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Tuesday, February 1, 2011

The Yield Curve And QE2

I saw people arguing about the shape of the yield curve. The yield curve is DIRECTLY SET by the Federal Reserve.

Normally, the Federal Reserve directly fixes the Fed Funds Rate, the overnight rate. The Federal Reserve indirectly fixes longer rates. The 1 year Treasury yield should approximately equal the expected average Fed Funds Rate over the next year. If they differed, a bankster would borrow at the Fed Funds Rate and buy Treasury debt. Alternatively, the bankster would short sell Treasury debt and lend the proceeds at the Fed Funds Rate. This arbitrage trade guarantees that "Yield on Treasury debt approximately equals average expected future Fed Funds Rate."

Normally, the Federal Reserve only monetizes short-term Treasury debt. Now, with QE2, the Federal Reserve is buying longer-term Treasury debt. This causes the yield curve to flatten. This isn't a free market occurrence. It's caused by the Federal Reserve (government).

The "too big to fail banks" have crossed into flagrant money grab territory. The 10-15 largest banks are "Primary Dealers". They have the perk of selling Treasury debt directly to the Federal Reserve. They also have an obligation to participate in each Treasury auction, but that's no hardship when they can immediately flip those bonds to the Federal Reserve.

The "Primary Dealers" buy Treasury debt from the government at a Treasury auction. A few weeks later, they sell those exact same bonds to the Federal Reserve for a profit. "Zerohedge" is keeping track of this explicitly. This trade is *ONLY* available to "Primary Dealers", the 10-15 largest banks.

They're buying low and selling high. They're borrowing from the government and lending to the government, making a profit. It's pure illicit interest arbitrage. That's how banks make money almost every day. That's why banks make huge profits while the rest of the economy is stuck in a severe recession/depression. Why would banks need customers, when they can borrow from the government and lend to the government?

In fact, some banks may know ahead of time exactly which CUSIPs the Federal Reserve is buying in the next round of QE2.

The Federal Reserve is one big price-fixing cartel. The USA does not have a free market. The yield curve is entirely determined by Federal Reserve current policy and expectations of future policy. By direct purchases, the Federal Reserve is fixing the shape of the yield curve. You can't gain any information from the yield curve, other than reading Federal Reserve policy and expectations.

Normally, the Federal Reserve directly sets short-term rates and indirectly sets long-term rates. With QE2, the Federal Reserve is buying longer-term Treasury bonds and directly flattening the yield curve.

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