowl away.

The last wizard, Alan Greenspan, badly miscalculated in his assessment which led to our current economic turmoil.

While it is nice to see positive returns in 401K statements and other monthly investment statements, be mindful of another tried and true piece of Wall Street wisdom . . . ‘the road to hell is paved with positive carry.’

In the meantime, as long as we understand the parameters of this situation, let’s enjoy Ain’t Nothing Like a House Party by the J. Geils Band!!

LD

This entry was posted on Tuesday, July 21st, 2009 at 1:59 PM and is filed under Ben Bernanke, Economy, Federal Reserve, General, markets. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.