Wednesday, December 30, 2009

Penny Arbitrage, the US Dollar, and the Commodities Market

Question: When is a penny worth more than a penny?

Answer: When there’s the chance for penny arbitrage.

Arbitrage is any investor’s dream come true! It is an opportunity to make money through a trade with zero risk of a loss. Literally: in an arbitrage situation, you cannot lose. If you can, then its not true arbitrage. While this may sound too good to be true, arbitrage is quite possible, and there is an entire niche of specialized investors who are constantly hunting down the latest chance to taken advantage of it. Arbitrage is an idiosyncrasy of the free market: as much as it might burn some people who don’t take advantage of it—including “people” of the international finance realm like those are the BIS, IMF, etc—arbitrage reveals locality in pricing over global uniformity. Therefore, of course, globalists hate arbitrage, because that locality threatens the centralized world they seek to unilaterally control. Here’s the IMF’s explanation of arbitrage, from
Demystifing Hedge Funds, an external document on the IMF's website:

"The technique of arbitrage tries to profit from the fact that sometimes an asset trades at a different price in different markets at the same time. Because an asset should have the same price in all markets at the same time, a way to capture a low-risk profit is to sell the higher-priced asset in one market (sell it short) and buy the lower-priced asset (buy it long) in the other market. When the prices converge, an arbitrage profit can be captured by selling the formerly low-priced asset and buying back the formerly high-priced asset. A typical example of potential arbitrage opportunities is company bonds that are convertible into equity shares of the company.”

Please note, by “asset,” the authors are talking about financial assets—market-traded securities, stocks, debt, derivatives, etc—and not off-exchange commodities. Commodities often have different prices in different geographic areas: bananas are cheaper in Guatemala than in Russia, right? The availability of a commodity is often geographically limited or specific, thus the above-mentioned “assets” are those electronically exchanged paper assets which are equally accessible in all corners of the planet. Indeed, commodities can be lsited on exchanges, and when they are, they also be subject to price uniformity, and possibily arbitrage when locality breaks that uniformity. Just recently, a
major arbitrage oppurtunity occured for Chinese copper traders who spotted a price difference between the London Metals Exchange (LME) price and the Shanghai price on futures contracts for copper: within hours, these savvy traders rallied the price up and pocketed a risk-free return. And of course, they never even touched the metal. It is pure arbitrage.

Arbitrage is not Chiquita buying bananas in Guatemala for $0.02/lbs, bringing them to the US, and selling them for $0.69/lbs. Chiquita is not conducting arbitrage because, while if everything goes well, they’ll make a nice profit, it is also possible that they could lose money. True arbitrage is totally protected from loss. Chiquita is trading: they are moving the cheap-to-produce, widely available, local commodity of bananas from a place like Guatemala to a higher-priced market where the bananas are otherwise unavailable, like Minnesota. Chiquita takes a risk and could lose: after all, the banana ship could get raided by gorilla pirates (not guerillas, but actual gorillas!), who eat all the bananas, kill the crew, and sink the ship. Its not likely, but its possible, and now Chiquita is out a load of bananas, a crew, and a ship. Therefore, there is risk to Chiquita’s venture, and so it is not arbitrage. Remember: arbitrage carries zero risk­—it must be impossible to lose. Also, true arbitrage happens nearly instantly: the trade is executed and the profit is collected. So, then, what is an example of arbitrage, and how to pennies relate to this?

Think about pennies while this example of arbitrage unfolds. Probably the simplest, easiest, and most common form of arbitrage happens when a trader realizes that the convertible bonds (bonds of a company that can be converted to stock in that same company) have a premium (or discount) to the current price of the equity (stock). This is called convertible arbitrage.
Demystifing Hedge Funds explains it as:

Convertible arbitrage. A strategy in which managers purchase a portfolio of securities that are convertible into other kinds of securities. For example, corporate bonds are often convertible into equity shares of the issuing companies. Normally, the prices of the bonds and shares trade in a close relationship. Sometimes bond and stock market conditions cause the prices to get out of line. Hedge funds buy and sell the bonds and stocks simultaneously, pushing the prices back into line and profiting from market mispricing."

