Regulation, Trade and Devaluation Wars, Dropping Rocks in Harbors and Quantitative Easing

 

Regulation, Trade and Devaluation Wars, Dropping Rocks in Harbors, and Quantitative Easing

Carlos M. Pelaez

The continuing recovery without sufficient vigor to generate employment is analyzed in (I), regulation, trade and devaluation wars in (II), quantitative easing in (III), risks of bonds and returns on equities in (IV), interest rates in (V) and conclusion in (VI). If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I Recovery without Vigor. The US economy continues to move forward but at a pace lower than in the expansion phase of the 1979-82 contraction with subpar growth that is insufficient for recovering the job losses during the recession. The report on personal income and outlays for Aug is encouraging (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). Personal income and disposable personal income both increased by 0.5 percent in Aug, higher than 0.2 percent and less than 0.1 percent in Jul, respectively, and personal consumption expenditures (PCE) rose by 0.4 percent in Aug at the same rate as in Jul. Inflation-adjusted disposable income rose by 0.2 percent in Aug in contrast with decline of 0.2 percent in Jul. The PCE price index rose by 0.2 percent in Aug equal to the increase in Jul and excluding food and energy, closely watched by the Fed, by 0.1 percent in both Aug and Jul. Real GDP, which consists of the output of goods and services produced in the US, rose at the annual seasonally adjusted rate of 1.7 percent in the second quarter, revised upwardly from the second estimate of 1.6 percent, after an increase by 3.7 percent in the first quarter (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp2q10_3rd.pdf ). Accelerating imports and decelerating private inventory investment were the factors causing the decline in the rate of growth in the second quarter that were compensated by increases in residential fixed investment, increases in state and local government spending and accelerations in nonresidential fixed investment and federal government spending. While real exports of goods and services grew by 9.1 percent in the second quarter, compared with 11.1 percent in the first quarter, real imports of goods and services rose by 33.5 percent in the second quarter, compared with a decline by 12.3 percent in the first quarter. The seasonally adjusted annual equivalent rate of construction spending increased by 0.4 percent in Aug relative to July but declined by 10.0 percent relative to Aug 2009 (http://www.census.gov/const/C30/release.pdf ). Construction spending in the first eight months of 2010 was $539.4 billion, which is 31.9 percent below $793.2 billion in the first eight months of 2006 (http://www.census.gov/const/C30/pr200608.pdf ). The business barometer index of the Chicago ISM rose from 56.7 in Aug to 60.4 in Sep, with production increasing from 57.6 to 64.3 and new orders from 55.0 to 61.4 (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20September%202010.pdf ). The national ISM report was less encouraging with decline of the general purchasing managers’ index to 55.4 in Sep from 56.2 in Aug, new orders to 51.1 in Sep from 53.1 in Aug, production to 56.5 in Sep from 59.9 in Aug and employment to 56.5 in Sep from 60.4 in Aug (http://www.ism.ws/ISMReport/MfgROB.cfm ). The Case-Shiller index of Standard & Poor’s shows deceleration in the rate of price increase in Jul 2010 relative to Jul 2009 from 4.1 percent in the composite 10-city index and 3.2 percent in the composite 20-city index compared with 5.0 percent and 4.2 percent, respectively, in Jun 2010 relative to Jun 2009 (http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us---- ). Large automakers in the US reported double digit increases in sales in Sep (http://professional.wsj.com/article/SB10001424052748703859204575525953404310076.html?mod=wsjproe_hps_LEFTWhatsNews). Initial jobless claims declined to 453,000 in the week ending on Sep 25 or by 16,000 relative to the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Initial jobless claims fell during the latter part of 2009 but have stabilized around 450,000 in 2010, which still remain at a high level.

II Regulation, Trade and Devaluation Wars. In her famous essay based on protectionism in the 1930s, the celebrated economist Joan Robinson argues that:

In times of general unemployment a game of beggar-my-neighbour is played between the nations, each one endeavouring to throw a larger share of the burden upon the others. As soon as one succeeds in increasing its trade balance at the expense of the rest, others retaliate, and the total volume of international trade sinks continuously, relatively to the total volume of world activity. Political, strategic and sentimental considerations add fuel to the fire, and the flames of economic nationalism blaze even higher and higher (Joan Robinson, “Beggar-my-neighbour remedies for unemployment,” Essays in the Theory of Employment (Oxford, Basil Blackwell, 1947, 156-57).

