The Bubble of All Bubbles

When the government intervenes into the financial system, it disrupts the supply-and-demand balance, but eventually, true market forces can win out. Months ago, a plan to use $300 billion to buy long-term bonds shocked the market like a cattle prod…sorry, I’m always a commodities guy.

Remember back in March when the Federal Open Market Committee made a surprise announcement that it would spend Treasury funds to support long-term government bonds?

This announcement rocked the world. The 30-year Treasury bond futures jumped almost 8 full basis points ($8,000 per contract), sending rates crashing lower with the yield on the widely followed 10-year note down to 2.5%, from over 3% in one day. As a direct result, the dollar was smacked down nearly 500 pips ($5,000 per contract), versus the euro currency.

This last-gasp financial plan to purchase and support the Treasury market was and is, at best, a short-term fix to prevent the bubble of all bubbles from bursting.

If we flash back to last fall, the stock market panic was driving some investors to guarantee a negative return on their money for the safety of the full faith and credit of the Federal Reserve.

That same money that ran to bonds in order to escape equities is in danger of unwinding and going on the move again – after all, money goes where it is treated best.

Don’t believe me? Just ask Warren Buffett.

In his 2008 letter to shareholders Warren Buffet described the situation this way, “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the US Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”

The Fed’s action follows similar tactics used by the Bank of England, which pledged up to 150 billion pounds toward buying its government bonds. This quantitative easing of buying debt with newly printed money expands the deficit and, most importantly, is the match lighting for inflation.

According to Edward Chancellor’s skeptical commentary in the Financial Times:

There is no question that a determined central bank can get rid of deflation. It is simply a question of printing enough money. Economists have another term to describe the monetization of government debt. The history of “seigniorage” goes back to the debasement of the coinage under the Roman emperors. Seigniorage is really a tax on holders of money and government debt which is paid via inflation. When carried to excess, it leads to hyperinflation.

This leads to the eventual sale of accumulated bondholding by the government and the impending pop of the bubble, leaving greater financial issues in the long run. Unnatural forces at work in the market can only serve to exacerbate the problem.

As witnessed by the market action in May, restless investors are searching for higher returns on their money than the pittance they chose to accept last fall for safety.

At that time, the dollar and Treasuries sold down to lows not previously seen in the last six months. More selling is in the cards as an appetitive need for risk increases with general global market confidence.

Human nature will lead some to move money out of safety and chase higher returns in the fear of missing out on a stock market turnaround. Emotion can be a great detrimental force and can disrupt a sound disciplined investment plan. Don’t miss this flow of funds! How? By positioning yourselves in hard assets.

The unprecedented movement of funds into Treasuries was and is a concern – but it’s also a huge opportunity when that money comes back into the market. The numbers will be staggering. The gold market moved over 40% with just the spillover money seeking safety in the financial chaos.

When even a small portion of that moves into hard assets, the commodities bulls will be on the stampede again…for oil, gold, soybeans, silver, wheat, coffee, and more.

People will continue to drive, heat, eat, produce goods and services, and put the “consume” in “consumer.” Conspicuous consumption may be out, but pent-up demand for goods we need has only been delayed, occasionally to extreme consequences. Consider this example from the Associated Press:

Store Owner Gives Would-be Robber Bread and $40

SHIRLEY, N.Y. (AP) – A Long Island convenience store owner who was confronted by a bat-wielding would-be robber has shown mercy on the man by giving him a loaf of bread and $40. Convenience store owner Mohammad Sohail pulled a rifle to defend himself against the would-be thief, who then dropped to his knees and begged for forgiveness.

The man explained that he was battling economic hardship and was just trying to feed his family. Sohail put down the rifle and gave the man $40 and a loaf of bread.

Another sign of economic transition was the jump in short-term rates a week ago, pricing in a quarter-point rate hike down the road. In Agora Financial’s Resource Trader Alert we’ve been concentrating on the bond sell-off described above, and have been doing quite well with the Treasury unwinding. However, the market is now acknowledging that rising rates are also something worth watching closely.

Keep an eye on movements in the dollar. The dollar index weakness down to the December lows at 78 was not calmed by a rise in long-term yields. The inevitability of the Fed eventually raising rates to address inflation fears strengthened the greenback back above 81.

Stocks continued to extend their upward run 11 out of the last 13 weeks. The major indices have been in the positive for 2009. Some consolidation and profit taking will likely take place after these new relative highs.

This next step forward will include some global demand rebound as life continues on for the billions around the world who are not money managers, bankers, or insurance executives mired by overleveraged portfolios and bad bets.

Commodities and things of real value should do very well. This new upward phase in the asset market is taking place after a bottoming from the recent and unnatural price depression of vital resources that are consumed every day.

It all comes back to commodities.


Alan Knuckman
for The Daily Reckoning

The Daily Reckoning