Let’s say you are a trader. You are looking through convertible bonds, and notice that Company Z’s stock is trading at $10 a share. You also notice, however, that for some reason, Company Z’s convertible bonds are trading at 99% of face value, and are convertible to 11 shares. You do the math: you can buy $100 face value of Company Z’s bonds for $99, and it convert to 11 shares at $10 a share. In other words, you can buy spend $99 and get $110, instantly. You don’t know anything about Company Z, nor do you particularly care, because you will execute the buy and sell of the bonds and converted stocks instantly and simultaneously. Others, of course, will quickly notice this, and soon those with the bonds which you seek to purchase will demand a higher price (or convert the bonds to stocks themselves), and/or those with the stock you wish to buy will sell and buys bonds, thus driving down the price of the stock. Either way, the arbitrage will quickly evaporate, as the bond price will go lower or the stock price will go higher to equalize, or the stock will go higher and the bonds lower. Either way, those others in the market with Company Z bonds/stocks will have the market power to demand a higher price which will correct the arbitrage situations.

So, in convertible arbitrage the trader exercises the right to convert one to the other, or use one to purchase the other at a zero risk of loss. It must be instantaneously, electronically accomplished so that the arbitrager never “holds” the bonds/stocks, which will soon be subject to correction. The other huge example (though much less common) version is regulatory arbitrage. In regulatory arbitrage, traders can take advantage of some legal constraint that varies in different markets. Regulatory arbitrage plays one government’s policies against another, or with Basel II, one securitization framework against the other. There are financial geniuses in the
regulatory arbitrage market, who have, as mere individuals, actually greatly hampered the Bank for International Settlements’ push for “standardisation” by revealing that the BIS’ Basel II framework itself is wrought with contradictions and arbitrage opportunities—and they are using it against the banks with great success. And banks themselves use regulatory arbitrage. Regulatory arbitrage along these lines, according to many analysts and the disgruntled finance ministers of the top twenty economies (aka the G20), had a significant role in sparking the current meltdown, particularly and specifically with the Basel II minimum capital requirement’s various ridiculous “capital calculation” schemes. (But I’m getting sidetracked: there will be a complete post on the role of regulatory arbitrage in Basel II soon.) So, that’s basic financial asset arbitrage. It’s a simple concept, even though the execution can be a little complex, and arbitrage helps keep prices of financial assets in line throughout the global paper investment market.

Thus is one example of paper asset arbitrage. Now for commodities arbitrage—penny arbitrage. I acknowledge outright that my penny arbitrage example is in no way a true arbitrage, because you cannot instantly make profits nor can you execute it while sitting behind a trader screen. To be totally technical, penny “arbitrage” is more like a hedge, as one “asset” (the penny) exposes the holder to two different markets simultaneously—the copper market (as a copper penny) and the currency market (as a unit of the US dollar). But unlike hedging, it actually carries zero risk--you'll always have whatever you started with. Therefore, I’m going to call it penny arbitrage, and maybe you’ll see why and agree.

Penny arbitrage demonstrates what fiat money does: it disintegrates value. Reach into your pocket, and pull out all of the change. Of course, we already know that any pre-1965 quarters or dimes that you might have in that mix are 90% silver, and therefore, currently, those silver coins are worth more than ten times the face value (in fact, with silver at about $17/oz today, they’re worth over twelve times face value). But, in all honesty, it is not very likely that you’ll have a pre-1965 quarter or dime. Most of the silver coins have been pulled from circulation by investors and collectors who know what they are worth, and so you’ll have to pay the about $12.29 for 4 silver quarters (in other words, $12.29 for $1 face value). That said, however, it is very likely that you’ll have some pennies. And it is also very likely that you’ll have some copper pennies.

