Phisix: Don’t Ignore the Bond Vigilantes

A human group transforms itself into a crowd when it suddenly responds to a suggestion rather than to reasoning, to an image rather than an idea, to an affirmation rather than to proof, to the repetition of a phrase rather than to arguments, to prestige rather than to competence.” Jean-François Revel French Journalist and Philosopher

This is one chart which every stock market bulls have either ignored or dismissed as irrelevant.

Yields of 10-year US Treasury Notes skyrocketed by 249 basis points or 9.7% this week to reach a TWO year high of 2.829% as of Friday’s close. This represents 803 basis points above the May 22^nd levels at 2.026%, when the perceived “taper” talk by US Federal Reserve chief Ben Bernanke jolted and brought many of global stock markets down on their knees.

While US markets, as embodied by the S&P 500 (SPX), recovered from the early losses to even carve milestone record highs, ASEAN markets (ASEA-FTSE ASEAN 40 ETF) and ASIAN markets ($P1DOW-Dow Jones Asia Pacific) posted unimpressive gains. Such failure to rise along with US stocks has revealed her vulnerability to such transitional phase, see red vertical line. 

Considering what I have been calling as the Wile E. Coyete moment or the incompatibility or the unsustainable relationship between rising stock markets and ascendant bond yields (including $100 oil), it seems that signs of such strains has become evident in US stocks.

As I previously wrote[1],

The stock markets operates on a Wile E. Coyote moment. These forces are incompatible and serves as major headwinds to the stock markets. Such relationship eventually will become unglued. Either bond yields and oil prices will have to fall to sustain rising stocks, or stock markets will have to reflect on the new reality brought about by higher interest rates (and oil prices), or that all three will have to adjust accordingly...hopefully in an 'orderly' fashion. Well, the other possibility from 'orderly' is disorderly or instability.

The S&P fell 2.1% this week adding to last week’s loss as yields of 10 year USTs soared (see green circle).

Rising yields affect credit markets anchored on them. This means higher interest rates for many bond or fixed income markets and fixed mortgages[2]. 

And given a system built on huge debt, viz, $55.3 trillion in total outstanding debt and $179 trillion in credit derivatives, rising interest rates will mean higher cost of debt servicing on $243 trillion of debt related securities[3], thereby putting pressure on profit margins and increasing cost of capital which magnifies credit and counterparty risks. Higher rates also discourage credit based consumption, thereby reducing demand. 

In essence, ascendant yields or higher interest rates will expose on the many misallocated capital brought about by the previous easy money policies.

One example is margin debt on stock markets.

The recent record highs reached by the US stock markets have been bolstered by inflationary credit via record levels of net margin debt (New York Stock Exchange).

Should rising yields translate to higher interest rates and where market returns will be insufficient to finance the rising costs of margin credit, then this will lead to calls by brokerage firms on leveraged clients to raise capital or collateral (margin calls[4]) or be faced with forced liquidations.

And intensification of the offloading of securities due to margin calls may become a horrendous reflexive debt liquidation-falling prices feedback loop.

Since 1950s, record margin debt levels tend to peak ahead of the US stock market according to a study by Deutsche Bank as presented by the Zero Hedge[5]. 

In 2000 and in 2007, the aftermath of record debt levels along with landmark stock market prices has been the dreaded debt-stock market deflation spiral or the stock market bubble bust.

Net margin debt appears to have peaked in April according to the data from New York Stock Exchange[6]. This is about 3 months ahead of the late July highs reached by the S&P 500 echoing the 2007 cycle.

But will this time be different?

Rising Yields Equals Mounting Losses on Global Financial Markets

Rising yields extrapolates to mounting losses on myriad fixed income instruments held by banks, by financial institutions and by governments. 

For instance, bond market losses exhibited by rising yields on various US Treasury instruments has led to record outflows in June, which according to Reuters represents the largest since August 2007[7].