Joan Robinson argues that world economic activity is reduced by this collective behavior because of the loss of the gains from specialization of labor. In her analysis, interest rates fall in countries increasing their balance of trade while interest rates rise in countries experiencing a mirror fall in their trade balance. Monetary policy may accentuate these effects:

Owing to the apprehensive and cautious tradition which dominates the policy of monetary authorities, they are chronically more inclined to foster a rise in the rate of interest when the balance of trade is reduced than to permit a fall when it is increased. The beggar-my-neighbour game is therefore likely to be accompanied by a rise in the rate of interest for the world as a whole and consequently by a decline in world activity (Ibid, 157).

The tools of increasing the balance of trade considered by Joan Robinson include: (1) devaluation; (2) wage reduction, including increasing work hours at the same wage; (3) export subsidies; and (4) tariffs and quotas to restrict imports (Ibid, 157). Robinson also makes the famous remark that the argument that tariffs must be used in retaliation to imposition of tariffs by other countries “is countered by the argument that it would be just as sensible to drop rocks into our harbours because other nations have rocky coasts” (Ibid, 158).

Contemporary events in the 1930s were consistent with the concerns of Joan Robinson. From the second quarter of 1930 to the third quarter of 1932 imports by the US fell 41.2 percent and exports by a similar percentage (Douglas Irwin, Review of Economics and Statistics 80 (2, 1998) cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 208, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars, 179). A major part of this decline was caused by the contraction of US real GNP by 29.8 percent, inducing Americans to reduce the purchase of all goods, including imports, like never before. Ad valorem equivalent rates of duty on imports rose from 21.08 percent in the Act of 1913 and 34.61 percent in the Act of 1922 to 42.48 percent in the Smoot-Hawley Act of 1930 (Irwin, 327). Sophisticated econometric measurements conclude that about 20 percent of the 40 percent reduction of imports was caused by the higher tariff and the deflation effect that occurs because actual percentage tariffs increase as the price of imports declines (Ibid). The UK followed with the Abnormal Importation Act in November 1931 and the Import Duties Act in Feb 1932 and other countries imposed retaliatory duties (Joseph Jones cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 208). The volume of exports and imports of industrialized countries fell by about 30 percent between 1929 and 1932 (Jacob Madsen cited by Pelaez and Pelaez, Globalization and the State, Vol. II, 208-9).

The analysis of trade, devaluation and regulation wars after 2008 is more complex than during the 1930s. There have been government interventions by national monetary authorities throughout the world to maintain the competitiveness of their currencies and complaints of foreign exchange wars. The sharp fluctuation of selected foreign exchange rates is shown in Table 1. The euro lost 33.4 percent to the US dollar from Jul 2008 to Jun 2010 but has gained 13.5 percent recently. The Japanese yen has revalued by 24 percent since Jun 2008. The Australian dollar is one of several “commodity currencies,” characterized by high domestic interest rate differentials and correspondingly strong foreign exchange rates, recovering from significant devaluation to about even. Commodity or high yielding currencies receive foreign capital inflows through the carry trade, which consists of short positions on the low-yielding currency, such as the US dollar, and long positions in fixed income, commodities and emerging market stocks (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4).

 

Table 1, Exchange Rates

	Peak	Trough	∆% P/T	10/1/10	∆% T 10/1/10	∆% P 10/1/10
EUR USD	7/15/08	6/8/10		10/1/10
Rate	1.59	1.192		1.378
∆%			-33.4		13.5	-15.4
USD JPY	8/18/08	9/15/10		10/1/10
Rate	110.19	83.07		83.51
∆%			24.6		-0.5	24.2
USD CHF	11/21 /08	12/8/09		10/1/10
Rate	1.225	1.025		0.975
∆%			-16.3		-5.1	-20.4
GBP USD	7/15/08	1/2/09		10/1/10
Rate	2.006	1.388		1.573
∆%			-44.5		11.8	-27.5
AUD USD	7/15/08	10/27 /08		10/1/10
Rate	0.979	0.601		0.972
∆%			-62.9		38.2	0.7