So, do it now, check your pennies: any one with a date of 1981 or older is a 95% copper coin. During 1982, the penny’s composition was changed from 95% copper, 5% zinc to 95% zinc, and only 5% copper (coating), due to the increasing price of copper, which had
peaked to over $1/lb in 1980, and was holding steady above $0.70/lb. (Do you see where this is going yet?) Some 1982 pennies are 95% copper, and some are 95% zinc, but you cannot easily tell unless you weigh them: the copper pennies weigh about 3.1 gm, and the zinc pennies weigh about 2.5 gm. Of course, the price of copper wasn’t simply increasing on its own in a vacuum as industrial commodity: the price of copper was increasing relative to the value of the dollar (or, in this case, the penny), which, because of its inflationary fiat nature, is constantly deteriorating. Congress changed the composition of pennies in 1982 because the cost of making the physical coins was increasing, while the purchasing power value of each $0.01 was decreasing.

Now for the arbitrage: those easy-to-find copper pennies have a declared face value of $0.01. Therefore, for monetary exchange, a penny (whether copper or not) is worth only $0.01. But, as copper, your little penny exposes you to the commodities market, and as metal, the little thing is worth more that double the face value—its actually worth a whopping $0.02 (or 0.0217498, to be more precise, today, Dec 30 2009, with copper at $3.35/lb). That is penny arbitrage.

As stated above, the
mass of a copper penny is 3.1 grams, but as it is 95% copper, the actual copper content is 95% x 3.1 = 2.945 grams. There are 28.35 grams to an ounce (metric converter), and 16 ounces to a pound, therefore 453.6 gm/lb. So, to calculate the price per gram of copper, simply convert the price/lb to price/gm by following this equation:

Price/lb ÷ 453.6 = Price/gm

At $3.35/lb, copper is currently $0.0073853 a gram. At 95% copper, each copper penny contains 2.945 gm copper. Therefore, multiply the price by the content weight, and you’ll see that each copper penny contains $0.0217498 worth of copper, or more than twice the face value.

An easier way to do this is to calculate the number of copper pennies needed to make a pound of copper. Copper pennies are 95% copper and lose very little of their composition through circulation.

Number of 95% copper pennies needed to make 1 lb copper:

453.6 (gm in 1lb of copper) ÷ 2.945 (gm of copper in 1 penny) = 154.023 pennies.

So, you need 155 pennies (or $1.55) to have one pound worth of copper. Of course, as they are 5% zinc, these 155 pennies will actually weigh slightly more than one pound if placed on a scale (they'll weigh 3.1 gm x 155 = 480.5 gm / 453.6 gm (per pound) = 1.059 lbs).

Now, consider that the current price per lb of copper is $3.35 (Dec 30 2009). Do you get it now?

As the table above demonstrates, the price of copper overwhelms the one-cent face value of the penny when the metal hit $1.55/lb. A copper penny will be worth a dime ($0.10) when copper hits $15.41/lb.

For historical comparison, the Treasury could no longer afford to maintain the 90% silver content of halves, quarters, and dimes by 1962. The value of the paper dollar had decreased (read: "had been debased by the Federal Reserve System") to the level that silver was nearing a 1:1 ratio. The year 1964 was the last for 90% silver coins (40% silver halves through 1968, and then all circulating coins were silver-free). Since 1965, when silver traded at roughly $1.10 - 1.29/oz, the price of silver has increased by approximately $16.90, or 1536% (based on recent $18/oz silver; silver is today at about $17, and reached over $20 in early 2008).

Likewise, since gold was removed from the $35/oz peg in 1971, the metal has moved $1065, or 3043% (based on recent approximate $1,100/oz gold).

Therefore, as a monetary unit, a copper penny (and its zinc version) is pegged at $0.01, which sets both the floor value and the investment price for it as an “arbitrage” opportunity. However, as a piece of metal, the old copper penny’s value is over 2 cents. Over the long term, the copper price will likely rise in step with general prices, especially as the industrial demand for copper increases and more nations become industrialized, but an even greater factor in the “price” of copper will be the long-term loss of value of the US dollar unit.

