The
Fed’s Bubble Trouble By Euro Pacific Capital - January
9, 2009
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.
But we should know that the bursting of the bond market bubble
will have even more dire consequences than the bursting of
prior bubbles in stocks and real estate. Significantly higher
interest rates and inflation that will result will severely
compound the current problems. Imagine how much worse our
economy would be if we faced double digit interest rates?
In addition, not only will homeowners be confronted with record
high mortgage rates, but the Government will be staring at
trillion dollar annual interest payments on the national debt,
making interest by far the single largest line item in the
Federal budget. Just like homeowners who relied on teaser
rates, the Government will face a similar problem when all
its low-yielding short-term debt matures.
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.
Mr. Schiff is president of Euro Pacific Capital and author
of "The Little Book of Bull Moves in Bear Markets"