Symbols: USD: US dollar; EUR: euro; JPY: Japanese yen; CHF: Swiss franc; GBP: UK pound; AUD: Australian dollar; P: peak; T: trough

Note: percentages calculated with currencies expressed in units of domestic currency per dollar; negative sign means devaluation and no sign appreciation

Source: http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3000

 

Currency intervention is extending throughout the world in a type of “hidden” currency war (http://www.ft.com/cms/s/0/8beeb262-ca56-11df-a860-00144feab49a.html ) with some countries in alert (http://www.ft.com/cms/s/0/33ff9624-ca48-11df-a860-00144feab49a.html ) . There are some six central banks trying to depreciate their currencies, with Japan in the leadership (http://professional.wsj.com/article/SB10001424052748703882404575519372149380764.html?mod=wsjproe_hps_LEFTWhatsNews ). Japan depends on exports for growth and employment and has been intervening by direct purchases of dollars to weaken the yen in what is becoming an important domestic political issue (http://www.ft.com/cms/s/0/cdb28962-c67d-11df-8a9f-00144feab49a.html). Earlier interventions were not very successful (Pelaez and Pelaez, The Global Recession Risk, 107-9). Daily trading in foreign exchange in the world has reached $4 trillion such that intervention is not likely to succeed even with purchases of $20 billion by Japan (http://www.bis.org/publ/rpfx10.pdf?noframes=1 ). Japan is also crafting another $55 billion stimulus package together with possible further action by the Bank of Japan with the objective of depreciating the yen (http://www.ft.com/cms/s/0/cedc5ea0-c987-11df-b3d6-00144feab49a.html). Several Asian central banks of exporting countries have been intervening without much success to depreciate their currencies relative to the dollar but have allowed some limited appreciation to contain inflation because appreciation of the yuan by China could maintain their competitiveness (http://professional.wsj.com/article/SB10001424052748704116004575521123462281554.html?mod=wsjproe_hps_MIDDLEThirdNews).

The US House of Representatives passed on Sep 29 the Currency Reform for Fair Trade Act (H.R. 2378). The intention of the legislation is to increase US manufacturing by approving countervailing duties to compensate for a “fundamentally undervalued currency”(http://www.speaker.gov/newsroom/legislation?id=0406 ).The characterization of China as a “currency manipulator” could trigger the extensive and damaging US process of antidumping and safeguards (Pelaez and Pelaez, Globalization and the State,Vol. I, 174-8, Government Intervention in Globalization, 95-7). While the legislation passed in the House by wide bipartisan vote of 348-79, it is not likely to be considered by the Senate this year and could still not be implemented by the executive (http://professional.wsj.com/article/SB10001424052748704116004575522401651849766.html?mod=wsjproe_hps_LEFTWhatsNews).

Martin Wolf finds the explanation of the currency conundrum by insufficient demand in the advanced economies that desire to grow by exports and a net capital outflow to emerging countries that run a compensatory current account deficit while the US attempts to inflate the economy and China maintains a strong currency, accumulating $2.5 trillion dollars in reserves (http://www.ft.com/cms/s/0/9fa5bd4a-cb2e-11df-95c0-00144feab49a.html ). Wolf concludes that the current episode of beggar-my-neighbor policies may not end well. The World Trade Organization finds that world merchandise trade increased by 25 percent in the first six months of 2010 relative to the same period in 2009 (http://www.wto.org/english/news_e/pres10_e/pr614_e.htm ) and forecasts growth of 13.5 percent for the entire year of 2010 (http://www.wto.org/english/news_e/pres10_e/pr616_e.htm ). Deceleration of world trade could further worsen employment creation in many countries.

