Friday, November 2, 2012

Marginal purchases will continue until real term structure steepens

Note: for those unfamiliar with terminology of TIPS, please see Give me a Break (even) for some basic discussion
Last night, I finally came up with a concise way of expressing my Fed policy view: "Marginal purchases will continue until real term structure steepens."

Real term structure flattening means that "too much money, not enough paper" is still valid, and marginal Fed LSAPs are reducing the supply of available financial assets enough to lower rates by increasing supply of reserves and reducing supply of risk-free assets. Bear steepening of the real term structure would mean that either marginal asset-buyers have decided other assets offer better prospective returns (flight-to-safety has ended), private credit is growing at a faster pace than the Fed is reducing supply of assets (deleveraging has ended) or, more likely, a combination of both. A side effect of rising and steepening real rates would be that the discount rate (ex-effect from break-evens) used to discount future private cash-flows would rise and therefore, all else equal, that would mean lower asset prices across the board for cash-flow generating assets. I use the real term-structure for this mental exercise because expected returns of non-risk free assets are affected by inflation expectations both in variable-rate instruments (loans, FRNs, some ABS, equities) through rate expectations and fixed-rate instruments as well through expected default rates and recovery expectations. Not to worry, though, falling asset prices due to higher real rates are an eventual inevitability of the Fed's exceptionally accommodating monetary policy and must be accepted as such. All it will mean is buying the same assets at higher expected returns, and should be welcome news for anyone with more financial assets than liabilities.

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