The largest UST holder, the Chinese government and her private financial institutions, who supported the UST last May[8], apparently changed their minds. They sold $21.5 billion in June. 

Meanwhile the second largest UST holder, the Japanese government and her financial institutions unloaded $20.3 billion signifying a third consecutive month of decline.

Combined selling by China and Japan accounted for 74% of overall net foreign selling.

Total foreign holdings of UST fell by $56.5 billion or by 1% to $5.6 trillion in June where about 71% of the total UST foreign holdings represent official creditors[9]

The Philippines joined the bond market exodus by lowering her UST holding by $1.9 billion to $37.1 billion in July.

However, Japanese investors, mostly from the banking sector, reportedly reversed course and bought $16 billion of US treasuries during the first week of August[10].

Instead of investing locally, as expected from the audacious policy program set by PM Shinzo Abe called Abenomics, the result, so far and as predicted[11], has been the opposite: capital flight. The lower than expected GDP in June also exposes on the continuing reluctance by Japanese investors to invest locally (-.1%)[12].

Politicians and their apologists hardly understand that policy or regime uncertainty and price instability obscures the entrepreneurs’ and of business peoples’ economic calculation process thereby deterring incentives to invest. When uncertainty reigns, especially from increased interventions, people opt to hold cash. And when government debases the currency, people will look to preserve their savings via alternative currencies or assets.

This only shows how the average Japanese investors have been caught between the proverbial devil and the deep blue sea.

It’s not just in UST markets. Losses have spread to cover many bond markets

In the US, bond market losses led to redemptions on bond funds as investors yanked $68 billion in June and $8 billion in July. The Wall Street Journal[13] reports that the June outflow signifies as the first monthly net outflow in two years, according to the Morningstar

Again the actions of the bond vigilantes are being reflected by the reflexive feedback loop between falling prices (higher yields) prompting for liquidations and vice versa.

Rising yields will not only translate to higher cost of capital, which reduces investments, and diminished appetite for speculation, the sustained rate of sharp increases in bond yields accentuate the “the uncertainty factor” in the financial and economic environment. Outsized volatility from today’s mercurial bond markets compounds on the uncertainty factor by spurring a bandwagon effect from the reflexive selling action and in the reluctance by investors to increase exposure on risk assets.

As bond yields continue to rise the losses will spread.

The Impact of Rising UST Yields on Asia

US Treasuries have been also used as key benchmark by many foreign markets. Hence, rapid changes in US bond prices or yields will likewise impact foreign markets.

And as explained last week, substantial improvements in the US twin (fiscal and trade) deficits postulates to the Triffin Paradox. This reserve currency dilemma implies that improved trade and fiscal balance means that there will be lesser US dollars available to the global financial system which has been heavily dependent on the US dollar as bank reserve currency and as medium for trading and settlement. 

Such scarcity of the US dollar may undermine trade and the the reserve currency recycling process between the US and her trading partners.

Higher yields and a rise in the US dollar relative to her non-reserve currency major trading partners are likely symptoms from a less liquid or a dollar scarce system

And if rising UST yields have indeed been reflecting on growing scarcity of the quantity of US dollar relative to her non-reserve currency trading partners such as ASEAN, then higher yields would likewise imply pressure on the currencies, and similarly but not contemporaneous, on prices of financial assets.

All four currencies of ASEAN majors are under duress from the bond vigilantes.

The pressure on prices of other financial assets will be a function of accrued internal imbalances that will be amplified by external concerns.

One exception is the Chinese yuan whose currency has yet to be adapted as international currency reserve. The yuan trades at record highs vis-à-vis the US dollar, even as her 10 year yields have been on the rise[14].

In the meantime, fresh reports indicate that despite all the previous regulatory clamps applied by the Chinese government, China’s bubble has been intensifying with new home sales rising in 69 out of 70 cities in July, and with record gains posted by the biggest metropolitan cities[15].