III Quantitative Easing. There is no “vigor” in US economic recovery for creation of jobs and reduction of job stress but there is moderate recovery of economic activity. Sovereign risk doubts in various European countries have not been resolved with the potential of affecting banks throughout the region including large banks in France and Germany. Stress tests require four types of measurements that are difficult to obtain: (1) relatively accurate forecasts of the economy moving forward or at least risk events of substantial impact even if of low probability of occurrence, such as sovereign debt stress, growth and employment; (2) behavior of financial assets and prices related to the economic forecasts or events such as prices and yields of bonds and their derivatives, risk spreads of key transactions including loans and probabilities of default of sovereigns and financial institutions and their clients; (3) relation of major classes of assets and liabilities of banks and other financial institutions to the economic events and prices, probabilities of default and so on; and (4) measurements of the impact on bank balance sheets of the movements in major classes of assets and liabilities and probabilities of default (see Pelaez and Pelaez, International Financial Architecture, 101-62, Globalization and the State, Vol. I, 78-100, Government Intervention in Globalization, 57-74, Financial Regulation after the Global Recession, 164-6). If this knowledge were available, large financial institutions such as Lehman Bros and hundreds of regional banks would not have collapsed. There is no such thing as reliable stress tests of banks throughout the diverse complexity of European Union financial systems, or elsewhere, that can give comfort. Stress tests are an important ingredient of risk management that adds value but significant uncertainty may remain (Myron Scholes, Crisis and risk management, American Economic Review (90, 2 2000) cited in Pelaez and Pelaez, International Financial Architecture, 110). In fact, the allegedly perfect “economic science” of theory and policy, including exotic “shock and awe” quantitative easing, is as imperfect as risk management (http://www.federalreserve.gov/newsevents/speech/bernanke20100924a.htm#f15).The US dollar/euro rate reflects complex behavior of multiple determinants, including essentially the relative performance and stability of the financial systems and economies of the euro zone and the United States. The uncertainty about the euro zone is significant because of the doubts about stress tests while US data confirm subpar growth but significantly controlled financial system except for continuing failures of regional and smaller banks (http://professional.wsj.com/article/SB10001424052748704760704575516272337762044.html). There are still sovereign debt issues in medium-size countries plagued with large deficits relative to GDP (http://professional.wsj.com/article/SB10001424052748704654004575518091992302632.html?mod=wsjproe_hps_LEFTWhatsNews ). The upfront effects of bank bailouts in Ireland can result in a deficit of 32 percent of GDP this year (http://www.ft.com/cms/s/0/d8578e16-cc69-11df-a6c7-00144feab49a.html ) with possible hard repercussions in the European economy (http://professional.wsj.com/article/SB10001424052748704116004575523121071932284.html?mod=wsjproe_hps_TopLeftWhatsNews).

Why does the US dollar devalue relative to the euro? The ICE Dollar Index, measuring the US dollar index relative to a trade-weighted basket of currencies, touched on Friday the lowest point since Jan (http://professional.wsj.com/article/SB10001424052748704116004575523121071932284.html?mod=wsjproe_hps_TopLeftWhatsNews ). The prime suspect of dollar weakness is the statement of the need for “unconventional” measures, or quantitative easing, by a voting member of the Federal Open Market Committee (FOMC) and one that will vote next year (Ibid, http://blogs.wsj.com/economics/2010/10/01/feds-dudley-further-action-is-likely/ http://www.ft.com/cms/s/0/fe753938-cd66-11df-ab20-00144feab49a.html). The stage was set by earlier reports that the Fed is considering smaller-scale purchases of long-term bonds that it could roll back if the economy improves instead of the announcement in March 2009 of the purchase of $1.7 trillion of long-term securities that was somberly called “shock and awe” (http://professional.wsj.com/article/SB10001424052748703694204575518222145769804.html?mod=wsjproe_hps_TopMiddleNews). The combination of these statements suggesting zero short-term fed funds rates and declining long-term rates with strong manufacturing data in China stimulated risk positions in the carry trade from zero interest rates in the US to short the dollar and go long on commodities, emerging market stocks and high risks. There was a major rally in commodities with crude oil futures hitting $81.73/barrel, gold future $1320/ounce and copper 369.55 cents/pound (http://online.wsj.com/mdc/public/page/mdc_commodities.html?mod=mdc_topnav_2_3000 ).

