Diary

The Velvet Trap - Looked Good for a While

The Velvet Trap – Looked Good for a While

The Chinese hold the bulk of the debt in the form of interest bearing US treasury bonds.  The interest rates on these bonds are approximately 1% to 2%.  At this level of interest rate, the bonds are losing value when inflation is taken into account.  When the bonds mature, the value will not even cover the inflation rate over there life. So why in the world doesn’t China demand a higher return for new bond purchases? This of course would cause all interest rates to rise? Here are the three reasons.

 

Reason number one is the Chinese would not want to do anything to hurt or disrupt the economy of their biggest customer.  There would be less hope of ever getting their money back.

 

Reason two is the Federal Reserve has been the largest buyer of treasury bonds and will be through June. The program is titled QE2 (Quantitative Easing) and will end this June. The Fed must keep interest rates low hoping to provide enough cash to turn the economy around.  It is how these bond purchases are paid for that few would ever believe.  It goes like this. The US Treasury creates a bond. This bond is purchased by the Federal Reserve simply crediting the banks cash account, merely a paper entry.  This is like you buying a new Mercedes and going home and making an entry on your computers bill pay, without available cash, to credit the car dealer for the car.  This would be buying your own debt. This chart shows the results of this practice, an exploding money supply, or cash. This shell game has allowed the Federal Reserve to create money out of thin air.  Of course this will work only to a point, and then we hit the wall.

 

The third reason is the Chinese themselves.  If the Chinese were to demand higher interest rates on purchases it would cause high interests rates all around.  If we had higher rates, all longer term maturity bonds would drop in value.  So the Chinese would be setting fire to their treasury holdings.  Some say it doesn’t matter because the bond holdings will eventually reach maturity at face value.  Wrong, if the US is forced to pay higher interest rates on the debt, we will have to continue to expand the money supply to pay the higher rates.  This of course will cause further inflation.  So the maturity, or face value of a treasury bond, will be paid for with a dollar of less value.

 

Ben Bernanke

Federal Reserve Chairman

 

This money supply chart shows the efforts to add cash to the economy by the Federal Reserve. If we had a growing economy it would be no big deal.  However, we have GDP (gross domestic product) growth somewhere around 2%, depending on your source.

 

So inflation is locked in for the future.  We have increasing cash chasing a flat amount of goods and services being produced. There is no mystery in this outcome. The Federal Reserve charter is to maintain low unemployment with minimum amount of inflation.  To show low inflation the Fed changes what they count in there basket of items to price. They have excluded food and energy in the new method. I don’t use these two things anyway, do you?  Under the1990’s definition, inflation is now around 10%.  As long as unemployment remains about 9% plus, the Fed will not reduce the growing money supply.  Certainly the stage is set for QE3.  Without question, continued money creation is needed to take the place of a growing economy.  If we get QE3, the dollar will continue to get trashed.  The benefit of this continuing dollar drop is twofold.  First, US Companies sell more products overseas because of relative price reductions.  Secondly, any US debt on the books looks like it is being reduced. This is because we can pay debt off with cheaper dollars because of its depreciated value. So, momentum being what it is, look for more of the same.