A few years from now, when you look back at the stock and bond market action since the election, I can predict with near-certainty that one phrase will reverberate in your mind: “Why didn’t anyone see it coming?”

Of course, the massive shift in risk ahead is patently obvious today and everyone should realize it right now. To put it as plainly as possible, the bond market is primed for an epic “contraction”, such as we have not seen in many decades.

The 30-year bull market in bonds continues with investors investing over a trillion dollars more despite the record low rates.  Washington is running a trillion-dollar deficit for the fourth year in a row yet they have experienced no problem borrowing at lower and lower rates.

You can and should be taking steps to prepare yourself for what is to come. To avoid taking action, putting on blinders and hoping against hope, is directly contrary to common sense. Now that you know this, it is time to act.

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The very short version of the facts is this: U.S. Federal Reserve Chairman Ben Bernanke has undertaken an unprecedented strategy since the credit collapse. It had a simple aim, to blunt the effect of the near-total collapse in confidence on our banking system and credit markets.

We are not here to second-guess Bernanke (which is pointless) or to criticize his decisions (what’s done is done). Arguably, the Fed achieved its goal. Unemployment rose in the recent recession but did not mushroom into a Great Depression-style jobs meltdown. The jobless rate has fallen, if inconsistently.

The Fed’s dual mandate remains, credibly or not, in full force. Bernanke and Co. claim to be equally concerned with inflation and the employment rate. Both have been fairly well controlled, almost to the point of hypnotizing us into believing that the economy is near a recovery. Every week, we wait for the latest bit of economic tape in hopes to prove the point: housing, inflation, jobs, and then back to housing again.

Stocks nearly fully recovered and the pundits on TV pound the table for more, claiming that equities remain undervalued. Sounds great, but where does that leave bonds, and specifically U.S. Treasuries? If stocks are undervalued, are bonds overvalued? If the economy weakens from here, is it possible that stocks are overvalued and bonds undervalued?

The answer is, quite possibly, both. And that means that a money manager who seeks to lower volatility with a typical 60/40 split of long-only stocks and bonds might very well be holding a lit match in a gas-filled mine shaft.

The reason is this: When a recovery finally takes hold, the Fed will have to backtrack on many billions of dollars in commitments to artificially low bond yields. Nobody knows how much private money will flow back into equities, leave stocks for rising bond yields, do both, or neither.

What we do know is this: bonds are priced higher because of the Fed, and stocks are priced higher because of the Fed. Take the Fed out of the picture, and what happens?

 

Stay tuned for our next piece, The Worthlessness of the U.S. Public Debt

 

Want to get more of Bill’s take? Just ask him!

 

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