The effects of the first round of quantitative easing and the expectation of a new round of quantitative easing create multiple distortions in risk/return decisions by financial and nonfinancial entities. Such distortions were an important cause of the credit/dollar crisis and global recession. An excellent example of firm-level distortions is that bank costs cannot fall below zero percent but revenues continue to decline, eroding operational margins in lines of business such as preventing funds to earn management fees, insurance companies to issue annuities and instruments at fixed rates and banks to earn a spread of loan rates relative to near zero CD rates (http://professional.wsj.com/article/SB10001424052748703882404575520020341772404.html?mod=wsjproe_hps_MIDDLEFifthNews). Financial repression occurred in emerging countries as a result of interest rate controls such as ceilings on deposit and loan rates (see books by Edward Shaw and Ronald McKinnon, both in 1973, and other literature cited in Pelaez and Pelaez, Globalization and the State, Vol. II, 81). Quantitative easing is a form of controlling interest rates, in this case not only short-term rates but also long-term yields, distorting allocation by business models that can no longer choose projects by calculating relative net present values.

IV Risks of Bonds and Returns of Equities. The “shock and awe” quantitative easing by Fed purchasing $1.7 trillion long-term securities created what is probably the highest concentration of a bond portfolio with the Fed holding over 20 percent of 10-year equivalents of several classes of bonds (http://www.newyorkfed.org/research/staff_reports/sr441.pdf). Another “shock and awe” bond purchase or a succession of smaller bond purchases could raise the Fed holdings of asset classes over 30 percent of 10-year equivalents. The Fed could simply be adding to market risk, creating a disorderly future collapse of bond markets with possible adverse effects on the overall economy. Bond yields could surge at the mere hint of rolling back the Fed portfolio. The interest rate is closely related with aggregate wealth. It is possible to conceive of income as a flow, Y, that is obtained by applying a rate of return, r, to a stock of wealth, such that: Y = rW (Milton Friedman, A Theory of the Consumption Function, 1957). Dividing both sides of this equation by r, W = Y/r. As r declines toward zero, W increases without bound. The first round of near zero fed fund rates, reduction of the long-term interest rate by less direct quantitative easing of suspending auctions of the 30-year Treasury, housing subsidy of $221 billion per year, policy of affordable housing and purchase or acquisition of $1.6 trillion of nonprime mortgages resulted in increases in perceived wealth by households and business that caused the credit/dollar crisis and global recession, creating the illusion that there were no risks because monetary policy could prevent crises (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). Households and business were encouraged by government policy to take high risks using high leverage with minimal liquidity and unsound credit decisions. There are multiple important determinants of the interest rate: “aggregate wealth, the distribution of wealth among investors, the expected rate of return on physical investment, taxes, government policy and inflation” (Jonathan Ingersoll, Theory of Financial Decision Making, Rowman, 1987, 405). Aggregate wealth is a major driver of interest rates (Ibid, 406). Unconventional monetary policy, with zero fed funds rates and flattening of long-term yields by quantitative easing, causes uncontrollable effects on risk taking that can have profound undesirable effects on financial stability. Excessively aggressive and exotic monetary policy is the main culprit and not the inadequacy of financial management and risk controls.

Quantitative easing is even less operational when there are legislative restructurings and regulation that frustrate investment and consumption, resulting in recovery without vigor. The minutes of the FOMC meeting on Aug 10 provides evidence on an important cause of weakness in investment, spending and hiring: “a number of participants reported that business contacts again indicated that uncertainty about future taxes, regulations, and health-care costs made them reluctant to expand their workforces” (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100810.pdf 7). Restructurings and regulation causing lack of vigor in the recovery are altering business models of firms that have hoarded cash because of the uncertainty in calculating rates of return of investment. The bond market is becoming a big bubble blown by the “little guy” or retail investors that allocated $375 billion to mutual bond funds in 2009 and $230 billion until presently in 2010 and households withdrawing $70 billion from US equity funds in 2010 even as the stock market has returned 4 percent (Jason Zweig, The bond “bubble”: are small investors taking too big a bet? WSJ, http://professional.wsj.com/article/SB10001424052748704029304575526172764480294.html?mod=wsjproe_hps_MIDDLEForthNews). Bloomberg estimates that US corporate bond offerings reached $340 billion in the quarter Jul through Sep, making it the busiest in history while Fed data show banks reducing commercial and industrial lending by 11.4 percent to $1.24 trillion in the week ending on Sep 8 compared with $1.4 trillion a year earlier (http://noir.bloomberg.com/apps/news?pid=20601087&sid=aGFlWGfowKrQ&pos=4). Banks are reluctant to lend because of uncertainties, including regulation, making it difficult for smaller companies, dependent on bank loans, to borrow for investing in their projects. The issue of worldwide corporate bonds reached $145 billion in Sep alone, the highest in record. The issue of high-yield bonds in 2010 reached $191.4 billion, which exceeds the prior annual records with three months left in the year. Investment-grade corporate bond yields reached the lowest ever on Sep 28, 3.645 percent, much lower than 4.935 percent a year earlier, according to index data of Bank of America Merrill Lynch reported by Bloomberg (Ibid).

