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Thursday, August 12, 2010

MOAB - Mother Of All Bubbles

It appears that there is an unforeseen disaster emerging right under everyone’s nose. This disaster is the next bubble that will pop and devastate millions. The bubble in question is US Government debt. For the past 28 years or so interest rates have traveled mainly in one direction, down. This downward trend in interest rates has been a boon to many. As most of you know, when interest rates fall the value of higher interest rate debt increases. The amount of increase is inversely proportional to the drop in rates. So for over a couple of decades one could have invested in bonds and done very well collecting interest and even making capital gains.

Due to the worsening economy and multiple economic shocks money has run for perceived safety and that means US Dollars and US Government debt. The safety trend is alive and well particularly after the news from last couple of days. Since the 2008 meltdown the general public has shifted funds from equities and equity funds to bond funds at a frenetic pace. The hedge funds of course are not to be left out of any trade and recent reports indicate that as much as 1.8 Trillion dollars in assets have been plowed in to the bond market. It is true that the bond market is huge and very liquid, however, policy decisions and external shocks can have large effects on bond prices.

I look at the current situation in the bond market and see rates at historical lows, a FED that wants to keep them there (at least most of them do) and John Q rushing head long in to the market thinking it is a no lose proposition. For me this sends off warning signals that the bond market as large as it is has become yet another crowded trade, dare I say a bubble of monumental proportions. While the game could be played longer to keep rates down or even push them further down it does appear that the end is neigh. John Maynard Keynes has been famously quoted saying ,“markets can stay irrational far longer than you can stay liquid”. One could argue that the bond market has been irrational for quite a while already given the horrible and worsening US fiscal condition and the Dollar, investors should be receiving much higher rates but instead rates are kept near zero. The FED and other factors have caused interest rates to be pushed lower and lower, just like a compressed spring only a catalyst is needed to cause them to bounce significantly.

As I write this article there are many cross currents that could cause a break in the bond market. Fed President Bullard’s notion of raising rates that he espoused the other day could have unintended consequences if it were used. A round of Quantative easing where the FED begins monetizing the debt in a meaningful way is a sure indication that trouble is around the corner.

A break in the dollar to the downside would be problematic, as well as, the general perception that things are coming apart. I can’t tell you exactly when this will happen or what factor or combination of factors will cause the bond market to unravel, but the odds are very high that it will. The FEDs practice of MOPE or management of perceived expectations has worked very well up to now, but houses built on sand foundations rarely hold up long. Once the government bond bubble bursts, a crowded trade will become a stampede.

Stay out of the way of the stampede there are better places to put your hard earned money. If you are already in the stampede zone you might consider moving to safer ground before the general population does. The millions of players in this market can get spooked on a moment’s notice and small stream of everyday redemptions will swell to that of white water rapids or in a worst case Niagara Falls.

Disclosure: Short US Treasuries - This is not a recommendation to buy or sell only my opinion. Do your own due diligence and consult with a financial advisor before performing any transactions

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Dudley Do Right To The Rescue! Yet another MOPE installment. – Random Thoughts | Moneta Advisors, LLC. said...

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