Fed’s “Rent Control” Policies Starting to Distort

We’ve posted many pieces (see here,  here and here) on how the Fed’s manipulation of the yield curve through QE and Operation Twist is distorting long-term interest rates — the most important price in the world, in our opinion — and creating disequilibrium in the credit markets.  This is not easily apparent as we see only the interest rate and have to really dig to find quantity and the types of buyers.

Think back to Microeconomics 101 and the supply and demand graphs on rent control.  When government intervention imposes a price ceiling on rents it creates a shortage of affordable rental units.   Similarly, when Fed policies attempt to impose a ceiling on long-term interest rates,  a shortage of funds will ensue,  unless a steep enough yield curve compensates for maturity arbitrage.

Keep this on your radar as the “rent control” policies may be starting to bite.  Even non-price sensitive buyers of bonds are starting to balk.

After reports that China has been reducing its Treasury exposure, Bloomberg writes,

“What we may be seeing from China is similar behavior to many domestic investors,” said William O’Donnell, head U.S. government bond strategist at Royal Bank of Scotland Group Plc in Stamford, Connecticut, one of 21 primary dealers that trade with the Fed. “With 10-year notes sub 2 percent they don’t have a lot of interest or appetite for Treasuries.”

The Fed will have to extend Operation Twist or engage in a new round of QE to keep rates from spiking to equilibrium levels, in our opinion.   And we know markets almost always overshoot.

The alternative is increased shortages of loanable funds for longer term fixed income securities, which could force the U.S. government to:  1)  shorten its new issuance maturity structure;  and/or  2)  rely more and more on the financial sector for financing, such as Japan.

Interestingly Zero Hedge wrote a few weeks ago,

Primary Dealer Treasury holdings of Dealers surged to an all time high of $102 billion, a whopping increase of $37 billion on the week, which matches only the surges seen during the post end of quarter window dressing discussed extensively before. The driver were exclusively bonds in the “Bills” and “Under 3 Year” category, which rose by $37.7 billion.

Markets are way too complacent about the potential for a huge bond market debacle, in our opinion.

(click here if chart is not observable)