The potential risks of principal losses in bonds relative to capital gains in equities are illustrated by Table 1. The last column in the table shows the percentage change in major equity indexes, the dollar, commodities and the yield of the 10-year Treasury. Equities and commodities have experienced double-digit gains while the dollar has depreciated and the yield of the 10-year Treasury has collapsed from a peak of 3.986 percent to 2.513 percent. The returns on equity are simple instead of annual equivalent percentage changes. For example, the Dow Jones Industrial Average (DJIA) has gained 11.8 percent since Jul 2, that is, 11.8 percent in about three months, which under discrete compounding is equivalent to 56.2 percent reinvested in four periods. The recovery continues with moderate rates of growth. What could drive future stock market returns? Corporations are hoarding close to $3 trillion in cash that is beginning to be used with leverage in attractive consolidation by mergers and acquisitions. Changes after Nov 2 could create a pause in legislative restructuring and regulation that could reduce uncertainty, stimulating investment and consumption. The combination of a wave of mergers and acquisitions with reduction of uncertainties of legislation and regulation could cause an outflow of funds from bonds into equities. Bonds would suffer principal losses equivalent to rising yields while equity prices would rise. Another round of quantitative easing would run against investment decisions as it has happened during the legislative restructurings and regulation.

 

Table 2, Stocks, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% to 10/01	Week 10/01	∆% T to 10/1
DJIA	4/26/10	7/2/10	-13.6	-3.3	-0.3	11.8
S&P 500	4/23/10	7/2/10	-16.0	-5.8	-0.2	12.1
NYSE Financial	4/15/10	7/2/10	-20.3	-11.6	-0.8	10.9
Dow Global	4/15/10	7/2/10	-18.4	-6.4	--	14.7
Asia Pacific	4/15/10	7/2/10	-12.5	-0.2	1.4	14.0
Shanghai	4/15/10	7/2/10	-24.7	-16.1	2.5	11.5
STOXX Europe	4/15/10	7/2/10	-15.3	-8.5	-2.2	8.0
Dollar	11/15/10	6/25/10	22.3	9.8	-2.0	-10
DJ-UBS Comm.	1/6/10	7/2/10	-14.5	-4.1	-0.8	12.2
10-year Treasury	4/5/10	4/6/10	3.986	2.513

T: trough

Source: http://online.wsj.com/mdc/page/marketsdata.html

 

V Interest Rates. The yield curve of US Treasuries shifted downwardly with the 10-year Treasury at 2.51 percent which lower than 2.62 percent a week ago and 2.71 percent a month ago. Risk flight in Europe caused the 10-year government bond of Germany to trade at 2.29 percent for a spread relative to the equivalent Treasury of -23 basis points (http://markets.ft.com/markets/bonds.asp?ftauth=1286119976582 ). The Treasury with coupon of 2.63 percent maturing on 08/20 traded on Oct 1 at a price of 100.84 or equivalent to a yield of 2.53 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-011010 ). The price would fall to 88.9135 for settlement on Oct 4 if the yield were to back up to the recent peak of 3.986 percent on Apr 4, for a loss of principal of 11.8 percent. Quantitative easing while investment funds are diverted from bonds back into equities is subject to a duration trap of heavy market losses.

VI Conclusion. Equities worldwide have rebounded with two-digit percentage gains since the lows of Jul 2, almost returning to the levels before the Apr sovereign risk doubts in Europe. Record issues of bonds at lowest historical yields have continued to attract funds from risk-averse investors who may realize the duration risks of principal losses resulting from rising yields as funds flow into equities. Another round of quantitative easing in this environment appears inopportune. Bond yields could back up with intolerable losses if markets anticipate sales of bonds from the Fed portfolio (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

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