The Fed’s Bubble Trouble

A few weeks ago when the Fed announced a strategy designed to bring down long-term interest and home mortgage rates through unlimited Treasury bond purchases, government debt staged a spectacular rally. To the unschooled market observer, the spike may be difficult to understand. After all, why would the value of Treasury bonds rise while their underlying credit quality is deteriorating faster than Bernie Madoff’s social schedule? The move is actually a perfect illustration of the tried and true Wall Street strategy of “buy the rumor and sell the fact”.If it is well known that Fed will be a big purchaser of Treasuries, those buying now will be positioned to unload their holdings when the buying spree begins. If the Fed pays higher prices in the future, traders can earn riskless speculative profits. If the traders lever up their positions, as many are likely doing, even small profits can turn unto huge windfalls.

The downside of course, is that all of the demand for Treasuries is artificial. Treasuries are now in the hands of speculators looking to sell, not investors looking to hold. These players are analogous to the mid-decade condo-flippers who flocked to new developments for quick profits. They did not intend to occupy their properties, but rather flip them to future buyers. Once these properties came back on the market, condo prices collapsed, as developers were forced to compete for new sales with their former customers.

This is precisely what will happen with Treasuries. Just as the U.S. government issues mountains of new debt to finance the multi-trillion annual deficits planned by the Obama Administration, speculative holders of existing debt will be offering their bonds for sale as well. In order to prevent a complete collapse in the bond prices the Fed will be forced to significantly increase its buying.

However, since the only way the Fed can buy bonds is by printing money, the more bonds they buy the more inflation they will create. As inflation diminishes the investment value of low-yielding Treasuries, such a scenario will kick off a downward spiral. But the more active the Fed becomes in their quest to prop up bond prices, the bigger the incentive to hit the Fed’s bid. The result will be that all Treasuries sold will be purchased by the Fed. But with the resulting frenzy in the Treasury market, and with inflation kicking into high gear, we can expect that demand for other debt classes that the Fed is not backstopping, such as corporate, municipal and agency debt, to fall through the floor, pushing up interest rates across the board.

In order to “save” the economy from these high rates the Fed will then have to expand its purchases to include all forms of debt. If that happens, run-away inflation will quickly turn into hyper-inflation, and our currency will be worthless and our economy left in ruins.

To avoid this nightmare scenario, the Fed should pull out of the bond market before it’s too late and let prices fall to where real buyers, those willing to hold to maturity, re-enter the market. Given how high inflation will likely be by the time this happens, my guess is that long-term Treasury yields will have to rise well into the double digits to clear the market.

The grim reality of course is that when the real estate bubble burst the Government was able to “bail-out” private parties. However, when the bond market bubble bursts, it will be the U.S. Government itself that will be in need of the mother of all bailouts. If U.S. taxpayers or foreign creditors are unwilling or unable to pony up, and if the nightmare hyper-inflation scenario is to be avoided, default will be the only option. If misery really does love company, Bernie Madoff’s clients might finally find some comfort.

9 Responses to "The Fed’s Bubble Trouble"

  1. Average Jane   January 11, 2009 at 7:08 pm

    Mr. Ryskamp, your points would be so much more well received if you were to present them in a respectful, collegial manner instead of resorting to puerile name-calling.

  2. Cinquero   January 12, 2009 at 1:37 am

    When Peter speaks about inflation in combination with bonds, it is probably not very wise to use a consumer inflation index. I’d rather compare it with a bond inflation… :-)

  3. flow5   January 16, 2009 at 11:09 am

    How does the FED follow a “tight” money policy and still advance economic growth.? What should be done? How is the Treasury bubble averted?The money creating depository banks should get out of the savings business — gradually (REG Q in reverse-but leave the non-banks or the financial intermediaries unrestricted).What would this do? The commercial banks would be more profitable – if that is desirable. Why? Because the source of all time/savings deposits within the commercial banking system, are demand/transaction deposits – directly or indirectly through currency or their undivided profits accounts (this part of the argument is uncontested).Money flowing “to” the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know.The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.This redistributes the flow-of-funds, and increases the supply of loan-funds in the long-term markets, it decreases long-term interest rates in the process, and it stimulates real-gdp & increases employment.

  4. flow5   January 16, 2009 at 11:34 am

    This (above) was what the FED successfully did in 1966 (check the numbers).

  5. Eugene Bersing   January 17, 2009 at 5:17 pm

    Whether there would be hyperinflation or deflation would depend upon whether or not the neewly- createdhigh- powered money ever got into the real economy. Currently, we have deflation largely because of the fact that M-0 is not getting into the real economy but is going from the Fed to the banks, and then right back to the Fed again. The Fed advances money to the banks, which use it to buy long- term gov’t. bonds, so that the money goes right back to the Fed and the banks get to slowly acquire capital via interest- rate arbitrage- get money from the Treasury for free or from the Fed for 0.25- 0.50 percent and use it to buy long bonds yielding 2.5- 3.0 percent. This is a riskless procedure for the banks, but guarantees a velocity of money equal to zero- which is why all these bailouts cannot and will not affect the real economy. However, if, for whatever reason, the banks were to start to lend freely to the real economy once again, then there is certainly the potential for hyperinflation! Now, a stimulus plan that injected demand into the real economy would have a salutary effect on income and employment, as well as counteracting deflation (totally unlike the money squandered on financial bailouts). But if too much money is borrowed (or “monetized”) to spend/pay for financial system bailouts, then it probably will be the case that the excessive demand for money capital (worldwide, mind you) will drive interest rates into the stratosphere, even if we were to have no stimulus package, along with a deflationary depression! Therefore, I say: no more bailouts! We need the bailout for the real economy and ordinary and poor people, not for the Madoffs and assorted banksters and fraudsters of the world. If, as is likely, the big money- center banks are insolvent, then we should nationalize the banking system, and save ourselves a trillion- plus dollars- dollars that should be spent on something that will keep the wolf away from the doors of those of us who are not fortunate enough to be Wall Street potentates. BAILOUT THE PEOPLE- NOT THE BANKS!!!