Notes From Underground: Is the Fed In a War?

I pose this question as a challenge to all of those traders and investors, and a call to action. There is so much discussion about the onset of inflation but do the inflationists have the fortitude to attack the FED where it hurts: the long end of the yield curve? The primary focus of the FED has been on the part of the QE purchases has been the shorter end as 80% of the FED‘s balance sheet is five years or less. If the inflation concern is of the magnitude suggested by the mainstream media then market participants OUGHT to be selling the longer duration Treasuries because as we know the Wall Street mantra is DON’T FIGHT THE FED.



If my assets were vulnerable to the negative effects of inflation there would be a need to protect by selling long duration Treasuries. This would FORCE the Powell FED to either RAISE FED FUNDS RATES OR ELSE INDULGE IN YIELD CURVE CONTROL IN AN EFFORT TO KEEP LONGER YIELDS FROM RISING. This is the market’s obligation, to CHALLENGE THE CURRENT STATE OF FED/TREASURY POLICY. The U.S. central bank maintains that inflation is TRANSITORY as short-term price increases are due to supply bottlenecks in raw materials and labor mismatches all caused by the covid pandemic. Once things normalize the short-term price pressures will abate.

If so, then the FED is correct and there is no need to change its present strategy of buying shorter duration assets in its quest to purchase $120 billion of Treasuries and MBS each month. The FOMC members continue to maintain that the concern is about the mismatch in jobs as the REAL UNEMPLOYMENT RATE (as measured by FED economists) remains elevated at roughly 9%. Remember that Chair Powell has reiterated his belief that FED policy remains as is until all those who lost jobs through NO FAULT OF THEIR OWN have been gainfully employed and most probably at higher wages. (I believe American private sector workers are in need of a pay raise as they have born the brunt of 25 years of capital flowing around the globe in search of low wage driven productivity gains, or as Tomas Picketty summed up, R>G.)

The increased concern about rising inflation flies in the face of the Powell/Yellen doctrine of creating enough jobs to right the wrongs of the jobs destroyed in response to the pandemic. Who is correct? I don’t know but if the FED‘s stance is sustained inflationists OUGHT to cause a steepening of the YIELD CURVE as it engages in market forces. The operative concern for investors is how high can 10- and 30-year yields rise before the FED reaches into its toolbox to find a way to curtail the rise in long-term yields.

This is of great importance because the market is heavily influenced by the ALGOs that use the 30-year yield as the key to trading myriad assets (equities, bonds, precious metals, foreign currencies). This is a very UNCOMMON outcome of the FED policy being at zero interest rates for the next two years. The 30-year has never been the determinant of asset values as the short-end/fed funds has been the KEY variable in gauging FED policy. If the FED was deemed to be BEHIND the CURVE raising short-term rates was the answer which would flatten the CURVE as the FED responded to market concerns about an overheating economy.

The FED has committed itself to realizing its FULL-EMPLOYMENT  MANDATE at the expense of TRANSITORY INFLATION. It’s time for the market to challenge the cental bank’s desire to rely on its beloved forward guidance. Making the FED uncomfortable is the market’s job, as well as causing as much pain to as many people as possible.

***There is continued concern about supply bottlenecks being the driving force of higher prices. There is some proof but I would caution that the greater force is the stockpiling of raw materials by the Chinese. In the Stanley Druckenmiller interview last week on CNBC, he cited the spring 2020 bond destruction, which resulted in the FED buying all types of DEBT was because FOREIGNERS DUMPED U.S. TREASURIES as the central bank embarked on a massive global liquidity enhancement program. (Think swap lines opened with many new foreign central banks and other efforts to slow the liquidation of assets.)

If DRUCKENMILLER is correct it would explain why raw materials began to rise well before the GLOBAL ECONOMY halted its dramatic contraction. The Chinese YUAN made its low on May 27, 2020 just as commodity prices were gaining their footing after the BLOOMBERG Commodity Index had dropped by more than 25% in three months. Even before the vaccine announcement in November, the BCI had rallied back almost 20% from its January 2021 high.

The inflation argument found in resulting supply shortages falls flat when you look at GLOBAL GRAIN markets, which experienced a 33% price increase even as Brazil and the U.S. produced BUMPER CROPS. Even though global economic growth improved grains, metals like copper were rapidly increasing in PRICE. If Druckenmiller is correct, the question needs to be asked: DID CHINESE SELLING OF U.S. TREASURIES LEAD TO THE CHINESE PURCHASING AND STOCKPILING REAL ASSETS IN AN EFFORT TO COMBAT THE FED’S DESIRE TO PROVIDE UNLIMITED LIQUIDITY?

Did the Chinese outwit the global actors in a quest to protect their paper assets? The answer may cause a shift in our views about the present rise in commodity prices. There was a Reuters article on Friday titled, “U.S. Tariff Review Considers Commodity Shortage, Inflation–Official.” This discussion is laughable for the U.S. imports almost zero commodities from China so why would that be the area of concern?

The strengthening YUAN would be a far better barometer of Chinese impact on global raw material prices. There’s lots to think about but watch the long-end of the yield curve to discern market action. If the FED chooses like Bartleby the Scrivner not to play then how STEEP can the yield curve go. When Paul Volcker was FED chair he INVERTED the yield curve to more than 600 basis points in an effort to crush inflation. How steep will the FED allow the CURVE to rise in an effort to hit its inflation target?