Curiously the report also says that the China’s property markets expect minimal intervention from the Chinese government.

If true then this means that in order for the Chinese economy to register statistical growth, the seemingly desperate Chinese government will further tolerate the inflation of bubbles which has brought public and private debts to already precarious levels. 

Rising yields of Chinese 10 year bonds will serve as a natural barrier to the bubble blowing policies by the Chinese government. The sustained rise of interest rates in China may prick China’s simmering property bubble that would lead to a disorderly unwinding that risks a contagion effect on Asia and the world.

Europe’s Bizarre Divergences 

Yet, rising UST yields has thus far affected Europe and Asia distinctly.

Bond yields of major European nations[16] as Germany, United Kingdom and France have been on the rise, the former two have resonated with the US counterpart. Yields of German and UK bonds have climbed to a two year high as shown in the upper window [GDBR10:IND Germany red, GUKG10:IND United Kingdom yellow and GFRN10:IND France green].

Paradoxically bonds of the crisis stricken PIGS have shown a stark contrast: declining yields [GGGB10YR:IND Greece green, GBTPGR10:IND Italy red-orange, GSPT10YR:IND Portugal red and GSPG10YR:IND Spain orange.]

I do not subscribe to the idea that such divergence has been a function of the German and French economy having pushed the EU out of a statistical recession last quarter[17]. Instead I think that such deviation has partly been due to the yield chasing by German, UK and French investors on debt of PIGS. But this would seem as a temporary episode.

Such divergences may also be due to furtive manipulation by several European governments given the election season. As this Bloomberg article insinuates[18]:

The bond-market calm that has descended on the euro area in the run-up to next month’s German election masks unresolved conflicts that have frustrated the region’s leaders for more than three years.

Greece needs more debt relief, the International Monetary Fund says; Portugal is struggling to exit its support program; Spanish Prime Minister Mariano Rajoy is battling corruption allegations and calls to resign; France faces unrest as Socialist President Francois Hollande follows through on his promise to cut pension-system losses.

But if the bond vigilantes will continue to trample on the bond markets then eventually such whitewashing will be exposed.

The Fed’s Portfolio Balancing Channel via USTs

In my opening statement I said that every stock market bulls have either ignored or dismissed the activities of the bond vigilantes as irrelevant to stock markets pricing.

It seems that the mainstream hardly realize that USTs have been the object of the Fed’s QE policies. In other words, what the mainstream ignores is actually what monetary officials value.

The FED now owns a total of 31.47% of the total outstanding ten year equivalents according to the Zero Hedge[19]. And with the current rate UST accumulation by the FED, or even with a “taper” (marginal reduction in UST buying), eventually what used to be a very liquid asset will become illiquid. This would even heighten the volatility risks of the UST markets.

The FED uses USTs as part of the policy transmission from its “Portfolio Balance Channel” theory which intends to “affect financial conditions by changing the quantity and mix of financial assets held by the public” according to Fed Chairman Bernanke[20]. This will be conducted “so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar asset”

In other words, by influencing yield and duration through the manipulation of the supply side of several asset markets, such policies have been designed to alter or sway the public’s perception of risk and portfolio holdings in accordance to the FED’s views.

Unfortunately the above only shows that markets run in different direction than what has been centrally planned by ivory tower based bureaucrats.

Whether in the US, Europe or Asia, where policymakers have been touting of the perpetuity of accommodative or easy money conditions, markets, as the revealed by bond vigilantes, has been disproving them. Soaring bond yields flies in the face of “do whatever it takes” promises.

Bottom line: Rising UST yields have been affecting global asset markets at a distinct or relative scale. 

Rising yields has been a function of a combination of factors such as the growing scarcity of capital or the shrinking pool of real savings at an international level, the unsustainability of inflationary boom, the Triffin Paradox, growing scepticism over central bank and government policies and of the unsustainability of the current growth rate of debt and of the present debt levels (see chart above[21]).

