The United States, and every country, is subject to a monetary authority and legal tender laws. Here in the U. S. we have the Federal Reserve, a central bank that plans money and credit. The Fed thought they had perfected their planning (but of course it cannot be perfected). They thought they had ended the boom and bust cycle, and brought us into a brave new era, their so-called great moderation that ended in 2008. All they really did was manage the banking system to the brink of insolvency.
Let’s try a thought experiment. Suppose the monetary central planner attempts to fix the problem of insolvency by massive injections of liquidity. The central bank buys bonds. It dictates rates near zero on the short end of the yield curve, and promises not to raise rates for years to come. What perverse outcome would we expect?
Arbitrageurs see a green light, telling them that they can safely borrow short to buy long bonds. As the price of a bond goes up, the rate of interest goes down – it’s a rigid mathematical inverse. This is how suppression of short-term rates causes suppression of long-term rates.
This poses a problem for investors. Every investor has a minimum yield he must earn in order to meet his goals, such as retirement. When the yield available in government bonds falls, this gives the investor a strong push to other bonds with higher yields. Some Treasury bond owners sell, and go into AAA corporate bonds. This, of course, pushes up bond prices and pushes down the yield. This pushes some AAA corporate investors into AA bonds. And so on.
This post was published at GoldSeek on 29 August 2014.