Is the Treasury Bubble ready to burst?

Quantitative easing is a process by which the Federal Reserve purchases assets (such as treasury bonds or mortgage backed securities) from banks. The cash that is made by the banks for selling their assets to the Federal Reserve becomes excess reserves that is supposed to be used for lending. This is supposed to stimulate the economy.

The Federal Reserve has already engaged in one round of quantitative easing since the beginning of the economic crisis purchasing $1.7 trillion worth of bonds and mortgage backed securities between 2008 and 2010. This pushed the yields on treasuries to near-record lows and kept interest rates artificially low (0.25%).

But the banks aren't lending and the economy is not recovering, because the banks are engaged in what is known as the carry trade. Lending money out at a higher interest rate than what you had borrowed it for.



After 2008, banks were undercapitalized because of all the mortgage write-offs they had. Rather than issuing new shares of stock and diluting their capital, Bernanke allowed the banks to borrow money at a short-term borrowing rate of 25 basis points. Rationally, the banks took that borrowed money and invested in long treasuries yielding 4.5% at the time. Essentially the banks were making ==Y*(4.5%-0.25%)== (Y being the amount of money invested) risk free! So why lend out to the public who was losing their job, had no savings, and had a high probability of defaulting on their loans?



Of course, you can play the carry trade game. But the risk is that if interest rates start to move up, you need to get out fast. Last November, Bernanke said that inflation was on the horizon. To me he is hinting to the banks that he is going to hike interest rates sometime in the near future to tame the inflationary pressures and that now is the time for the banks to get out of the carry trade. Then he announces QE-2, “We’re gonna make $600 billion available to the economy for buying treasuries,” in other words, "I, Ben Bernanke, will deflate the carry trade bubble so don't you all storm out that door at the same time." At the moment, the plan to deflate the bubble seems to be working as interest rates have not gone up significantly.



On a previous post I made, November 2, 2010, I told my followers to watch what was going to happen to treasuries the following day. November 3, 2010 came and yields spiked on the QE-2 announcement. That spike, I suspect, was due to the banks exiting the carry trade and could be the day that marks the end of the bull market in US treasuries.

Today the Fed is the proud owner of billions of dollars worth of US treasuries and in months time will realize how expensive they got it for. With QE-2 expiring in June, what is going to happen to interest rates? They'll be going up. How high? It's anybody's guess.

• You can play the Treasury Bubble burst by going long TBT, PST, and other treasury bear ETF.

• The next FOMC is on April 27

• I will be short Treasuries some time in the future

• cheers