Troubled Bubble for the Fed?

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 nice rally. To the most observers, the spike may be difficult to understand. After all, why would the value of Treasury bonds rise while their underlying credit quality is deteriorating? The move is actually a perfect illustration of the tried and true 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 would be positioned to unload their holdings when the buying spree begins. If the Fed pays higher prices in the future, traders can earn 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 not unlike 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.

This is precisely what will happen with Treasuries. As the U.S. government issues mountains of new debt to finance the trillions in annual deficits planned by the Obama Administration, speculative holders of existing debt will be offering their bonds for sale. In order to prevent a collapse in the bond prices the Fed will have to significantly increase its buying.

The only way the Fed can buy bonds is by printing money, the more they buy the more inflation they will create. As inflation diminishes the investment value of Treasuries, this scenario will could result in a downward spiral. 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.

To “save” the economy from these high rates the Fed will then have to expand its purchases to include all forms of debt. When 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 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, long-term Treasury yields would have to rise well into the double digits to clear the market.

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. How much worse would our 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 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 huge 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.