Bill Gross is exactly correct.

The entire market is stupid rich. Two-year AAA municipal yields are at 0.75%, 30-year Treasuries are at 4% in the face of insanely large deficits, and the S&P is priced at twenty times backward-looking earnings. The price of commercial mortgage backed securities rated single-A has more than doubled since March, which is just madness.

The Financial Times Sept. 27 suggested that this might prompt a bank rally:

The recent rally in the markets for “toxic” securities could deliver a significant boost to US banks’ third-quarter earnings if financial groups decide to book accounting gains on assets that caused them billions of dollars in losses during the crisis.

Wall Street executives and analysts say the significant rise in the price of mortgage-backed securities and other once-battered debt offers banks the first meaningful chance to “write up” some of the value of these distressed assets.

It’s a better guess that this already has caused a bank rally which is well past its best-used-by-date.

The only way to finance a Treasury deficit pushing $2 trillion is through the banking system. Even if savings rise to 10% of GDP and all savings go into Treasury securities, that only covers a trillion dollars. Foreign purchases might reach $300-$400 billion as China and other creditors are forced to swallow more US obligations for lack of other things to buy.

But I note that since May, although total bank credit has fallen from $9.35 trillion to $9.12 trillion, bank holdings of Treasury securities have risen to $1.383 trillion from $1.26 trillion. Expect this to continue: the Fed will keep money easy so that banks can continue to buy into the long end of the curve with security and keep long-term yields (and mortgage rates) low.

This is a potentially unstable meta-equilibrium, but banks have to do something with money (as does PIMCO), and they are buying the long end of the curve, where the yield is.

What should investors do who do not have to do anything? The best combination is fixed income (towards the long end of the curve) along with hedges against a dollar collapse, e.g. gold mining stocks. That was the stance I recommended on July 9 and I’m sticking to my story.

This entry was posted on Tuesday, September 29th, 2009 at 1:32 pm and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.