Bubble, Bubble, Toil & Trouble: The Fed found it easy to build a bond bubble, but finding it more difficult to unwind

Posted on July 11, 2013 by

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There is little doubt the Fed’s easy money policy, and especially the deliberate QE of buying long term instruments, has resulted in speculative flows investing in those assets.  As we related last week, the Fed’s discussion of tapering has resulted in immense turmoil, as speculators are wondering if capital needs to be redeployed away from U.S. government-favored assets.  Long bond yields, while still historically low, rose dramatically over the last several weeks.  The 10 year Treasure is now yielding ~2.6%, an incredible rise from the 1.6% yield earlier this spring!  The pain in multiple markets (bond & emerging markets) has caused the Fed to somewhat about face; yesterday Mr. Bernanke clarified that we’re still on the easy money path, with the markets (especially gold) responding favorably.  Yet, creating a bubble is easy–we all know at some point it will unwind, and when it does, the last several weeks have shown there may be dramatic changes to markets (whether precious metals getting clobbered a few months ago, or bonds getting crushed over the last several weeks).  And ultimately the leverage will turn the other way, and spread across all markets.  We may be about to see why we don’t want the Fed to have discretion to create bubbles.  The Federal Reserve’s easy money policy has lowered the price of risk, so we should not be surprised to know we get more of it (yes, the Law of Demand in effect).  At some point, the liquidity will stop–and the sooner the better–and the assets most favored by the policy will likely be hurt the most.  Get your umbrella out…

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