"The recent surge in the market for US government bonds has several characteristics of a classic bubble."

I mentioned recently that it was pretty funny how we're reading quite a bit about stopping bubbles, while a Treasury Bubble might be right in front of people's eyes and they're missing it. Via Alia, from the FT:

"Another bubble is brewing – bonds

By Edward Chancellor

Published: January 4 2009 18:27 | Last updated: January 4 2009 18:27

Central bankers around the world have promised to pay more attention to the dangers posed by asset price bubbles. Yet they seem unable to refrain from inflating new ones. The recent surge in the market for US government bonds has several characteristics of a classic bubble.( I AGREE )

A bubble is defined by extreme overvaluation. Ten-year Treasuries with yields at half-century lows meet this description. The current yield of little more than 2 per cent provides no protection against the return of inflation any time over the next decade. In normal times, there would be no argument that Treasuries are overpriced( I AGREE ). These are not normal times, however.

Another essential attribute of a bubble is that it should be sold with a great story. A decade ago, overblown expectations for internet commerce fuelled the technology boom.

Today’s great hype is deflation( I AGREE ). Tales of global recession and collapsing financial markets are embroidered with lurid narratives from the 1930s and Japan in the 1990s. This bubble is motivated by fear( YES. THE FLIGHT TO SAFETY. ) rather than greed. Investors are seeking to protect themselves against deflation and declining stock markets by blindly acquiring “risk-free”( GOVERNMENT GUARANTEED ) government bonds.

The behaviour of institutional investors also contributes to the bond bubble. Pension funds, insurers and others have sold off toxic securitised triple-A rated bonds and replaced them with Treasuries. Government bonds are also attractive for diversification purposes since they have held up while just about everything else in their investment portfolios has collapsed. Many of the more sophisticated bond bulls are playing a “greater fool” game. Like dotcom speculators of the late 1990s, they know there is a danger the market will sell off at some time in the future. Nevertheless, they are staying for the ride and hope to bail out before it is too late( THIS EXPLAINS WHY BUBBLES LAST SO LONG ).

A common feature of great bubbles is that they enjoy the support of the authorities. In 1720, the public acquired shares in the South Sea Company secure in the knowledge that the bubble was promoted by the government of the day.

Today’s bond buyers place their faith in Ben Bernanke. The Fed chairman has long made it clear he sees low long-term rates as a tool for combating deflation. In December, the Fed announced it was considering purchasing government bonds. Just as the “Greenspan put” emboldened stock speculators a decade ago, the “Bernanke put” has placed an apparent floor under the market for Treasuries.( TRUE )

The deflation story that drives the current bond bubble is more plausible than the dotcom pipe-dreams of yesteryear. Deflation is sparked by a combination of bank losses and tighter lending standards, increasing risk aversion( THE MAIN CAUSE ) and a rise in the demand for money, falling household consumption and higher savings, together with mounting unemployment and a widening output gap. All these conditions pertain today. If this crisis were left to its own devices, the result would likely be a pronounced and prolonged decline in the price level as occurred in the early 1930s.( I AGREE )

However, the authorities are not standing by idly. Instead, the Fed is bolstering the credit markets in numerous ways and has cut short-term rates to near zero. Some $7,200bn (£4,930bn, €5,150bn) has been pledged to support the US financial system, of which $2,600bn has already been spent. Although bank lending is currently stagnant, the monetary base climbed by 775 per cent in the year to November.

Broader monetary aggregates are also expanding. The St Louis Fed’s MZM measure climbed 11.2 per cent over the past year. Nor is there evidence of widespread deflation in the economy. Although, the consumer price index has started to fall, only transportation has showed a pronounced decline( TRUE ). There is also the fiscal response to consider. Morgan Stanley projects that in 2009 the gross US fiscal deficit, including asset purchases from the private sector, will exceed 10 per cent of GDP.

Mr Bernanke gained his moniker “Helicopter Ben” after his famous November 2002 speech in which he outlined the various ways by which the authorities could combat deflation. “The US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices of those goods and services,” stated the former Princeton economist and future Fed chairman.( I WISH HE'D MOVE FASTER )

“We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” Investors who purchase long-dated Treasuries at current prices are betting that a determined man with the dollar printing press will fail in his battle against deflation.( IT'S A BAD BET )

Edward Chancellor is a member of GMO’s asset allocation team"

Economists say a short period of deflation would be beneficial to the economy since it would raise people's purchasing power and confidence

From the Guardian:

"Explainer: Why is stuff getting so cheap?

