This post is a guest contribution by Dian Chu, market analyst, trader and author of the Economic Forecasts and Opinions blog.

The 10-year T-Note is currently yielding 2.5%, and the Fed’s latest quantitative easing initiative is becoming counterproductive to its stated purpose of trying to stimulate the economy by encouraging more risk taking, i.e. private capital utilization seeking attractive returns on investment opportunities. The issue is that Mr Ben Bernanke and the Fed governors, although great academics, have failed to take account of how traders and financial markets impact and take advantage of Fed policy.

The predominant trading and investing technique on Wall Street, the one they feel most comfortable employing, is the Trend Trade. There are several reasons for this occurrence, namely lack or originality, group think, attendance at the same investment conferences, closed community, technical analysis, perceived economic fundamentals, and profitable returns. In summation, continue to trade what is working, let your winners run mentality that pervades Wall Street thinking.

The Fed policy is meant to keep interest rates low to stimulate parts of the economy like the housing market and the banking system that can benefit from lower rates. However, the problem is that rates in the bond market were low enough before the latest quantitative easing, and lowering them further is not going to make a meaningful difference in the housing market or banking sector.

Once rates get to a certain point, they have essentially reached the level where any increased economic activity due to the low rates has already exhausted itself. Therefore other market conditions, like true demand for housing, and increased demand for loans from banks, will have to stimulate these sectors.

Equities and commodities, and not the bond market, are the true barometer for how well the quantitative easing (QE) initiative by the Fed is working. Since the latest QE, bonds have increased in price and decreased in yield. In contrast, both equities and commodities − the true barometers of risk appetite − have decreased in price.

By artificially providing an incentive for investors to buy bonds, which is having only a marginal benefit to banks and housing − in essence an ever-decreasing rate of return − they are disincentivizing risk taking overall in the economy, and feeding into a deflationary loop cycle or investing trend by private capital allocators.

There are measures the Fed can employ to stimulate the economy and encourage risk taking, but its latest move has backfired. A good sign that a stimulus initiative is working as intended will be inflation in the price of commodities as well as equities, and both have fallen dramatically since the latest Fed QE was announced. Forget the bond market as a good indicator of effective stimulus measures, it currently is a counterindicator and in the midst of an enduring Trend Trade, which is really only slightly different from other crowded trades of the past like the Crude Oil 200 March, Tech Bubble, or Flipping Miami Condos.

Recently, Stanley Druckenmiller announced that he is shutting down his hedge fund, and remarked that “I felt I missed a lot of opportunities in 2008 and 2009 and a huge move in bonds this year,” in other words he missed one of the most important money-making trades on Wall Street: the Bond Trend Trade, where fund managers, encouraged by Fed policy, really let their winners run to the tune of a 2.5% yield on the 10-year T-Note.

The Fed needs to disincentivize fund managers and Wall Street to stop the momentum in this Trend; however, it has to do this in a subtle manner. There is a huge component of investors in this Trend Trade who are not seeking the return of their capital, or the 2.5% yield on their capital, but the continual rising bond price is what keeps them in this trade and out of alternative “risk-oriented trades”. Ultimately, this is bad for the economic recovery.

A healthy level for the 10-year T-Note would be around 3% to 3.5%; even 4% is not too problematic. But here is the trick, the Fed basically needs to keep the bond yield of the 10-year T-Note stagnant at some level for an extended amount of time or, trading in a tight range, it needs to discourage any trend in either direction for the near term.

The last thing the Fed needs to do is to cause a stampede out of bonds, and start the Trend Trade working in the other direction. So it can even keep its current policy of buying treasuries to keep rates relatively contained on the low side, but augment this policy tool by another technique that adds liquidity in the system in which investors are encouraged/forced to take on increased risk through alternative asset classes like equities, commodities, and flipping Condos in Miami.

The point being that too little risk taking is just as bad for the economy as too much risk taking. And currently, the pendulum has swung in the direction of too little risk taking on behalf of bond investors, encouraged by Fed policy which, based upon fund manager returns in the asset class, continues to reinforce the trade, thereby causing most risk assets to depreciate in value, self-perpetuating the very act that the Fed is trying to combat, and thus a negative deflationary loop becomes a self-fulfilling prophecy.

There is an added component to the self-fulfilling deflationary cycle in that as these same investors talk their own book, i.e. the economy is going into a double-dip recession, this just scares more investors, who seek safety in bonds, further reducing risk allocation with regard to capital, thus raising bond prices further, and exacerbating the downward trend of the deflationary cycle.

This is one of the limitations of the makeup of the Fed board as it is always made up of PhD academics who understand the broad strokes of the financial markets, but lack the understanding of some of the nuances of financial markets like the Trend Trade.

The takeaway with regard to bond prices is that for the near term they want to keep T-Note yields at relatively low levels, provide stability for financing purposes, create a boring trading range, and encourage a portion of bond investors to move out of the asset class and take on more risk, thereby moving the 10-year T-Note yield to trade between 3% to 3.75%, with the goal of slowly moving rates back up to normal.

Source: Dian Chu, Economic Forecasts & Opinions, August 24, 2010.

Did you enjoy this post? If so, click here to subscribe to updates to Investment Postcards from Cape Town by e-mail.