Interest Rates - Arbitrage - Hedging - Deflation?

Pollock & MacKenzie

Warren Pollock is a guest author on Jim Sinclair’s Mineset and has been published in journals including the Journal of Homeland Security. John Mackenzie manages private capital and host's a gold forum/investors exchange on Yahoo groups.

Over the last few days Central bankers have been making statements to firm the dollar. There are also signs that they are taking less visible, coordinated action. While this action may provide short-term stability - by providing supply-side stimulus to inflate financial assets - in total these actions are actually deflationary.

The move to reduce the supply of guaranteed long-dated debt, which began with the withdrawal of 30-year notes, means that any debt retired must be replaced with debt at the shorter end of the yield curve. Of course, this action reduces the government’s cost of capital, at least in today’s environment. But in our view, this move also was made to encourage the issuance of mortgage-backed securities. Regardless of the reason, this shortening process is ongoing and it represents a major deflationary exposure in a way that investors may not have noticed.

Long bonds and Treasury finance
Long end paper has many uses. For investors, it provides a steady and predictable income stream against money borrowed in the marketplace. Additionally it provides arbitrage profits, which have become the most important aspect of our service-based economy. Every manufacturer has become a financier that borrows and re-lends money against guaranteed notes.

Lowering rates towards zero destroys this “new era” profit equation. With less capital available for arbitrage, there are less financial profits, and less money available for traditional capital expansion. Meanwhile, savers experience a negative return. These forces cause economic contraction and reduce systemic liquidity. ...Continued