I’ll be the first to declare that copper prices are very volatile: after a 60-year low of $0.60/lb in the 1990’s, copper has spent much of the last
15 years under $1.50/lb, which made the price nearly the same as the $1.55/lb copper-penny price. In 2006, the price of copper and nickel surged, making the coins more valuable as metal than as US currency, and forcing high replacement costs on the US Mint. Until 2006, it was not illegal to melt coins, but facing these high replacement costs, the Treasury prompted the US government to illegalize the melting of pennies and nickels (which are 75% copper, 25% nickel), and impose restrictions on the export of the coins to $100 face value. The copper price moved down in 2007 before again surging during the summer 2008 commodities bubble that pushed oil to $148/barrel. The melt/export ban remains in place for nickels and pennies. (A similar ban was placed on the melting of silver coins as part of the Coinage Act in 1967, and this ban was eventually lifted once the Mint could meet the US coin demand with the “clad” silver-free coins.)

At the 2006 and 2008 $4/lb level, $1.00 in copper pennies was actually worth $2.60 in copper. For the record: I am absolutely NOT suggesting to anyone to melt pennies or nickels—as detailed above, it is a federal crime punishable by a $10,000 fine and five years in prison, or both. I am simply using the difference in the “currency value” of copper pennies versus the “commodities value” of the copper in them to demonstrate what fiat money does to the value of our currency and the spending power of our savings.

So think about what the Federal Reserve’s fiat printing machine is doing to your savings next time you have a little copper penny in your hand. It is not rocket science, and it is not some crazy derivative: a dollar in paper, or as an electronic entry at your bank, is worth $1.00, period. Yet, a dollar in little copper pennies is currently worth $2.17. This is why we call the central bankers by their proper name: central banksters.

Perhaps anyone with electronic “cash” sitting in an account, or paper bills stuffed under a mattress, collecting zero or near zero percent interest should, maybe, think about turning all that savings into pennies, sorting through them, and filling up Arrowhead water jugs with the coppers! Hey--it can be a new home decorating item: a few thousand pounds of copper pennies in whatever will hold them! After all, it really doesn’t take up that much space: according to a very unscientific Google search, a 5-gallon Arrowhead jug filled with copper pennies would weigh about 245 lbs, and contain 35,000 pennies, or about $350 face value in pennies, with a copper content of 95%. Put it in the closet, and when copper is at $10/lb in 15 years, it will be worth $2275, or $1,925 more than the face value. Worst case scenario, the police-state raids your house, takes your pennies, and gives you Federal Reserve notes!

Left as electronic money in a savings account at 5% compounding interest (which you’d be lucky to find these days), that $350 will have grown to just $570 in 10 years (
calculator). Left as cash in an envelope, it will remain at $350, and simply further lose purchasing power as the dollar devalues. Considering this, pennies are looking better by the minute! Plus, there’s the added benefit of denying a banking institution from taking your $350 and leveraging it out at 10:1, "buying" up the economy, further contributing to inflation, strengthening the Federal Reserve System, and continuing the devaluation of the dollar and atrophy of spending power! Why not pennies?

In 1924, in the Weimar Republic, paper money was worth more as
fuel for the fire than currency; in 2009, in Mugabe’s Zimbabwe, a $1,000,000,000,000 (that's one TRILLION) in bank notes was used as wall paper. And today, a little old US penny is worth more as metal than as currency. We’re lucky..,but for how long?

Wednesday, December 16, 2009

Record Yield Curve: 230% above-average spread makes Mr. Bernanke 2009 "Person of the Year!"

It seems the lost souls over at Time Magazine (who, of course, named the CCX's Dr. Richard Sandor "Hero of the Planet" in 2002) have now again added to their menagerie of confused choices for the latest "Person of the Year:" the honors for 2009 go to Chairman of the Federal Reserve Board in Washington, Mr. Ben Bernanke.

