A Forex View From Afar

The Bubble Years And The Bubble Economy

Mr. Bernanke suggested in the last period, that the Fed might start buying longer-term debt. Tomorrow, the Fed may discuss this option, and possibly implement it. This means the Fed will further enlarge its role in the market, something that may not be a good thing.

In normal markets, the Fed acts in the short-term debt market with a maturity up to a year (also called Treasury bills). This happens because the Fed needs to be in control of the overnight lending rate, or the rate at which the primary banks trade funds. By buying and selling T-bills, the Fed has control of the rate most of the time, controlling the whole economy and the business cycle throughout.

However, in these unusual days, the Fed has reached the limits of conventional monetary policy. The short-term interest rates are as low as they can get, leaving the Fed with no room to move. In this environment, the Fed is expected to start buying longer-term debt, up to 10-years.

The immediate implications of this move will be that the yields on the longer-term bonds will move lower, as the price is driven up. This should steadily promote markets taking more risk, as the yields drop considerably. The search for revenue/profit will overtake most of the fear in the market, but this will happen slowly. In addition, some say the Treasuries already show bubble-like behavior.

As the economy recovers, the Fed will eventually have to lift rates again. If treasuries are really on a bubble, as some suggest, a possible rate hike from the Fed would be catastrophic for the economy, sending the yields higher in a snowball effect, obstructing the financial system once again. If the Fed will really go into the market and buy longer-term bonds, then it should develop an astonishing exit strategy from the ultra-low rates, to avoid another bubble.

One should think that the world economy has reached its current condition by facing two strong bubbles in just a few years. First, it was the tech-bubble and then it was the housing bubble. Now, we could be heading towards a Treasury-bubble.

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