Most surprising is the rally in US Treasuries following November's quarterly refunding.
As the chart shows, bond futures rallied from 114 to 119 before retracing to the 116 level today.
At the same time, spreads between Treasuries and BAA Corporates have widened more than 60 basis points.
EQUITY MARKET REACTION
The NYSE composite at first fell dramatically, signaling either a rise in long term interest rates of a decline in earnings.
As did the bond market, the equity market is retracing its steps.
MONEY SUPPLY
While all this is happening, the money supply growth accelerated exclusively from bank lending.
As the chart below shows, the Monetary Base has grown at a relatively mild 3% while MZM is growing faster every month.
INFLATION IS COMING
Money growth in excess of GDP growth causes inflation.
In its attempt to mitigate the damage from the Fed-caused rise in short term rates, the Fed has chosen to reflate the economy and allow banks to pour money into the system. This will cause inflation to rise in 6-18 months.
The Fed will then have to start raising rates again, and will probably push the economy into a recession in order to get money under control again.
SUMMARY
Until then, credit and equity markets will remain confused.
TACTICS
Money market arbitrage will continue to generate solid earnings.
Continue to reduce exposure to long term assets.
Re-evaluate asset pricing spreads to ensure an adequate return on risky lending.
Consider lengthening liability maturities further.
STRATEGY
Emphasize to senior management and the Board the dangers of money growth on inflation and interest rates.
Prepare them for action to lengthen liability maturities.
Discuss trading and hedging policies and procedures in preparation for future increases in long term interest rates.