While so far, Asia and other Emerging Markets appear to be the most vulnerable, should bond yields continue to soar, which implies of amplified volatility on the bond markets and eventually interest rate markets, the impact from such lethal one-two punch will spread and intensify.

This makes global risks assets increasingly vulnerable to black swans (low probability-high impact events) accidents.

Caveat emptor.

---

[1] See Don’t Worry Be Happy Stock Markets Ignores the Bond Vigilantes August 14, 2013

[2] See Emerging Market Rout: Prelude to a Global Crisis? June 27, 2013

[3] See The Wile E. Coyote Moment: US Treasury Yields Spikes! June 11, 2013

[4] Investopedia.com Margin Debt

[5] Zero Hedge Deutsche Bank Hopes "Not All Margin Calls Come At Once In Case Of A Sell-Off" August 13, 2013

[6] New York Stock Exchange Securities market credit ($ in mils.), 2013 www.nyxdata.com

[7] Reuters.com China, Japan lead record outflow from Treasuries in June August 16, 2013

[8] See Mayhem in the US Treasury Markets, No Problem, China to the Rescue! July 18, 2013

[9] US Treasury MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES

[10] Wall Street Journal Japanese Investors Buy Foreign Debt As Domestic Rates Fall August 14, 2013

[11] See Global Equity Markets: Signs of Distribution and Japan’s Capital Flight April 8, 2013

[12] Real Time Economics Blog Japan GDP Clouds Tax Debate Wall Street Journal August 12, 2013

[13] Wall Street Journal Bond Funds Outflows Shouldn't Panic Investors August 16, 2013

[14] Tradingeconomics.com CHINA GOVERNMENT BOND 10Y

[15] Bloomberg.com China July Home Prices Rise as Big Cities Post Record Gains August 18, 2013

[16] Bloomberg.com Rates & Bonds

[17] BBC.co.uk Eurozone edges out of recession

[18] Bloomberg.com Europe Muddles to German Vote as To-Do List Grows August 15, 2013

[19] Zero Hedge Good Luck Unwinding That August 15, 2013

[20] Chairman Ben S. Bernanke The Economic Outlook and Monetary Policy At the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming August 27, 2010

[21] Zero Hedge Dylan Grice On The Intrinsic Value Of Gold, And How Not To Be A Turkey July 31, 2013

Central Banks Buy Stock Markets in Record Amounts!

I always try to point out of the parallel universe or the detachment between financial markets and the real economy.

I also kept pounding on the table that stock markets are being propped up by central banks via QE and zero bound rates and not by any conventional methodology.

Now many central banks admit to buying record amounts of equities.

From Bloomberg:

Central banks, guardians of the world’s $11 trillion in foreign-exchange reserves, are buying stocks in record amounts as falling bond yields push even risk- averse investors toward equities.

In a survey of 60 central bankers this month by Central Banking Publications and Royal Bank of Scotland Group Plc, 23 percent said they own shares or plan to buy them. The Bank of Japan, holder of the second-biggest reserves, said April 4 it will more than double investments in equity exchange-traded funds to 3.5 trillion yen ($35.2 billion) by 2014. The Bank of Israel bought stocks for the first time last year while the Swiss National Bank and the Czech National Bank have boosted their holdings to at least 10 percent of reserves…

Managers of banks’ assets are looking for alternatives to holding government bonds after efforts to stimulate growth from the Federal Reserve, the Bank of Japan and the Bank of England helped send yields near to record lows. Central banks’ foreign- exchange holdings have increased by about $8.5 trillion globally in the past decade, exceeding levels needed for day-to-day currency administration.

First, central banks put up a zero interest rate environment. Then they flood the system with cash via asset purchases principally directed to bonds.

Next, they use low interest rates (as a strawman) to justify supposed asset “reallocation” into equities.

Media projects yield chasing phenomenon to have seeped into the central bankers mentality. From the same article.

