The Mother of All Bubbles?

Last Updated on November 24, 2020 by Oddmund Groette

 

Freeimages.co.uk

In January 2009 I wrote an article about the low yield on long-term government bonds.

Most of the OECD countries have a yield lower than 1%. That means the real rate is minus (adjusted for inflation)! Most countries have inflation that is higher than 2%. In Switzerland, the expected yield from 1 year to 5 years is negative. Even Denmark has a negative yield. In other words, investors buy Swizz and Danish government bonds and expect to lose money! Why? Simply because it’s regarded as a safe haven and investors are happy just to “protect” their money. They are extremely pessimistic. They are even more negative to other asset classes like stocks, commodities, and real estate.

It’s the same in US government bonds. With the current inflation rate, one is expected to lose close to 0.75% within the next 10 years.

And look at Japan. The government is running at a constant deficit financed by the private for years. How long can this continue?

Surely all this must be a bubble? I think so. It just takes a long time for it to burst. But it will, sooner or later. The central banks are building bubbles after bubbles! Let me explain, using the FED and the US as an example:

I’m no fan of the central banking system of printing money out of thin air. As far as I can see Bernanke and other central bankers are now on their way to creating the mother of all bubbles: the government bonds. Here is a summary of what the FED has done over the last 20 years. It’s not pretty:

In 1990-92, in response to a recession, the Fed slashed rates. As far as I can see this created a bubble in the bond market by encouraging leverage. In 1994 this “bubble” burst. In 1995, in response to a financial crisis in Mexico, the Fed bailed out a bunch of investors. This created more moral hazard and helped contribute to a bubble and the subsequent meltdown in emerging markets, and later the LTCM disaster in 1998. The Fed slashed rates again, and this might have caused tech stocks to go into an even bigger bubble, exacerbated by further injections of liquidity in anticipation of the Y2K “problem” (it turned out to be a non-problem). This caused the greatest stock bubble in US market history (?). Now, 12 years later, Nasdaq is still more than 40% lower. Later this was exacerbated by the terror in 2001. When World Trade Center crashed, Greenspan slashed rates to 1% and kept them there for over 2 years after the “recession” ended. This caused the biggest real estate bubble in the US since WWII, which in turn caused the financial crisis in 2008 and the bankruptcy of Lehman Brothers. Due to low interest rates the financial industry grew out of proportion compared to the “real” economy.

The falling interest rates since the beginning of the 90s have created too much leverage and too little saving. Greenspan’s policies caused huge leveraged investments in artificially strong assets, particularly real estate, bonds and equities since low interest rates prevent savings and encourage leveraging capital (as credit is cheap). This caused America to issue massive debt, but they used this to finance further consumption rather than production, increased productivity, or industry. This led to the formation of a debt bubble, as the United States entered a cycle of consuming foreign exports, issuing debt to its trade partners, and using the debt to consume more of their exports. A vicious circle.

As far as I can see, the central bank is the main culprit behind all these bubbles. Of course, there are a lot of factors, but the Fed artificially and needlessly causes bubble after bubble by printing money (and creating moral hazard), which causes bust after bust, which in turn responds to more bubble inflating. The bad investors need to lose money, not to be handed aid.

Now the Fed has taken rates to 0-0.25%, and purchasing long-dated Treasuries. This will create a huge bubble in the bond market, perhaps the mother of all bubbles.

The US yield curve as of 6th of july 2012
The US yield curve as of 6th of july 2012. Source: Bloomberg

As we have seen with prior bubbles, their creation leads to huge market distortion and misallocation of capital for years, followed by an incredibly destructive (eventual) crash. There is no reason to think this pattern will be any different. Treasuries will go to absurdly low yields (10 years treasuries is at 1.6% at this date), become hideously overvalued, suck in lots of savings and investment capital – and later crash.

At sufficiently low yields, the risk of capital loss on Treasuries becomes enormous. 30-year bonds can easily fall 40-50% in a year. Imagine what a 30-40% hit to bond prices would do to the average retirement portfolio or pension plan. It would be absolute carnage. Worst of all, it would hit the most risk-averse savers, since government bonds are traditionally viewed as a safe investment. However, as we all know, a sufficiently excessive price can turn any investment into an extremely risky one.

(On a side note: As far as I know, bonds have been a solid underperformer compared to stocks looking back over decades. Why would someone even consider saving in bonds for the very long term?)

The Fed is following its typical behavior of wreaking utter havoc in the markets and the economy. By trying to fight the last bubble (which is partly created) it is inflating the next. A bubble in the bond market could be even more devastating, once it finally hits, than the real estate bubble. Remember the last serious bond bear market in the late 60s and 1970s – that was a lost decade of inflation, recession, and total annihilation of savings. Many widows and pensioners were put into penury as their retirement funds collapsed due to soaring yields and inflation. A whole generation was effectively wiped out financially. The Fed continually says they will do whatever to avoid a recession – another form of saying printing enough money to inflate the whole problem. Bernanke studied the depression in the 30s and concluded it was due to contraction in the money supply. Now he is printing all he can to make sure the money supply does not contract. If things stabilize further down the road, think about the carnage if yields then have to increase.

This latest bubble, and its consequences, are going to cause the greatest financial crime of the 21st century in the western world. Later generations are going to get pounded, and the younger generation is going to end up footing the bill with increased welfare payments. Savings will drop significantly. All of this because the Fed created 5 bubbles in 15 years and no one did a  thing to stop them from creating the 6th (the bond market). Bernanke will go down as the worst Fed chairman since the Great Depression. He will fight the last war, doing way too much to stimulate the economy, and his legacy will be a bubble and bust in the bond market.