Watch Japan and China.........purchase of T-Bills

My friend just sent this in an email. Be interested in other's feedback about it:

Short-term U.S. rates are historically low. This is usually blamed on the Federal Reserve System, which is said to be maintaining a loose monetary policy. I don't believe that this is the reason
for today's low rates. This is because the adjusted
monetary base, which best reveals FED policy, is moving up
at comparatively low rates -- 4.2% per annum, year to year,
and under 3% since early March.

http://research.stlouisfed.org/publications/usfd/page3.pdf

I think the more likely explanation is the purchase of
T-bills by the central banks of Japan and China. They are
creating money domestically and buying T-bills with it.
They are doing this to keep down the price of their
currencies in relation to the dollar. This subsidizes
exports. This monetary policy creates demand for dollar-
denominated short-term U.S. government debt, which lowers
the T-bill interest rate because the seller (the U.S.
Treasury) can offer to pay a lower rate and still get
buyers.

Short-term rates in general also fall because other
borrowers are not facing stiff competition (high rates)
from the U.S. Treasury. They can therefore offer their
debt certificates at lower rates and still sell them.

When investors hear Greenspan tell Congress that
neither inflation nor deflation is imminent, some of them
conclude that interest rates will soon rise because the
economy is improving. There will supposedly be more demand
for loans by consumers and businesses. There is a lot of
guessing about what the FED will do then.

These days, the FED isn't doing much of anything. It
hasn't been doing much of anything for over a year. So, it
seems to me that financial speculators should pay more
attention to what the central banks of Japan and China are
likely to do. Not many of them do. This may be due to the
fact that most American speculators don't read Japanese or
Chinese, languages that are even more difficult to
translate than Greenspanese.


THE CARRY TRADE

The "carry trade" refers to the practice of speculators
to borrow money short-term and lend it long-term. If
someone can borrow money at 1.5% and lend it at 3%, he can
make a lot of money. He borrows a million dollars and pays
$15,000 a year for the privilege. He lends out the million
he has just borrowed at 3% and earns $30,000. He makes
$15,000 on the spread. How much money does he have to put
up as margin? A really big borrower can borrow on his own
name with no other collateral, or close to it. In effect,
the market is giving money away. Hint: the financial
markets never give anything away. There are no free
lunches. Look more closely at the deal.

These are great days for carry traders. With short-
term rates so low, the carry trader can borrow a lot of
money and buy long-term debt. But he takes a risk. If
short-term rates rise, the interest rate spread will shrink.
If they rise above long-term rates, which they do about a
year prior to a recession, the borrower can get wiped out.
His interest rate earnings will not pay for the interest owed
on his short-term debt. This happened to the savings &
loan industry in the late 1980s.

In any case, rising long-term rates are another way of
saying falling prices for bonds. So, the carry trader
finds that the market value of his million dollar bonds has
become $900,000. He is wiped out. To earn $15,000 a year,
he has lost $100,000 -- not a good deal. Carry traders
sell their bonds, further depressing their market price,
i.e., raising interest rates.

There are countervailing forces, of course. When
carry traders pay off short-term debt, this pushes down
short-term rates: fewer borrowers. The interest rate
spread gets wider. But the magnitude of the effect on
capital value of small interest rate increases in the bond
market dwarfs the effect of lower carrying charges in the
short-term market. Carry traders bear a lot of risk.
There are no free lunches in the financial markets.

If China and Japan's central bankers decide to stop
buying T-bills with newly created yen or yuan, this means
that their monetary policy will change. There will be less
demand for T-bills, which means that the U.S. Treasury will
have to pay higher rates in order to attract replacement
lenders. That would send a signal to carry traders: sell
long-term debt assets (bonds) and pay off short-term loans.
So, long-term rates will rise alongside short-term rates
under present circumstances, assuming that the carry
traders are major players today. With short-term rates at
historically low levels for three years, this is a safe
assumption. Everyone wants into a sure thing. "They're
giving money away!"

Central bank policies of monetary inflation always
create carry trade opportunities. Why? Because monetary
expansion (inflation) initially pushes short-term rates
lower than the free market would otherwise produce. Central
banks buy short-term government debt when they issue new
money. The supply of debt buyers rises. Short-term rates
fall. Carry traders sense a profit opportunity. The road
to easy street -- something (the fat interest rate spread)
for nothing (little perceived risk) -- once again beckons.

Carry traders have done well ever since the FED pumped
in massive quantities of fiat money in response to 9/11.
Making money now looks easy. The easier it looks, the more
players the interest rate spread attracts. Fools rush in
where Buffett fears to tread.

...Central Banks are financing The Great Stupid War of George Bush? That's the way it looks to me.

although there may also be some truth to your assumptions.