Central banks’ purchases of shares show how the “hunger for yield” is changing the behavior of even the most conservative investors, according to Matthew Beesley, head of equities at Henderson Global Investors Holding Ltd. in London, which oversees about $100 billion.

While part of equity purchases may indeed signify as yield chasing, a bigger segment has been politics.

Central bank investing in equity markets functions as subsidy or via redistribution of public money to stock market participants. That subsidy comes in support of the one of the biggest owners of stock markets whom are financial institutions e.g. investment trust, pension funds and insurance. Below chart from Bank of Japan’s flow of funds.

As I have long pointed out, central banks have imbued the Bernanke doctrine of propping up the economy via a supposed rekindling the “animal spirits” through stock market friendly policies.

As an academe Ben Bernanke wrote:

History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.

Mr. Bernanke’s preference of supporting asset markets has been converted into policies. This has been expressed in his 2010 speech, the portfolio balance channel, which explicitly states that the Fed’s buying of long term securities had been designed to “affect financial conditions by changing the quantity and mix of financial assets held by the public”. He reiterated the same in his Q&A segment in February report to congress stating the need to boost “household wealth--for example, through higher home prices” in order to promote spending. 

We really don’t need conspiracy theories. Market manipulation via indirect and direct interventions have been made official. 

Central banks outside the US has only made interventions more direct.

Nonetheless all these propping up of asset markets via inciting of the speculative frenzy, has reduced the incentive for the public to invest in productive enterprises (see UK as example) and has been ballooning a global pandemic of bubbles which commensurately has been increasing fragility of the overall financial economic system.

Rising stocks has engendered a manic phase as manifested by the portrayal of central bankers as superheroes.

Yet when stock market bubbles go bust, taxpayer money will get vacuumed into the sinkhole. Otherwise if the currency will be destroyed, skyrocketing stocks like in Zimbabwe in 2008 may only buy 3 eggs.

The US Dow Jones Industrials at Record Highs

One of the key benchmark of the US stock market finally sets a new record. 

From the Bloomberg

America, birthplace of the credit crisis that erased $37 trillion from global equity values, is leading the world’s stock markets back.

The Dow Jones Industrial Average (INDU) rallied 126 points to 14,253.77 yesterday, joining Denmark’s OMX Copenhagen 20 Index among major stock gauges in the 45 largest markets to regain all-time highs, according to data compiled by Bloomberg. Four years after bottoming, equity benchmarks in those countries are an average of 27 percent below their peaks, the data show.

About $10 trillion has been restored to U.S. equities, fueled by the fastest profit growth since the 1990s and monetary stimulus from the Federal Reserve. Retailers, banks and manufacturers led the recovery from the worst bear market since the 1930s as the Dow took less than 65 months to rise above its previous high set on Oct. 9, 2007, more than a year faster than the recovery from the Internet bubble.

Here is what I wrote a month back,

If the actions of the broader Russell 2000 (RUT) and Dow Transports (DJT) should serve as clues, then we are bound to see the Dow Industrials and the S&P in new record territory soon. That’s because both the RUT (brown) and DJT (black) are at fresh milestone highs.

And US Federal Reserve chair Ben Bernanke must be very pleased as such has been the declared object of his wealth effect theory channeled through his portfolio balance sheet management (euphemism of manipulation)

Of course, he and his crew doesn't say that all these has been meant to shore up the banking cronies and the political class via the welfare-warfare state.
 
The fact is that the Dow’s record highs have been crafted as the US Federal Reserve’s Balance sheets also reached a milestone.

Chart from the Cleveland Federal Reserve

From St. Louis Federal Reserve

Major easing policies of ZIRP and QEs have driven US money aggregates M2 and MZM to record levels, as high powered money (adjusted monetary base) have also gained significant upside momentum (right window).

Like Philippines and the rest of ASEAN, the manic stage of the bubble cycles, which has been a global pandemic, has been intensifying. 

