Sunday, August 1, 2010

Will the Bond Market Sandbag the Fed?

Improbably, bonds have rallied for the last 30 years. When Ronald Reagan was elected president in 1980, rates on 30-year Treasuries were in the range of 15%. Today, they pay about 4%. Economists have estimated that real interest rates (i.e., rates net of inflation) run around 3%. Buying a 30-year Treasury today is like gambling on 1% annual inflation for the next thirty years. That's a riskapalooza if there ever was one.

The corporate bond market is also glowingly optimistic about inflation. Recently, McDonald's sold $450 million of 10-year bonds bearing interest of 3.5%. That's like gambling on 0.5% inflation per year for a decade. Then again, if you bought 10-year Treasury notes, which today pay under 3%, you'd be speculating that there will be deflation for 10 years. One would have to go back to the Great Depression to find a time when these investments would have been winners. Reality is we've got a huge bond bubble.

The Fed is desperately seeking inflation. It's keeping interest rates (short, medium and long) ultra low in an effort to stimulate growth, hoping that a little inflation will be like a round of cocktails before dinner that gets the party going. While neither prices nor GDP are cooperating, the Fed persists, in the belief that manipulating the money supply will somehow work a miracle when consumers are scared, corporations are cautious, and Wall Street finances speculations in derivatives rather than production of goods and services.

Here's the catch: if the economy revives, the Fed will have to raise rates. That could pop the bubble in the bond markets, clobbering yet another asset class. If that happened, holders of capital, already pummeled by the 2000 tech stock collapse and the 2008 stock market crash, real estate crash, auction rate securities collapse, etc., would suffer aggravated battered investor syndrome. They'd pull back from risk and consumption. The stagnation the Fed so publicly fears would follow.

But if the Fed doesn't raise interest rates after the economy revives, inflation would flare, ravaging the value of bonds as borrowers repay creditors with cheaper dollars. The bond bubble would pop in this scenario as well, producing severe battered investor syndrome and stagnation.

Thus, the potential for lasting recovery from the Fed's monetary policies may be capped by the bond bubble. There are other reasons why monetary policies may well fail (banks refusing to lend, consumers too scared to spend). But we've got a built-in booby trap set to spring if the economy revives.

The Fed surely knows this, and will probably hold off on raising rates as long as possible. Forget about the widely accepted view that the Fed should raise rates before inflation rears its ugly head to nip the problem in the bud. By incentivizing borrowing as much as possible, short, medium and long term, the Fed faces the possibility of injuring a constituency, creditors, it has tried to protect 100 cents on the dollar since 2008.

The Fed is damned if it does and damned if it doesn't. It has statutory responsibilities to promote full employment and economic growth. But if it succeeds in promoting growth with a little inflation fillip, it will likely pop the bond bubble and produce potentially large investor losses and a renewal of stagnation. Only a slow, agonizing, years-long recovery, with interest rates barely crawling up, would allow creditors to adjust to a rising interest rate environment without sharp losses. But unemployment would have to remain painfully high in such a scenario. Millions of unemployed Americans would pay the price for easing the bond market out of its current dilemma.

The Fed has yet to pop an asset bubble before it became a systemic threat. No doubt, it won't pop the bond bubble now. But it's laying the foundation for painful choices in the future.

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