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Bernanke’s Next Fed Created Treasury Bond Market Disaster

Stock-Markets / Financial Markets 2010 Dec 20, 2010 - 03:43 PM GMT

By: Michael_Swanson

Stock-Markets

Best Financial Markets Analysis ArticleLast week the major market averages traded in a narrow range, with the S&P 500 trading between 1246 and 1234, as they appear to be taking a small pause in the rally. I think there is a good change that they will breakthrough this range before the end of this week and start another move higher and if they don't do it this week they almost certainly will next week.

Everyone knows that the market moves up at the end of the year and everyone is bullish right now.


I worry though that after one more big move up that the market will make some sort of peak in the first few weeks of January and then start a sharp correction. If it happens things will play out much like they did at the end of the last year and beginning of this year. If you recall the market went sideways in the Fall of 2009 and then finally broke out at the end of the year only to pullback back sharply into February. But right at that top everyone was bullish in the sentiment surveys just like they are now.

What also is very similar is that if you recall way back in November of 2009 the fist cracks in sovereign debt problems hit the market when the nation of Dubai received a giant bailout. There was talk that the debt problems extended to Greece and other European nations, but those worries were totally ignored in the United States until they could no longer be denied.

Now Ireland just got a bailout and there is talk that Portugal and Spain will get smashed with debt problems within the first six months of 2011. Those worries are being totally ignored right now. So if when we do get a correction next year don't be surprised if it doesn't coincide with bad news from those countries hitting the market.

The most bullish of people say that the market is going up because the Federal Reserve is printing money and therefore nothing can make it fall again. CNBC's Steve Liesman has praised Ben Bernanke as being a "genius" for engaging in quantitative easing.

But quantitative easing IS NOT working and is actually now starting to cause some serious problems in the financial markets - which of course are being ignored at the moment.

In the past 15 years every time the Federal Reserve has lowered interest rates it has kept them low for too long and as a result created several man-made disasters. In the late 1990's they helped to create the Internet bubble when they lowered rates and kept them too long for too long in order to bailout the Long Term Capital Management hedge fund and then they printed money out of thin air to increase the money supply at the end of 1999 in order to ward of the phantom Y2k computer bug.

Then in the mid-1990's as a result of the fallout from that bubble they lowered rates and kept them too low for too long and created the man made real estate bubble.

Now as a result of the fallout from that bubble the Federal Reserve bailed out banks all over the world while the Federal government has brought us trillion dollar deficits. They have transferred the debts from international bankers on to the balance sheets of governments all over the world and so we now have the European debt crisis unfolding in front of our eyes and next year we will have bond problems in the United States - which are going to be a man-made disaster created by Bernanke's quantitative money printing scheme.

Back this past summer Bernanke argued that the economy was weakening and that quantitative easing would help the economy by lowering interest rates. He said that the Fed would simply buy US treasury bonds and that would make the value of those bonds go up and interest rates would fall as a result. All of this would provide a nice boost to real estate prices next year and help stimulate bank lending.

Well since Bernanke has printed money and bought these bonds interest rates have done the opposite - they have gone up and not down - as you can see from this chart below.

In fact the interest rate on the 5-year, 10-year, and 30-year bond has almost gone up a full percentage point. You may not remember, but Bernanke and his supporters (yes there are a few people inside the Federal Reserve telling him he was making another mistake) were saying in the summer that they were going to force interest rates down almost a full percentage point.

Bernanke DOES NOT have control over the bond market or the financial markets. The idea that he can just print money or change interest rate policy and make everything go in the direction he wants is a myth.

In fact many suspect that his own money printing policies are blowing up in his face and are making interest rates go in the opposite direction than he intended.

Some are claiming that Republicans are causing interest rates to go up. A reporter in this last Sunday's Wall Street Journal wrote, "as Fed officials prepare to assess the program next Tuesday, they confront the latest counterweight to their interest-rate plan: the tax agreement between congressional Republicans and the White House that would extend Bush-era cuts and reduce payroll taxes. This has sent bond yields higher, not lower, by leading investors to expect more growth and inflation and to fret more about budget deficits." Personally I'd rather see the tax cuts than not see them. They are only a very tiny part of the deficit story.

So some bond investors are now worried about even bigger government deficits so are starting to demand more interest for their bonds.

Others worry that inflation could rise due to Bernanke's money printing operation and are starting to demand higher interest for their money too. Indeed we saw commodity prices jump across the board in the Fall and Summer right after Bernanke announced his plans to go through with quantitative easing.

It is hard to discern the motives of millions of bond investors. Whatever the case it is clear that Bernanke's money printing is not forcing interest rates down as he thought it would, because it is causing more bond investors to LOSE CONFIDENCE than just blindly trust him and therefore they are demanding more interest for their money. It is that simple.

There has been one unspoken elephant in the room throughout the debate on quantitative easing. In the summer he argued he was going to buy the bonds to help the economy. In reality he HAD to buy the bonds. Foreign investors were pulling back from buying US Treasury bills. The US was going deeper into debt to the tune of trillion dollar deficits and China was not stepping up and buying all of this debt. So someone had to buy it and that person was the Fed.

As long as we continue to have winless wars in Iraq and Afghanistan and Obama style pork barrel bailout programs that results in trillion dollar deficits we will have some version of quantitative easing and deficit spending - and as we can see from the past few months this is going to result in worries over the deficit, worries over inflation, and higher interest rates. It will be Bernanke's bond buying disaster.

That means higher gold prices and higher commodity prices. Yes I worry about an across the board correction in the first quarter of next year, but if it comes it will be a buying opportunity for commodities and precious metals.

As for the rest of the market I'm not so sure. You see at some point higher interest rates are going to become a problem for the US economy. They will help put a lid on the major market averages.

For now though don't worry. It is the holiday season and the market always goes up into the end of the year.

Subscribe to my free weekly newsletter for more in depth analysis of the financial markets with a discussion of individual stock picks. To subscribe for free click here.

By Michael Swanson

WallStreetWindow.com

Mike Swanson is the founder and chief editor of WallStreetWindow. He began investing and trading in 1997 and achieved a return in excess of 800% from 1997 to 2001. In 2002 he won second place in the 2002 Robbins Trading Contest and ran a hedge fund from 2003 to 2006 that generated a return of over 78% for its investors during that time frame. In 2005 out of 3,621 hedge funds tracked by HedgeFund.Net only 35 other funds had a better return that year. Mike holds a Masters Degree in history from the University of Virginia and has a knowledge of the history and political economy of the United States and the world financial markets. Besides writing about financial matters he is also working on a history of the state of Virginia. To subscribe to his free stock market newsletter click here .

Copyright © 2010 Michael Swanson - All Rights Reserved.

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