It would be a major error to see or interpret the current booming markets as "permanent" or "structural", as one day all these artificial props will reach its maximum threshold levels where imbalances will either have to be exposed and undergo a painful adjustment phase (bust) or that such imbalances will reflect on the purchasing power of the currency (currency crisis).

With Ben Bernanke, Who Needs Conspiracy Theories?

Populist economic writer John Mauldin is contemptuous of conspiracy theorists. He writes, (bold mine)

I find the belief that there is a “Plunge Protection Team” simply bizarre. You know, the guys who are supposed to control the stock market? The “Working Group on Financial Markets”? If there is one somewhere, deep in the bowels of government, they are the most incompetent conspirators ever assembled. And no one has come forth and spilled the beans in a memoir after 25 years? Puh-leeze!

A conspiracy theory, according to Wikipedia.org, purports to explain an important social, political, or economic event as being caused or covered up by a covert group or organization.

On the other hand, the “Plunge Protection Team” (PPT) or otherwise known as the “Working Group on Financial markets” was created by ex US President Ronald Reagan via Executive Order 12631 which according to Wikipedia.org, “was used to express the opinion that the Working Group was being used to prop up the markets during downturn”. 

Of course, technically speaking the EO 12631 didn’t explicitly say direct control.

One of the main the stated purpose of the group according to the Federal Register 

Recognizing the goals of enhancing the integrity, efficiency, orderliness, and competitiveness of our Nation's financial markets and maintaining investor confidence, the Working Group shall identify and consider:

(1) the major issues raised by the numerous studies on the events in the financial markets surrounding October 19, 1987, and any of those recommendations that have the potential to achieve the goals noted above; and  

(2) the actions, including governmental actions under existing laws and regulations (such as policy coordination and contingency planning), that are appropriate to carry out these recommendations.

(bold added)

In short, the US government can justify her actions to “carry out” “any of those recommendations that have the potential to achieve the goals” through opaque legal semantics.

So contra Mr. Mauldin, by edict, the Working Group on Financial Markets, a.k.a  PPT, is a legally constituted entity which therefore exists, unless a new edict has been made to repeal them.

As to whether or not this group represents “a conspiracy theory” is another matter.

And it would likewise be equally misguided to look into “the deep in the bowels of government” for attempts to control the stock and or financial markets. All one needs is to open one's eyes.

The above chart exhibits the tight correlation between the Fed’s balance sheet and the S&P 500 as I earlier pointed out. 

Have Fed policies not caused or contributed to the rising stock markets?

Last July, the New York Fed even bragged about how Fed policies has had “an outsized impact on equities relative to other asset classes” that has boosted returns by 50% as I earlier posted here.

Let us read directly from the incumbent Fed Chair Ben Bernanke, first when he still was in the academia: (bold mine)

There's no denying that a collapse in stock prices today would pose serious macroeconomic challenges for the United States. Consumer spending would slow, and the U.S. economy would become less of a magnet for foreign investors. Economic growth, which in any case has recently been at unsustainable levels, would decline somewhat. History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.

So Mr. Bernanke believes then that supporting the stock market has been a requirement for “smart” central bankers.

From Bernanke’s 2010 Jackson Hole speech on the Portfolio Balance channel (bold mine)

I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed's strategy relies on the presumption that different financial assets are not perfect substitutes in investors' portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets…

So current policy has been meant to cause, if not influence, the “quantity and mix of financial assets held by the public.” Mr. Bernanke’s belief then has now been actualized through ZIRP and QE policies.

Two days ago Ben Bernanke on the wealth effect at the semi annual monetary policy report to the Congress (bold mine)

Monetary policy is providing important support to the recovery while keeping inflation close to the FOMC's 2 percent objective. Notably, keeping longer-term interest rates low has helped spark recovery in the housing market and led to increased sales and production of automobiles and other durable goods. By raising employment and household wealth--for example, through higher home prices--these developments have in turn supported consumer sentiment and spending.

