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A Better Question: Will the Fed Pop a Bubble It Wants?


It's going to end badly.

Will the Federal Reserve see the next bubble?

That question was asked rhetorically by The New York Times this week, as the editorial staff asked out loud what many people were already wondering.

Judging by the current state of our credit markets, I doubt it will, especially when it's a bubble they themselves desire.

As I wrote earlier last year, what we've seen in the fixed-income market over the past year represents nothing short of a forced march into risk led by the Federal Reserve.

It's Central Banker 101. Take short-term rates to zero, announce quantitative easing, and you push retail depositors into either credit or duration risk and invite institutional investors to "carry" anything they can find -- borrowing on a short-term basis to purchase longer maturity, higher yielding, or just plain riskier assets.

For the banking industry, this "manufactured" steep yield curve generates enormous capital without shareholder dilution.

But unless improvements in the credit market and the banking industry lead to a sustainable turnaround in the economy, the Federal Reserve's actions will lead to nothing more than a bubble -- as market prices continue to diverge from realizable future values.

Looking at the current state of the fixed income market and the economy, it sure feels like a bubble to me, especially when I hear that bond mutual fund managers are "overwhelmed" by incoming cash.

But to me it's very interesting that yesterday the Bank of International Settlements called an urgent meeting of the leaders of the world's major banks to talk about "risk taking" in the banking industry.

Could the BIS have the same concerns that I have?

I think so.

But put yourself in the shoes of the Federal Reserve.

With unemployment in double digits and a weak recovery, the Fed can't raise rates. At the same time, not raising rates just invites more people to join the forced march into risk.

Now I'm sure that the BIS is hoping that it can talk the banks into dropping out of the forced march, but with credit losses on bank loan portfolios at historical highs, I think the BIS is going to face a real push back.

The banks need earnings.

And honestly, even if the banks were to drop out, I suspect that others will gladly take their place in line.

All of which leads me to conclude that this bubble, like every other bubble I've studied, will end badly as prices move too far.

But I'm afraid that for the Federal Reserve the consequences will be profound.

As I offered earlier this week on the Buzz, contrary to what Federal Governor Kevin Warsh says, liquidity isn't confidence, it's false bravado.

And I suspect that in the not-too-distant future we'll see that distinction in real time.

But, unfortunately, all those people who got out of the equity market at just the wrong time last spring will find that bonds aren't any safer a place to invest.

Deflation does not discriminate.
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