Wednesday, December 23, 2009

Billionaire Paulson Right About Higher Rates, But For the Wrong Reasons

The recent rise in long-term US interest rates comes as good news for several leading hedge fund managers, including billionaire John Paulson, who have positioned their trading books to benefit from higher yields on US Treasury securities, reports FT. He's right about interest rates headed higher.

But his reason for why interest rates are headed higher. Paulson, who made big gains earlier this decade by betting against the subprime mortgage market and whose firm, Paulson & Co, manages $33bn, has said he believes that government stimulus efforts would inevitably lead to higher inflation and a corresponding rise in rates.

“It will be difficult for the government to withdraw the economic stimulus,” Paulson said in a speech. “An increase in the monetary base leads to an increase in the money supply, which leads to inflation.”

This is just completely wrong. As I have pointed out, an increase in the monetary base does not necessarily mean an increase in money supply. Further, I suspect that the trillion dollars held by banks as excess reserves are the funds that they will use to pay back the Fed as Bernanke winds down the emergency credit facilities.

Rates are headed higher because of a combination of tight money, not easy money, and huge government borrowings expected in 2010.


  1. Obama is the next Tiger Woods. Just as Tiger's image was completely made up and protected by the media, Obama's image as a smart, articulate, calm and cool operator is going to unravel.

    I don't know if it will be Michele taking a golf club to his head that will cap things off, but whatever the event is, it will be just as entertaining... but much more tragic for the country.

  2. Mr. Wenzel,

    Love your blog. I have a question concerning your above post on tight money. If the Fed really isn't "printing", why is there not an arbitrage opportunity by borrowing short at 0 and lending long at 3.5? In other words, if the Fed isn't actively pushing down short term rates (and the curve is positive), why aren't short term rates rising? Thus flattening the curve? Thanks and Merry Christmas--

  3. Rates really aren't at 0%. That's a myth. The effective Fed funds rate is 0.12%.

    The banks are doing a very conservative arb when they are borrowing from teh FEd from emergency facilities and then earning money by keeping the funds with the Fed as excesss reserves.

    The danger with borrowing short and lending long is if rates move against you. I fully expect yields to go higher across the yield curve, thus it is very dangerous to borrow short and lend long.

  4. Below is the FOMC statement. I've added in brackets the amounts in billions, as of December 16, to be eventually wound down.

    In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve’s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve’s announcement of June 25, 2009. These facilities include the

    Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility [$0],

    the Commercial Paper Funding Facility [$14],

    the Primary Dealer Credit Facility [$0],

    and the Term Securities Lending Facility [$0].

    The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements [$14] by February 1.

    The Federal Reserve expects that amounts provided under the Term Auction Facility [$86] will continue to be scaled back in early 2010.

    The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility [$47] remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral. The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.

    Additionally, the Primary credit facility will be shortened in duration. Even if we assume all $19 billion of it will be wound down too, that's still only a total of $180 billion, out of about $1.10 trillion in excess reserves. That leaves about $920 billion. Am I missing something?