In short, whether the stock and/or housing markets both of which constitutes household wealth, FED policies have been designed to control or to influence prices in support of these sectors.

Central bankers all over the world, in fact, has mimicked or assimilated the Greenspan-Bernanke doctrine.

In May of 2012 the Bank of Japan reportedly bought record amounts of ETFs. Central banks from Israel, South Korea and Czech Republic have jumped also into the stock market buying bandwagon. Whether as investment or as policy, government intervention on stock markets or financial markets serves to support them. 

Is this a conspiracy theory? Apparently not. Because such policies have become explicit (and not covert), from which again, the intent has been to cause or attempt to control prices of financial markets—as the stock and the housing markets—supposedly to promote the wealth effect theory. (In reality the wealth effect theory is a camouflage to advance the interests of welfare warfare state and the banking cartel whose relationship is underwritten by the US Federal Reserve)

In short, we don’t need conspiracy theories, the continued enforcement of Bernanke’s creed has been enough to tell those who are willing to listen that financial markets including the stock markets are being administered, managed or manipulated for political and secondarily economic objectives.

Wealth effect policies are, in reality, unsustainable asset bubble inflation policies.

Poker Bluffing FOMC: Probable Stop in Bond Buying

Here we go again. Authorities of the US Federal Reserve in an implicit pabulum about “exit strategy”.

From Yahoo news:

The Federal Reserve will keep buying bonds indefinitely to try to keep long-term borrowing costs low. It's just not clear how long indefinitely will be.

Minutes of the Fed's last policy meeting show that officials were divided about when to halt the purchases.

Some of the 12 voting members thought the bond purchases would be needed through 2013. Others felt they should be slowed or stopped altogether before year's end. This group worries that the bond buying is keeping rates so low for so long that it could ignite inflation or encourage speculative buying of risky assets.

The Fed last month ended up approving open-ended purchases of $85 billion a month in Treasurys and mortgage bonds to replace an expiring bond-purchase plan and maintain its level of purchases.

The minutes covered the Fed's Dec. 11-12 meeting. In a statement after the meeting, the Fed said it planned to keep a key interest rate at a record low even after unemployment falls close to a normal level — which it said might take three more years…

The minutes showed that "several" Fed policymakers thought the bond buying should probably stop well before 2013 ends.

They babbled about “exit strategy” in 2010. They tattled of withholding QE 3.0 in 2011.

At the end of the day: the US Federal Reserve ended up with the opposite: escalation of their balance sheet via increasing asset purchases (chart from Cleveland Federal Reserve).

That’s why I call them the Poker Bluffing Fed.

A ‘probable end’ to bond buying translates to higher interest rates.

This will mean more than just ideology, this entails how the Fed authorities views the world and their path dependent ways of implementing policies (solving problems) in accordance to such purview: particularly demand based management, the wealth effect and the portfolio balance channel.

Of course, higher interest rates will likely ruffle or pummel financial markets severely which monetary authorities have been so sensitive to protect. 

These include the stock markets which has been Fed Chair Ben Bernanke’s once held basic creed for ‘smart’ central banking, and the bond markets where the US government—as well as global governments—and key US and international financial institutions have substantial exposures, if not deep dependency, on credit easing policies.

Just to give a few examples:

The opaque derivatives markets have been mostly anchored on interest rate based derivative contracts whose maturity has been shortening.

Notes the Bank of International Settlement:

Interest rate contracts have become increasingly short-term in recent years. Notional amounts of contracts with maturities of more than five years fell by 9% in the first half of 2012 to $117 trillion, or 24% of total interest rate contracts. By contrast, the volume of contracts with a maturity of up to one year went up by 4% to $207 trillion, or 42% of the total. In the mid- and late 2000s, longer-term contracts accounted for up to 35% of all interest rate contracts.