The Bankster Report has not analyzed what Time's parameters are for selecting these various annual "Persons," but one thing we can declare is that for the banks, Ben Bernanke might be the "Person" of their lifetimes! A dream come true! Today, as Mr Bernanke's mug is staring through the gloss on Time's cover, the banks ought to be hoisting the Chairman up on their shoulders, and marching around in celebration of their luck to have such a wonderful advocate. Mr. Bernanke & Company over at the Fed are making banks a lot of money, and they're making it very easy.

Nevermind the $700 Billion in TARP infusions from Treasury; forget about the $307 Billion in outstanding corporate bank/non-bank bonds that the FDIC is guaranteeing through the Temporary Liquidity Guarantee Program; exclude the Fed's purchase of $1.01 Trillion in agency/GSE paper from the banks and sovereigns; and just ignore the $1 Trillion Troubled Asset Relief Program--no, for this report, the Person of the Year, Mr. Bernanke's latest accomplishment is the Fed-induced yield curve spectacular!

The yield curve is the difference between interest rates on short-term debt and the long-term debt, and it is how banks make money off loans. They simply borrow short, and lend long. For banks in the US, this is usually done through US Treasuries, as part of the of fiat bankster masterplan. The banks can borrow short-term from the Fed (at the current near-zero Fed funds rate), take the "money" as an advance, and use it to buy short-term interest-bearing Treasuries, which have a higher yield than the "cost" of the Fed-"borrowed" money in the first place, and then with the borrowed/created money, simply use the short-term, low-cost (free!) money to front long-term, higher-interest yielding loans (like mortgages, etc). That's how to make a nice banker's profit. Or, of course, a banks can use a simple fixed-income strategy and simply borrow money to buy short-term paper, and then use the short-term paper's yield to purchase/finance loans to themselves for the long-term (10-year, 30-year) Treasury paper with the nice 3.5-4.5% yield, which they buy today and "pay themselves back" for in 10 to 30 years. Beautiful. A revolving fiat door of money creation.

And this money creation is a dream come true right now, because it is cheaper than ever. The practically free money which banks can borrow from the Fed right now at 0% cost needs only to yield them 0.1% for them to make a profit, and yet with the record yield curve, they are making much, much more than a measly 0.1%. In fact, in March 2009, the yield curve between the 2-year and 10-year note (the 2-10 spread) snuck over
275 basis points (bps, 100 bps is 1%), which broke the previous record by one bps. Its at 273 bps today--today, which is day-two of the Federal Open Market Committee meeting. At 2:15pm today, we will get the Fed's latest dictatorial decision on what this small group of men at the FOMC who are running the nation's monetary system will do with the low-as-possible interest rate level for the Fed funds rate. Of course, its at 0 to .25% right now, where its been for a year, and most people aren't expecting a change. Which is why Mr. Bernanke is "Person of the Year!"

When the Fed did the unprecedented last year and sunk the Fed funds rate to 0%, it did so to obviously encourage banks to borrow so it could flood the system with "liquidity" and save the world. Additionally with the TARP infusions, the Fed could bankroll the troubled banks by making it nearly impossible for them to lose money: even with the two times last December when the Treasury sold 3-month t-bills at a negative interest rate, banks could still make money off them if they purchased them, because they could hold them on reserve at their District Reserve Bank, and they would earn interest from the Fed. [Of course, that is hypothetical, because that would really only be temporary for a bank in so much trouble that it was buying 3-month bills to place them on reserve with the Fed, because the Fed needs (is supposed to, anyway) collateral for the original borrowing.] But it is an instructive example. All that said, the ideal place to make money for banks is still where it has always been--borrowing short and lending long, and thus the Fed's second strategy in steepening the yield curve steep is a dream come true.

