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The Fed's decision yesterday to continue the zero funds target rate "for an extended period" -as well as continuing with a program to spend hundreds of billions in additional dollars to prop up the long end of the curve sent a clear signal that, from their perspective, deflationary concerns have subsided while fears that inflationary pressure on the margin may expand are still far on the horizon.

For inflation hawks who have been watching oil and other components in the energy and industrial commodity complex, as potential canaries in the coal mine, the Fed's decision sets the stage for a potential nasty spike if any external catalyst develops. Based on my anecdotal research, traders old enough to remember the twin energy crises of 73 and 77-79 seem to be much less inclined to discount this risk.

On the rate front, the resilience of Chinese and Japanese lenders combined with Bernanke's blank check sets the stage for a sustained stay here at zero. Despite contracting by over 25 basis points since the first week of the June the spread between the 10s and the 2s continues to hang in above 250 providing the gang that could shoot straight -our government backed banking community, with more time to cash in on the free money spread feast. As long as this steepness continues we can presumably look forward to GMAC continuing to run those funny ads for their Ally subsidiary that take cheap shots at the surviving members of the banking community that haven't mugged the taxpayer yet.

Meanwhile, with absolute rates at absolute historical lows, it's an absolute sure thing that scores of supposed geniuses at funds and big banks are piling into the "reverse carry" trade -borrowing in dollars to buy higher yielding bonds issued by Brazil or other muscular developing economies. This will make them look absolutely brilliant when the dollar finally rolls over decisively.

With all that taken into account, our strategic thoughts remain relatively unchanged beyond some duration adjustments:

  • We still expect that inflationary pressure will start to return in earnest during Q4 -and furthermore that in the current "free money" vacuum it has the potential to expand at a rapid pace that will catch a lot of people unprepared.
  • We expect that treasury yields will start to rise on an absolute basis later this year DESPITE fed policy sentiment as investors factor concerns about ballooning debt and inflationary pressure into the equation. We think that this divergence between the target and the curve will be mirrored by expansion in the spread between treasuries and higher yielding corporate bonds.

As always, timing is everything, and we will be constantly looking for signals to test our thesis with. If the math doesn't support our thesis -or price action defies it, we WILL change our tactical risk management stance in response because that is the only way that we know how to invest -opportunistically.

Andrew Barber