Continued from “Why Didn’t Anybody See It Coming?”

The Federal Reserve has publicly stated that it is in the bond market to stay. The rate-setting committee of the Fed, the FOMC, recently recommitted to keeping the interest rate at virtually zero until 2015. Bernanke himself is hinting he will step down in 2014. That kind of runway gives the central bank time to continue to tinker around the edges of its long-standing policy of vacuuming up new U.S. debt, thus supporting demand and keeping bond prices high.

The 30-year Treasury started out 2012 at just under a 3% yield. It has remained within a handful of basis points, over or under, all year until now. The 10-year Treasury has done a similar dance below the 2% mark.

Meanwhile, the annualized, seasonally adjusted Consumer Price Index (CPI) is at 2%. Consider for a moment what that really means. Investors holding 10-year U.S. debt are doing so at break-even…maybe.  30 year investors are counting on a 1% return.

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When you put that on a teeter-totter, you get a very clear idea of what will happen if nothing else changes. Investors holding debt maturing at less than 10 years are guaranteed to lose money. Investors holding longer-dated debt are making a pittance relative to risk assets such as stocks. The dividend yield on the S&P 500 is just over 2%. The slightest appreciation in stocks beats bonds silly.

Is the “miraculous” rebound in stock prices starting to make sense now? If so, congratulations, you’re thinking like a central banker.

The trouble, of course, is that absolutely nobody except for governments and some very unusual insurers thinks about U.S. bonds as long-term investments. They all expect to “rent” the safety of U.S. paper for much shorter periods and then be able to cash in that paper for currency at any time.

One is immediately reminded of all of the bubbles of yore: Dutch tulips, South Sea shares, the dot-com craze. By definition, when an asset reaches impossible valuations then the valuations are, in fact, impossible to maintain.

That is exactly what’s happening in the bond market today. Only instead of Dutch shopkeepers bidding up bulbs or online day traders shuffling around shares of profit-free web properties, the cash flowing into bonds has come, in part, from fearful global investors and, in part, from our own central bank, the Fed.

The idea that the Fed will stay the course in its bond-buying scheme is absolutely absurd on the face of it. Bernanke knows he must exit the market. He’s not waiting to give you and me time to get out. He’s waiting only because he’s concerned, still, that the U.S. economy could turn inward on itself.

His view, one which he has shared publicly in the past, is that when credit crises erupt, as they do from time to time, governments react by doing far too little. The result, according to Bernanke’s own research as an expert historian of the Great Depression, is a rapid, uncontrollable decline in prices, also known as deflation.

Here’s where the trouble really begins. Once a central bank — or a bond market — is convinced that deflation risk has diminished, all bets are off.

 

Stay tuned for our next piece, Prepare Now for ‘Debtmaggedon’

 

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