photo by cliff1066

Written by Nathan White, Paragon’s Chief Investment Officer
Taken from Paragon’s 2Qtr 2011 print newsletter  

Bond market yields are lower now than when the government was running a surplus a decade ago. Something is wrong with this picture. If you didn’t know otherwise, the low yields might lead you to believe that our national debt is low and sustainable. Further, just looking at the current yields,  you might think that our future budgetary concerns have been resolved due to significant entitlement reform.


If real reform has not happened, then why hasn’t the bond market called the government’s bluff and reacted negatively to the prospect of future insolvency?

Part of the answer is in the question – future. Currently, everything is working. There is no crisis, and so he market is behaving as such. The government has a habit of only dealing with problems when they become crises. On the other hand, maybe the reason the bond market has not signaled caution is because a rather large participant (and that’s putting it mildly), namely the Federal Reserve, has been buying pretty much all of the debt. A government entity is buying government debt thereby expanding its already massive balance sheet.

I don’t care how you spin it, but something is not right with that picture. 

The Federal Reserve’s second round of quantitative easing ended in June. Ironnically, the ramifications of the program ending, along with a slowdown in economic growth, continued Eurozone soverign debt worries, and the U.S. debt ceiling fight, have caused people to flock to the safety of Treasuries sending yields back down to historic lows.

The Fed plans to continue maintaining its balance sheet by reinvesting principal and interest in an attempt to provide support for the anemic recovery. At this point, all further actions by the Fed produce lower marginal gains for the risks taken. The Fed is in no hurry to reduce its massive balance sheet, and it looks like it will not raise rates until well into 2012 and possibly 2013. I don’t believe the Fed will act until unemployment is significantly lower.

What will they do if the market forces them to act?

The real test of the Fed comes when they need to tighten monetary policy, but the economic and political climate are placing heavy pressure against such a move.

Volcker faced this climate in the late 70’s and early 80’s when inflation was soaring, and he had the guts to make the right move. This caused short-term pain, but long-term prosperity. Will the current Fed do the same when its time comes?

Who will fill the void now that the biggest buyer of new government debt is gone? Will foreigners continue to step up to the plate along with banks and the public? If market participants start to perceive that the U.S. obligations are nearing the tipping point, you will see rates rising ahead of Fed action.

If and when this unfolds is difficult to assess. It could be in a month, a year, five or 20 years from now. 

To be continued next week…

Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.