Thursday, October 18, 2012

Too much money, not enough paper

If you follow me on twitter, you are by now very well acquainted with the title of this post. What it refers to is the fact that the Fed's LSAPs are creating a surplus of liquidity and scarcity of product in capital markets, which has driven prices up in any financial asset that generates yield (and many that don't). During this yield chase--or, as I like to call it, The Great Incredible Paper Chase--debt issuers have done what any rational party would have done when there is more demand than supply of a good they can produce, they've stepped up production. As long as the Fed is expanding their balance sheet, the market will have the capacity to absorb new issuance, but it is important to remember that the Fed's balance sheet expansion will not continue forever and that, at some point, they will halt expansion and/or mop-up reserves. At that point, if the issuance of new paper and the capacity of the market to absorb it are in equilibrium, the equilibrium will be upset and, like anyone who has taken an economics 101 course can tell you, prices will reflect it.

So, before getting into a fist-fight over the last tootsie roll left in the mud after the yield piƱata, remember that the eventual draining of reserves by the Fed will have full-size snickers raining from the skies and no amount of tootsie rolls will be a fair trade for even a bite-sized milky way.


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