The Fed, and specifically the FOMC, is the major mover of the yield curve. It is the only body that can, with the stroke of a pen, increase or decrease interest rates through its monopoly control over the Fed funds rate. The markets can influence the Fed, obviously, and the Fed vastly influences the markets, but control of the yield curve is really in the hands of the Fed. What we are experiencing right now is a positive, steep yield curve--a record positive, steep yield curve.. A positive curve is considered normal, of course, because that means that shorter-term debt is less risky than longer-term debt, and thus the yield for shorter-term debt is lower. In a stable economy with a solid future, that is the normal trend.

Conversely, a negative (or inverted) yield curve occurs when shorter-term debt is more expensive than longer-term debt, thus yielding a higher return than longer-term debt--and this is obviously not normal. It should not normally be more risky to hold shorter debt than longer debt, and in fact, the inversion usually is not outright do to risk. Instead, it is often due to concerns over liquidity and concerns over a change in profitability, and even more so, concerns over the central bank's moves. In an inverted yield curve, economists (and the Fed) use the 3-month/10-yr spread, because the 3-month is effectively priced at the Fed funds rate (for example, right now its at 0.03%, the Fed funds is at 0-.25% target range). Because of the fact that central banks control interest rates, an inversion can technically happen at any time: if a central bank feels like it, the central bank is the only body in control of the base rate, and it move it up higher than the 10-yr (or anything else!). For example, if the Fed came out at 2:15 today and said they felt like moving the rate to 4%, we would instantly have an inverted yield curve, as the 10-yr is yielding only 3.56%, so the short-term money would be more expensive than the long term debt. There's no way they will actually do that--but they can.

Thus, an inverted yield curve generally results from either a central bank's choice to increase the short-term borrowing rate (the Fed funds) in such a sharp jolt that it moves the yield higher than the long-term debt already issued and on the market, or a choice to decrease (or standstill) the short-term borrowing rate in an unexpected way, because the market may sense that as uncertainty and start itself driving down the long-term price by dumping long-term in favor of short-term. Also, the central bank's choice not to move increase rates signals that rates may have reached a high, a bubble may have peaked, and therefore a recession is coming which is force the central bank to cut rates. There are also other market-driven reasons this inversion can occur, but they are all related to the central bank: the market anticipates the central bank will do something contrary to the trend and therefore attempts to lock in higher rates; market anticipates a rapidly nearing shortage in liquidity or credit and therefore moves from long-term to short-term to increase access to cash; or the market anticipates serious tumult (recession) that prompts a rush to the safety of cash and the more liquid, shorter-term debt. Any way, its a bad sign! Since 1969, every inverted yield curve has forecasted a recession by 5 to 18 months (called the "lead time"). The last inverted yield curve we saw in Treasuries was in
July 2006--15 months before the December 2007, the month that the National Bureau of Economic Research determined the official start of the current recession. Also worth noting is that the inversion itself occurred one month after the FOMC decided not to raise the Fed funds rate which it had been steadily pumping up since 2003. The market noted the same trend that the Fed did--something was coming, and the Fed was going to start cutting rates to prevent it, and further the bubble with cheaper money. This table demonstrates the peak of the Fed funds rate. From 2003 through June 2006, the FOMC increased the Fed funds rate from 1% to 5.25%. Since July 2006, when the yield curve inverted, the Fed has sunk the rate from 5.25% to 0%.

From this current zero-level, it is impossible to see an inverted yield curve, because rates can only go up. Therefore, what we are seeing today with Mr-Person-of-the-Year-Bernanke's Fed is the polar opposite--a record steep positive curve. As I mentioned above, the 2-10 spread is at 273 bps today. The 3-month/10-yr is at 353 bps. But even more impressive, however, is what is happening right now with the yield difference between the 2-year and 30-year Treasuries. The 2-30 spread was at
373 bps less than a week ago, which is a nearly 30 year record. I just checked it today, and its at 368 bps as I write this. Anyone can check the spreads on 2's, 10's, and 30's on this Bloomberg Government Bonds page. To determine the yield spread, simply subtract the short-term yield from the long-term. [For example, when I checked it today (December 16 2009) the 30-year was at 4.51% (or 451 bps), and the 2-yr was at .83% (83 bps), thus 451 - 83 = 368 bps spread].