Higher interest rates would likely increase the counterparty and default risks for the humongous derivatives market.

The recovering US real estate market has also been latched to recent low interest and credit easing policies by the US Federal Reserve

Given that the Fed holds substantial mortgage securities and where the Government Sponsored Enterprises (GSEs) account for 99.5% of the mortgage market, a possible rise in interest rate will likely undermine their portfolio holdings (of the Fed and the GSEs) at the taxpayer’s expense (chart from Freddie Mac)

Also, given that the US Federal Reserve has financed practically 61% of US treasury debt in 2011, a desistance of support by the US Federal Reserve on US treasury debt enhances the risks of a debt default by the US government. 

US Treasury securities held by the FED has been programmed to grow through the recently implemented QE 4.0 (chart from the St. Louis Federal Reserve)

Likewise, given that publicly held debt by the US will continue to expand, higher interest rates possibly means amplified credit and rollover risks for the US government. (charts from the Heritage Foundation)

Of course foreign currency swaps, the marked difference between total bank deposits and loans in the US banking system, devaluation as an official policy, and many other factors have become dependent on the backings and credit easing policies of the US Federal Reserve.

Thus the (possible histrionic) dissension among FED authorities may be interpreted as the following possibilities:

-trial balloon to see how financial market responds (yes commodities down, but stock markets losses were marginal so far),

-spur of the moment sentiment by Fed authorities that will easily shift once downside volatility resurfaces

-an attempt to manage or control “inflation expectations” via indirectly targeting commodity prices. Gold prices bore the brunt while the US dollar rallied from yesterday’s announcement. This could also be part of the surreptitious design to suppress gold prices

Yes current policies are unsustainable. But FED authorities are unlikely to tergiversate on the direction of policymaking which has been adapted by almost every central banker around the world since 2008.

To repeat, authorities of developed economies whom has embarked on credit easing policies via ZIRP and balance sheet expansions account for 95% of the USD 98.4 trillion global bond markets, where 45% of the share of the bond markets are government bonds.

The bottom line is that current credit easing policies have been deeply intertwined or embedded with the interests of the status quo or particularly the political-economic cartel of the welfare-warfare state, crony banks and central banking.

Authorities of the FED will most likely evade the responsibility from the financial market bloodbath or meltdown that may ensue once interest rate substantially rises.  And like Pontius Pilate, they will likely be washing their hands and leave tightening to the marketplace.

How US Federal Reserve Policies Linked the Bond Markets with Equity Markets

Fed policies have enormous impact on the financial markets. Part of this has been to interlink the actions between the bond and equity markets. Perhaps this could be part of the US Federal Reserve Chair Ben Bernanke’s Portfolio Balance channel or “once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public.”

At his blog, Dr. Ed Yardeni explains (bold mine)

The bond cult is dominated by individual and institutional investors desperate to get some yield north of zero on their fixed-income investments. This is most evident in the monthly mutual fund data compiled by the Investment Company Institute. Over the past 12 months through October, net inflows into bond funds totaled $392 billion; equity funds experienced an $80 billion net outflow. Since the start of the latest bull market in stocks during March 2009, net inflows into equity funds was virtually zero, while bond funds attracted $1.25 trillion.

Nonfinancial corporations have been borrowing money from the bond cult, whose members have been desperately scrambling to lock in yields as the Fed has driven them closer to zero. Over the past four quarters, mutual funds purchased $267 billion in corporate and foreign bonds. To the extent that some of these funds have been used to buy back shares, the bond cult has been financing the bull market in stocks. This was all masterminded by the Fed’s equity and bond cults and implemented with their NZIRP and QE programs.

Such relationship partly explains the Risk ON-Risk OFF scenarios, as well as the current recovery in US housing. 

The bottom line is that asset markets have become immensely interdependent with each other that enhances the risks of contagion. 

Oh you can bet that such interrelationships have not just been limited to the US but to the world.