Wednesday, August 18, 2010

The Bubble in the Bond Market

There is an op-ed piece in the Wall Street Journal that I believe everyone should read. It is written by Jeremy Siegel and Jeremy Schwartz and is titled “The Great American Bond Bubble.” ( I believe this article is important enough and should be read even if you don’t exactly agree with the argument, which I don’t.

Siegel and Schwartz contend that the current “bubble” in the bond market is comparable to the bubble that occurred in the United States stock market in the 1990s. The reason for this bubble: “Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.” In effect, they argue, investors are too concerned about the possibility of slow economic growth and price deflation.

In order to make these “bets” investors have moved money from the stock market into the bond market. “The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.”

My argument is slightly different. The Federal Reserve has held its target interest rate, the Federal Funds rate, in a range from zero percent to 0.25% since December 16, 2008 to the present. The yield on the 10-year constant maturity, United States Treasury issue has ranged over this time from about 4.00% to about 2.75% where it now stands at. The 3-year constant maturity has stayed in the 2.00% to 0.80% range.

Thus, investors could (and can) borrow money at close to zero interest and invest at a substantial spread...and THIS IS A RISK FREE TRANSACTION!

This is called the “carry trade”! Duh!

What about interest rate risk, the risk that interest rates will rise?

Well, the Federal Reserve, in its infinite wisdom, has taken care of that by promising the financial markets that it will maintain its low target interest rate for “an extended time.” Well, the “extended time” has lasted for twenty months so far and given the news coming out of the Open Market Committee meeting last week, it sounds like the “extended time” will last well into 2011.

The carry trade seems like it has a pretty safe bet for “an extended period of time.”

The Fed seems to be accomplishing two things in following such a policy. First, it is helping the Federal Deposit Insurance Corporation, the FDIC, resolve the problem of dealing with a massive amount of insolvent “smaller” banks in an orderly fashion. This work-out still has a long way to go by all accounts.

Second, the Fed is helping the federal government place massive amounts of debt. Never before has so much government debt been placed in the open market. And, given projections that the federal government will have to place $15 trillion or more of its debt in the next ten years, the Fed faces a daunting task of accommodating such a huge supply of Treasury securities.

The Federal Reserve has certainly accomplished some major things in helping the FDIC and the Treasury Department and in doing so has subsidized the large banks, major corporations, and other investment funds who could partake of the “carry trade” opportunities it created. Too bad if you are a smaller organization or don’t have the wealth to partake.

The Fed subsidy is lining the vaults of the large banks, the large corporations, and the large
investment pools. They are awash in cash!

And, we have a bubble in the bond markets!

This is the third financial market bubble in the last 15 years or so: the stock market bubble in the late 1990s; the bubble in the housing market in the 2000s; and now the bond market bubble. All of these are a product of the Federal Reserve.

I don’t disagree with Siegel and Schwartz in terms of the possible consequences of the current bubble.

“Those who are now crowding into bonds and bond funds are courting disaster.”

“Furthermore, the possibility of substantial capital losses on bonds looms large.”

“One hundred times earnings was the tipping point for the tech market a decade ago. We believe that the same is now true for government bonds.” (Siegel and Schwartz contend, for example, that “The interest rate on standard noninflation-adjusted Treasury bonds due in four years has fallen to 1% or 100 times its payout.”)

However, given my argument, these consequent outcomes and the timing of them depends upon the Fed. The “extended time” will end at some point in the future and the Fed will have to let rates rise. When it does there will be a whole bunch of new problems it will have to face.

The Fed seems to be careening from one serious problem to another and appears to be “out-of-control”. ( Over the past 15 years or so, the Fed has created one bubble after another, one problem after another, and now finds itself in an almost untenable position. It has pumped an excessive amount of reserves into the banking system. It is subsidizing the cash pools of large banks, large corporations, and large money interests. It has been overly accommodative to the financing of the debt of the federal government. And, now its risks bankrupting a large number of people, as Siegel and Schwartz suggest, when it ever raises its interest rate target. What next?

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