You might be thinking: 30-year record--that would put it back to Volker days, right? Right! Besides the one in 2006, there was another major inverted yield curve in April 1980, when the 3-month T-bill actually was actually yielding 240 bps more than the 10-yr note! Major volatility in interest rates controlled by the Fed was the cause of this. It was an incredible year: in
December 1979, the Fed funds rate was at 13.78%. Three months later, by March 1980, the rate was 17.19%. And by December 1980, the rate was 18.9%. However, between March and December, the rate dipped to barely over 9% in July. As a result, the Fed single-handedly produced a yield curve, which likewise signaled to the market that a recession was near, and further put the pressure on bonds, and everything else. Its demonstrates the FOMC's iron grip on yields, and their prerogative to whipsaw when they feel like it. Or, as Mr. Bernanke is now doing, to lay it on thick.

Mr. Bernanke has created the opposite of the Fed-induced inversion today, because he has made the Fed-induced record steep yield curve! In fact, there's a 230% above-average return for banks on long term loans, as measured by the yield spread, which the banks are enjoying right now*. Of course, the Fed's argument is that without such a huge and unprecedented profit margin, the whole system would come crashing down because the banks would fail! They are half right--the banks would fail. But this system is already in shambles. This is clear: even as the banks are making record profits off spread lending with very limited risk exposure (or none at all if they are earning interest on reserves at the Reserve Banks), they are still fearing for their existence, and they are doing so for at least three reasons. Firstly, banks simply don't know how many of the new loans, and especially the older loans, one their balance sheets will fail. Even a record yield curve, when the spread is funding commercial, consumer, or mortgage loans, is only profitable when the loans are performing. Second, the banks don't know if the Fed will change its currently practically non-existent collateral requirements for all the heavy borrowing they are doing. If the Fed changes its currently liberal collateral terms, banks could find themselves without enough deposits or securities to offer as collateral for the advances, which would force them into the more expensive Fed Discount Window for emergency money. Thirdly, and most critically, the banks know that rates cannot stay at zero forever. If they make too many fixed-rate long-term loans at the current rate, they could find themselves paying more to fund the loans short-term than they are actually making long-term.

Banks, despite this currently easy money, are now actually anticipating a decrease in the real value of the money they make from cheap loans, and the steep yield curve which would normally be indicating profitability and confidence is being tempered by a realistic acknowledgement that the short-term Treasuries--at their record low yield supported by the near-zero Fed funds rate--must, must, must go up, its just a matter of when. There's the problem. The banks don't know what that 2-yr note will cost them in two-years, they just know it will be more. So in response, they are building in inflation. And we know this because they are saying it with their purchases and their actual statements.

As for their statement through purchases, short-term paper is looking ever more appealing. The Treasury is not having any problem selling the short-term debt (3-month, 6-month, 12-month, and 2-year). Its the longer-term 10-year and especially the 30-year that isn't so red-hot right now. In fact, yesterday's (Decemeber 15, 2009) auction was characterized by some "sluggish bidding" which pushed the 10-year note on the secondary market to 3.6%, the highest level since August. Interestingly, just last week, and in anticipation of the auctions, the 10-year moved up slightly, sending the yield down a tad from 3.48% to 3.43%. Conversely, by the time of the actual auctions, buyers had a change of heart--perhaps because by this week, they'd seen better estimates on the latest inflation numbers, the Consumer Price Index (CPI), and seen the actual numbers on the Producer Price Index (PPI). Yesterday's auction came after the release of the PPI numbers--which were much higher than economists' estimates and which indicated an inflation blip: producer prices soared by over 1.8% in November alone. Long-term Treasuries already offering only record low-yields look even less attractive after a number like that.

Today, the Consumer Price Index numbers were released. Last weeks' estimates on what to expect were hoovering around December 16 CPI numbers indicate a 0.4% rise in prices in November, 1.8% adjusted over the year. The Bloomberg economists' survey was expecting 0.1%. Both numbers are unexpectedly high.

