The Fed and Bonds

Harry Dent has extensively researched cycles in stocks, real estate, business, politics and even sunspots! He mentioned that cycles that drive debt higher, like the one we’re in now, tend to overinflate all financial assets. These types of bubbles are more likely to pop simultaneously.

Like the real estate bubble Harry predicted 20 years ago that has since burst, we seem to exist in a “bubble economy.” The most recent real estate bubble burst in 2006 is now reinflating. The commodity bubble is in the process of popping with oil prices down more than 50% in a few short months. And the stock market is in a bubble that is seemingly “unpoppable.”

I’ve been keeping my eye on another bubble that seems to be getting out of control… interest rates. More specifically, U.S. Treasury bond prices. We don’t usually think of dropping interest rates as a bubble but when rates drop, prices go up and do so because investors see too much risk elsewhere or a future economic outlook that is bleak.

There are many factors that influence the price of bonds — one being policy decisions by the Federal Reserve Bank (the Fed). The fact that the Fed only sets the interest rate policy in the Federal Funds Rate or the Interbank borrowing rate, affects rates all the way out the yield curve (short- to long-term).

In a healthy, growing economy, yields go up the further out over time. When the yield curve gets flat, the interest rates paid to long-term investors (30-year bond) is not much more than is paid to short-term investors (2-year note).

The long-term investor assume more risk the longer the duration of investment. Why would anyone risk more for less? A couple weeks ago I wrote about U.S. bond yields compared to others around the world and our rates are competitive, to say the least!

U.S. bonds are regarded as the safest so the demand remains high.

Why do I believe there is a bond bubble? The yield on the 30-year bond is down 35% in the last year while prices are up more than 25% on actual bonds. The Dow is up just under 12% in that time and the S&P 500 is up about 14%.

I’m not going to speculate as to what could be the trigger that causes the bond bubble to pop but the Fed has done much to create the bond bubble (among others) and the Fed could ultimately crash the market. The primary reasons behind the current false sense of stability have been keeping rates artificially low and feeding the markets liquidity with quantitative easing (QE).

The Fed’s credibility in adhering to its congressional mandates could fuel the fire. They are mandated to “promote maximum employment, production and price stability” and seem to have done a wonderful job of stabilizing and increasing stock prices.

On the other hand, they’ve done little to maximize employment wage growth. Consumer prices have increased unevenly as a result of the Fed tinkering over the last six years but wage growth has not followed.

The Fed has indicated their intentions to start raising interest rates sometime after the April FOMC meeting but investors don’t believe it and are still buying U.S. Treasurys. Many market observers (including Harry Dent) believe it’s more likely the Fed will re-engage in QE rather than raising rates.

Either way, I believe the Fed is backed into a cornrner and either move could be disastrous. If the markets believe the Fed has completely lost credibility, look out!

Lance Gaitan






Lance Gaitan

Lance has a unique ability to find big gains in the most boring of market. He manages to turn sleeping giants into a monster gain-makers – some of the most profitable investment opportunities of a lifetime.