Consequences of Fed policy - serial bubble blowing, the next stage...

Discussion in 'Economics' started by Cutten, Dec 27, 2008.

  1. In 1990-92, in response to a recession, the Fed slashed rates and helped create a bubble in the bond market by encouraging leverage. In 1994 this bubble burst. In 1995, in response to a financial crisis in Mexico, the Fed bailed out a bunch of investors. This created moral hazard and helped contribute to a bubble and then meltdown in emerging markets, and the LTCM disaster in 1998. The Fed slashed rates again, writing the Greenspan put, and this caused tech stocks to go into an even bigger bubble, exacerbated by further injections of liquidity in anticipation of the Y2K non-problem. This caused the greatest stock bubble in US market history. When this crashed, Greenspan slashed rates to 1% and kept them there for over 2 years after the recession ended. This caused the biggest real estate bubble since WWII, which in turn caused our current financial crisis.

    Now, after artificially and needlessly causing bubble after bubble, which caused bust after bust, which was in turn responded to by more bubble inflating, let us survey the current situation:

    The Fed has taken rates to 0-0.25%, and they are now talking about purchasing long-dated Treasuries. This is now in the process of creating an incipient bubble in the government bond market. The Fed is effectively granting a free put on bonds, as well as putting in a persistent bid which will get stronger once they actively intervene.

    As we have seen with prior bubbles, their creation leads to huge market distortion and misallocation of capital for years, followed by an incredibly destructive eventual crash. There is no reason to think this pattern will be any different. Treasuries will go to (even more) absurdly low yields, become hideously overvalued, suck in lots of savings and investment capital - and then they will crash.

    At sufficiently low yields, the risk of capital loss on Treasuries becomes enormous. 30 year bonds can easily fall 30-40% in a year if the yield gets low enough, say 1%, and then the market crashes. Imagine what a 30-40% hit to bond prices would do to the average retirement portfolio or pension plan. It would be absolute carnage. Worst of all, it would hit the most risk-averse savers, since government bonds are traditionally viewed as a safe investment. However, as we all know, a sufficiently excessive price can turn *any* investment into an extremely risky one.

    The Fed is following its typical behaviour of wreaking utter havoc in the markets and the economy. By trying to fight the last bubble (which it partly created) it is inflating the next. A bubble in the bond market could be even more devastating, once it finally hits, than the real estate bubble. Remember the last serious bond bear market in the late 60s and 1970s - that was a lost decade of inflation, recession, and total annihilation of savings. Many widows, orphans, and pensioners were put into penury as their retirement funds collapsed due to soaring yields and inflation. A whole generation was effectively wiped out financially.

    This latest bubble, and its consequences, are going to cause the greatest financial crime of the 21st century in the western world. The later baby boomers are going to get pounded like rented gerbils, and the younger generation are going to end up footing the bill with increased welfare payments. All of this because the Fed created 5 bubbles in 15 years and no one did a damn thing to stop them creating a 6th. Bernanke will go down as the worst Fed chairman since the Great Depression. He will fight the last war, doing way too much to stimulate the economy, and his legacy will be a bubble and bust in the bond market that people will still be writing about in 100 years time.

    There is a simple way to avoid this problem: abolish the Fed. The US did fine without it before it was created, after all. Of course, this won't happen. Which is why the historic boom and bust in bonds *will*. It will probably take a number of years, but in the end the party will be pooped and you will be left to clean up the mess.
  2. pma


    Cutten-a very accurate post you have here.I agree that abolishing the fed is the only solution,but getting rid of them is next to impossible.The mass media and educational system is very effective in keeping people in the dark.
  3. Japan has been doing the same thing for a decade and their "adsurdly" priced bond market has gotten even pricier. Folks have been calling for a bursting of the JGB "bubble" since Obama was an undergrad. Hasn't happened yet.

    I'm not saying I disagree with you. I'm sure shorting US gov't bonds will be a great move, but when. A year from now, 10 years, 20 years ...?
  4. This latest bubble, and its consequences, are going to cause the greatest financial crime of the 21st century in the western world.

    In addition to "Abolish the Fed"


    I wonder how much of the bubble is/was caused by interference of Congress in the business of the Fed reserve. If Congress is asking the Fed Reserve to direct monetary policy toward achieving real estate goals "homeownership" rather than letting the Fed Reserve work its magic but the result is not the desired effect of Congessional intentions. The tail wagging the dog.

    I don't know, just thinking out loud.
  5. this is totally false. low interest rates didn't cause the real estate bubble. they played a minor role, but the primary cause was loose lending standards and poor oversight.

    if you think low interest rates necessarily cause real estate bubbles, look at the 50s and part of the 60s. rates were lower then and there was no real estate bubble. home prices appreciated at a modest rate, nowhere near the 10-20% annual increases we saw in 2003-2006.

    had there been tight lending standards in 2003, even with the low rates we would not have had a r/e bubble.
  6. harkm


    Lets say inflations suddenly ticks up to 3 or 4 percent.(USD value drops and import prices rise) How is it possible that the Fed can keep 30 year treasury rates at 2.5 percent? Nobody would buy them. Yes, we can suppose the Fed will buy every one of them with printed money but that will just lead to higher inflation expectations and ultimately higher yields on everything else.
  7. aradiel


    Very interesting comments here guys, thank you.

    So inflation expectation would eventually the right timming to play the bonds shorting?
  8. dhpar


    wrong. low rates are the main reason we are where we are. you are right that "loose lending standards and poor oversight" played its role but that itself did not lead to overleverage and therefore it could have been treated on a micro level i.e. e.g. via bankruptcies and/or targeted government relief programs.

    low rates multiplied an otherwise manageable problem and i would argue that "loose lending standards and poor oversight" is actually a corollary of these low yields. let's recall how everybody was chasing each basis point not so long ago...
    note that the relaxation of lending standards came later in the bubble - not at the beginning - so it can't be a cause. rather it was a function of demand from securitization which had huge demand for leveraged investments from investors due to abnormally low yields (that did not beat even inflation)...

    enjoyable post Cutten - i am on the same side...
  9. Unfortunately we as investors/trader cannot do anything about the Fed, since it is almost impossible for us to unite in a way that would affect anything. So the question that should concern us is: How do we take advantage of the stupidity?
  10. dhpar


    personally i am interested in problems where finding a solution does not necessarily mean that it is directly applicable to a trading/investing world. that's likely why OP decided not to put this thread into "Trading" category.
    i am probably becoming too old...:p
    #10     Dec 27, 2008