Looking at November's PPI and CPI, anyone with realistic inflation expectations knows that a measly 4.51% on a 30-yr bond when a single month increase in consumer prices of 0.4% and producer prices of 1.8% is not going to help you one little bit. In order for interest (pun intended) to return to the long-term side, the yields will have to move up. Either the market will do this, or the Fed, or both. Meanwhile, as the interest in long-term debt dries up, the price will necessarily do down, and the yield curve could widen even more. Banks are holding short-term and cash. Why would any investor--unless it was a bank with access to the cheap Fed money-- be buying up long-term Treasuries at this near-zero Fed funds rate, when he knows that he will necessarily be hit when the Fed eventually increases rates? Why would he lock himself into the record low yielding return of the current long-term Treasuries, instead of waiting for the rates to increase and them buying the higher yield? And likewise, why would the banks, who do have access to the cheap money, use it to purchase long-term debt and thus contribute to a decrease in the yield spread buy increasing the price (decreasing the yield) of the long-term Treasury?

It is a standoff of sorts. The bond vigilantes cannot access cheap borrowed money from the Fed funds, and so they are not making a record spread--they are getting killed! While the banks this year have been profiting with a 2.75% average spread yield on their borrowed-money Treasuries, the people who actually held the Treasuries have been hit by over negative 2% . Investors are not stupid--the are going to shy away from the long-term debt until it starts rewarding them for holding it. And the banks are not stupid either--they are not going to contribute to a decrease in the yield spread that is making them money. The demand for long-term Treasuries is softening, which, of course, means that the Treasury is having to sell them at slightly higher yields to the reluctant purchases, which is, of course, further increasing the difference in yield between the short-term and long-term, thus steepening the curve. Simple, right?

Right. By November 30, the gap in the 2-year/10-year Treasuries was at 265 bps. So how does that stack up the normal 2/10 spread? Amazingly, it is
DOUBLE the 20-year average of 115! Its actually well over double--its some 230% over the 20-year average! Indeed, if I was a banker, Mr. Bernanke would be my "Person of the Year!"

But maybe only for this year, as that inflation monster looms. When banks start anticipating inflation--which are themselves experts on the topic through their happy contribution with fractional reserve lending and leverage--and when banks start getting perhaps a little scared about it, you know we're in trouble. From the November 30
Reuters article:

"This would normally be viewed in a positive light as a "steep" yield curve -- higher yields on longer maturity Treasuries than their shorter-dated issues -- usually signals market expectations of steady economic growth and an environment where banks can lend profitably. Under the current near-zero rate regime, however, this unusually steep yield curve undercuts those expectations. It instead reflects anxiety over the timing of a Fed rate increase and an uneasiness that it will keep rates too low for too long and cause a resurgence in inflation.

Concerns of rising interest rates have persisted despite the Fed's pledge it will keep borrowing costs at record lows for an "extended period" until a recovery is sustainable.

These nagging worries have fueled demand for Treasury bills even though they are yielding close to nothing, while bidding for longer-dated Treasuries has been uneven at auctions.

"There are longer-term concerns about fiscal and monetary inflation," said Jim DeMasi, chief fixed-income strategist with Stifel Nicolaus & Co. in Baltimore."

Yeah, you think?

Better snatch up whatever you can with that free money before it runs out, and hold on, banks. The latest report (
November 30) by Bloomberg on the subject determined that US banks increased their purchasing of US Treasuries with Fed-borrowed money by 26%. US banks, according to the latest December 2009 Federal Reserve Report (pg 27, or pdf pg 34) hold $165 Billion in new Treasuries. The same page also indicates that the same banks dumped about $380 Billion in agency/GSE paper, much of which was sold to the Federal Reserve (and this agency/GSE paper outrage is another report entirely, which will be forthcoming). But now you can be happy that the banks are raking in 230% above average returns on loans, all thanks to the Federal Reserve Chairman and "Person of the Year," Mr. Ben Bernanke.