According to Ben Bernanke: It’s a wonderful life, let’s enjoy!

March 3, 2011

Ben went back to Congress this morning to visit the House Financial Services Committee and a slightly longer question and answer session. Again the financial news networks devoted little time to his remarks despite the fact he offered a few nuggets for anyone willing to listen to the three hours of testimony. When asked when the Fed will act if inflation rises he said: It depends on inflation expectations and if the cause of inflation is broad based or a one off event. (oil?). Other items of interest: 1) Consumers will lose confidence if they don't see the labor market improve. (I agree), 2) QE2 is about changing asset values and stocks have rallied while corporate bonds spreads have narrowed versus Treasuries, 3) It's ok that Treasury rates have risen since it shows confidence in the economic rebound, 4) higher consumer spending will come after higher stock prices.

The Fed Chairman made it clear he is doing everything he can to push stock prices higher in the expectation those holding equities will spend some of the profits. The problem is not everyone is a trader and the average worker has no $$ to trade since they can barely afford today's gasoline prices.

Higher interest rates?

Mr. Bernanke brought up inflation expectations this morning and if he is true to his word must be somewhat concerned about recent action in the Treasury market. Despite almost daily buying by the Fed (today $6.689 billion 4-5.5 yr. notes) interest rates have not fallen and more importantly inflation expectations are at their highest levels of the year. The following is a grid that I update every day and it shows the 10 and 30 year Treasury bonds with their respective inflation components. http://www.earlywarningwire.com/pdf/10yeartip030211.pdf Notice the two lines highlighted in yellow with the dates of February 8 and March 2. In the last 15 trading days the 10 year nominal rate has fallen 27 basis points from 3.74% to 3.47% but the inflation component has risen 11bp while the real rate has fallen 38bp. The 30 year Treasury bond has declined from 3.77% to 3.57% (20 bp) but the inflation component is 6bp higher at 2.64%. I have learned after 45+ years of following the Treasury market and interest rates it is the inflation part of the overall rate that drives interest rate movements and the action of the last four weeks is sending a powerful message rates will soon move higher. It's too bad no Congress person asked the Fed head this morning about rising inflation expectations but I'm sure if they did he would have smiled and given them a reason the Fed was happy about that too! As usual he showed little concern for anything going wrong with the current Fed plan of print, print, print and tell everyone to spend, spend, spend.

A couple of other items could make the next week the perfect storm for higher interest rates. 1) Open interest in the 10 year futures contract has plummeted 119,578 in the last three days. It is doubtful the decline has come from short covering rather liquidation from longs hoping for lower interest rates due to daily Fed buying. Tomorrow the Treasury will announce the amount and schedule for next week's 3yr. 10 yr and 30 yr auctions with a total of $66 billion expected. Shorts are already being set as the only bullish factor for the market comes from the overnight financing part of the market and the current 10 year today was at MINUS 0.30%. Normally a short will reinvest proceeds at the daily repo rate (0.20%) but when demand for borrowing rises the repo rate falls and now shows the bears are positioned and hoping to cover at higher rates in next week's auctions. The key ingredient for this potent mix will come from the oil market which is driving everything else in the world, especially US equities. Trading tonight at $102.42 a move towards $110 will bring out more stock sellers that may want to hide in Treasuries but more likely gold which hit another new high today at $1435.

In summary, if oil stays near current levels and stocks don't continue Tuesday's decline it will be a perfect set up for a rise in long term Treasury rates to test the year's highs or potentially make an attack on the key 4.00% level.

Before entering any investment, everyone should consult with their own investment professional and discuss the risk of possible loss of capital.