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Monetary stimulus at full speed

The world financial system is increasingly stable since the crisis of 2008. However, we know that the actions taken by major central banks are far from being considered as lasting and complete. By contrast, the illusion of having arrived at a situation with minor systemic risks is one of the worst threats to the global financial situation.

Back then, it all started with cheap money from cheap credit, and the uncontrolled increase in house prices. This was only possible because the mild 2001 recession frightened everyone, even the Federal Reserve, which lowered the federal funds rate 11 times to reach 1.75% in December 2001. At that time, the economic outlook was already showing signs of being a party where everyone could join. Even so, the Federal Reserve appeared once more in June 2003 and lowered interest rates to 1%, then the lowest rate in 45 years. Once released into the race, the banks only increased business, and the sale of subprime loans seemed the best deal ever.

Multiple signs of danger and dubious quality of assets had not frightened investors. By May 2007, financial firms and hedge funds owned more than $1 trillion in securities backed by these subprime mortgages.

An estimated $3.2 trillion in loans had been made to homeowners with bad credit and undocumented incomes between 2002 and 2007. These mortgages could be bundled into Mortgage-Backed Securities (MBS) and Collateralized Debt Obligations (CDO) that received high ratings and, therefore, could be sold to global investors.

Since 2007, the Federal Reserve has been implementing an easy money policy. In fact, the Fed has set the interest rate on Fed Funds at 0% and has been injecting all the possible money in the economy through massive purchases of long-term Treasuries (NYSEARCA:TLT) and MBS. All this is thought to overcome the crisis of 2008 and keep it away forever.

The overnight interest rate cannot go higher until 2015 (at least that is what the Fed decided), and the hard work is now focused on lowering more and more long-term yields. Therefore, the Fed wants to improve the unemployment rate, and inflation is not allowed to exceed 2%. On top of that, with so much liquidity the stock market has been rising and looks strong, especially for those who want to believe it.

Long-term Treasuries

But, let's analyze what has been done from 2008 to date.

Throughout these years, monetary policy has been developed through several programs that have achieved their goals. Now, the same policy of monetary expansion aims to grow the U.S. economy.

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We may see in the table above that the Fed owns about 14% of the U.S. Debt held by the public. This position is growing fast on its way to $2 trillion. Though it is not the direct subject of this article, U.S. Debt is becoming an increasingly complex problem. In fact, Debt-to-GDP ratio has surpassed 110%. For now, it is important to notice the relevance of the Fed position as debt holder.

Operation Twist was a key program of quantitative easing that occurred whenever the Federal Reserve used the proceeds of its sales from short-term Treasury bills to buy long-term Treasury notes.

The direct purpose was to lower long-term Treasury yields, and, therefore, interest rates. It was only possible with massive buying of Treasuries by the Fed, which saw prices rise with this type of operation. In fact, higher demand leads to higher bond prices, which means lower yields. The Fed used Operation Twist to make loans more affordable, encouraging people to take out loans for houses, cars, furniture, machinery, travel, etc.

Operation Twist had begun in September 2011 with a $400 billion program, and ended in December 2012 when QE4 was announced. The twist showed that Mr. Bernanke was shifting the Fed focus from repairing the damage from the subprime mortgage crisis to supporting lending in general. The Fed also announced it would keep the Fed funds rate at zero until 2015. That is an extraordinary decision because, in fact, the interest rate on Fed Funds is a reflection of market conditions and market rates. In any case, the aim is flawed: it gives a signal to boost consumption, but blindly, without paying much attention to risk analysis. Undoubtedly, it again reminds of the origin of the crisis of 2007.

In the end, what the Fed intended was to move investors away from ultra-safe Treasuries into loans with more risk and return. By intentionally lowering yields, the Fed was forcing other investors to consider investments that would help the economy more without adequate risk assessment. This is obviously a highly arguable goal that will eventually lead to problems similar to those of pre-2007.

Optimists cheered as a great achievement when the yield on the 10-year Treasury fell to 200-year lows! Still, the economy was not growing, and unemployment remained high. It could not be otherwise since Quantitative Easing will not do much to reduce unemployment because liquidity is not the problem. In other words, there is little monetary expansionary policy can do to spur the real economy.

Is it a real Bubble?

In my opinion, there is no doubt that the most problematic bubble is still being formed and can be a real danger of enormous magnitude. I am referring here to the Treasury Bond Bubble. Let's take a look at this amazing chart of the 30-Year U.S. Treasury Bond Price.

Charts courtesy of StockCharts.com

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It looks just like a bubble, doesn't it? Since 1982, we can see a Bull Market of enormous proportions that has been gaining momentum over the past two years. Because Treasuries have risen continuously, yields in contrast have registered a huge decline over the years. There is no doubt that Treasuries are overpriced and that these levels are not sustainable for long. There is a rule in the markets: buy low, sell high. As much as Mr. Bernanke tries to prolong the inevitable, this bubble will burst.

The Fed's visible hand

To provide greater liquidity to the economy, the Federal Reserve buys Treasuries on the secondary market. If the Fed already has the interest rate at zero percent, the objective is to control the yield curve by buying longer-term Treasuries to lower their yield. At the same time, the Fed buys mortgage backed securities to inject more money in the system.

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There is an obvious problem here. The continuous increase of money in circulation implies a change in the behavior of market players in the wrong way. In general, there is now higher propensity to consumption which, most likely, will go beyond the available income. Moreover, there is a lower risk aversion. These are two situations that make the real economy unhealthy, and, in the medium term, probably out of control. Again, there is here the tendency to return to the behavior that led to the crisis of 2007.

The Federal reserve monetary policy aims to maintain record low yields and encourage all kinds of companies issuing bonds. In fact, bond investors will have less and less risk aversion and will buy bonds with increasingly unfavorable ratings since that may give them some spread. The benefit is all on the side of the issuers at the expense of investors. The economy itself is drawn into an ever more dangerous and unhealthy situation. It's a vicious cycle that works against the true interests of the U.S. economy.

In practice, the spread is the additional yield issuers have to pay to attract investors. As interest rates have been kept at an artificially low level, ever smaller spreads continue to attract investors for bond issues with lower quality. Leverage junk (high yield) issuance is close to the former record levels.

As the rate of inflation is a very real threat, it is a certainty that its rise would cause rates to rise, and bond prices to plummet.

If inflation rises on a slow pace it will eventually trigger the bursting of this bubble. I think it will come from an awareness of market conditions that will increase yields step by step in an inexorable way. Probably, we are witnessing this change in the market and the trend reversal is already a fact. I present below the 30-Year T-Bond Yield chart of the last three years. It is clear a significant increase in yields in the last four months caused by pressure on sales of 30-Y Treasuries.

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It will be a struggle between the Fed's wishful thinking and the harsh reality of business and markets.

Conclusion

There is currently a large scale bubble in Treasuries. Its former safe haven capability has developed into a risky asset category. Long-term Treasuries present an unbelievable high risk given that the yield is extremely low. Put another way, these Treasuries have a negligible upside potential and a huge downside potential. There is a significant likelihood that those assets may suffer a sudden drop, which would precipitate the burst of the bubble. This could bring severe damage to their holders.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: The Treasury Bond Bubble Means The Loss Of A Safe Haven