• Ashley Seager
• The Guardian, Saturday 3 January 2009
• Article history

News that pubs around the country are offering lunch for £1, shops are slashing prices and Wetherspoon's are offering a pint for less than a pound may look like good news for consumers but it is causing a headache of another sort for policymakers: deflation

Britons have been used to the price of some items such as flat-screen televisions and clothes falling for years, as cheap imports flood in from China. But usually other products were increasing in price. In the past year, food and petrol were rising and this has kept overall inflation at around 2% or 3%. Now, however, the price of just about everything seems to be coming down.

This has pulled inflation on the consumer prices measure down sharply from September's peak of 5.2% and the retail price index (RPI), which includes falling house prices and interest rates, down to just 3%. In his recent letter to the chancellor, Mervyn King, the Bank of England's governor, said it was possible the RPI would fall into negative territory, or deflation, this year. Economists say a short period of deflation would be beneficial to the economy( I AGREE ) since it would raise people's purchasing power( THIS IS MY BUYING POWER ) and confidence( A DIMINUTION IN THE FEAR AND AVERSION TO RISK ). But if deflation persists, people hold off buying things, leading to falls in demand and output( TRUE. WAITING FOR BETTER DEALS. ). Then firms, selling less, cut what they pay staff. They have less to spend and the deflationary spiral kicks off( YES ). The spiral is exacerbated as debt deflation kicks in. If inflation is negative, the real value of debt rises, increasing the pain for mortgage holders and reducing further their willingness to spend, since they face a higher debt burden( TRUE ). Since 1945, deflation has been considered yesterday's problem( LET'S HOPE IT IS ). The last time the published inflation rate went negative in the UK was 1947."

This post agrees with me that a short period of falling prices increases Buying Power and helps in the Diminution of the Fear and Aversion to Risk.

"After one bubble bursts, the only way to get out of the resulting recession, and to avoid a depression, is to create another bubble."

Peter Coy on Business Week with a post I like:

"This is war. On Dec. 16, the Federal Reserve announced it was stepping up what amounts to a shock-and-awe campaign against the most dangerous economic downturn in decades. In an unprecedented move, the Fed cut its short-term interest rate target to essentially zero while committing to buy mortgage bonds and other assets on a massive scale. The goal: to provide cheaper credit to every part of the economy, starting with housing.

Fed Chairman Ben Bernanke initially underestimated the fast-moving crisis( TRUE ), but now he's deadly serious( TRUE ). As a student of the Great Depression, Bernanke does not want to go down in history as the Fed chairman who allowed the U.S.—and possibly the world—to slip into the worst slump since the 1930s( CORRECT ).

Will the new battle plan work? Most likely yes—eventually ( I AGREE ). The Fed's monetary weaponry, in combination with the fiscal artillery of the incoming Obama Administration, are so potent that if they are used to their full extent they can almost certainly generate an economic recovery, potentially starting in the second half of 2009 ( I AGREE ). The problem is that today's all-out attack on recession may well generate a surge of unwanted inflation in 2010 or after( A VERY REAL POSSIBILITY ). But the Fed seems to regard that as an acceptable price to pay to avoid disaster now ( IT IS ).

True, the Fed has finally reached the end of the line on cutting rates—they can't go below zero. But it remains essentially unlimited in how much it can stimulate the housing market and broader economy by buying up mortgage-backed securities, Fannie Mae (FMN) and Freddie Mac (FRE) corporate debt, and other assets ( TRUE ). The Fed's early efforts are already showing some success( TRUE ). Since it said in late November that it would buy such securities, 30-year mortgage rates have fallen to 5.2% from 6%, and refinance applications have more than tripled. The Dec. 16 announcement will greatly( MODESTLY ) expand these purchases.

What's more, starting in early 2009, the Fed will pump money into markets for student, auto, credit-card, and small-business loans in hopes of helping those parts of the economy. All told, the Fed's assets—a measure of how much the Fed has lent, directly and indirectly—could go as high as $5 trillion, says Ed Yardeni of Yardeni Research. That's up from $2.2 trillion now. And the range of assets the Fed is permitted to acquire in an emergency is almost unlimited( VERY TRUE ). "It could buy a herd of cattle in Texas if it so desired," says Paul Ashworth, senior economist in the Toronto office of consultant Capital Economics.

These moves are so sweeping that they almost overshadow what would ordinarily be the biggest news of all: the Fed's Dec. 16 cut in its target federal funds rate to a range from zero up to 0.25%, the lowest in its history. The funds rate is what banks charge each other for loans to meet reserve requirements. In fact, the Fed's target had become irrelevant in recent weeks because what banks actually charge each other for those loans had already fallen to almost zero ( TRUE ). That's because of the huge surplus of reserves that the Fed has injected into the financial system( TRUE ).

Critics of the Fed say the central bank is running unacceptable( ACCEPTABLE ) risks of losses by itself and ultimately by taxpayers while propping up an unsustainable reliance on debt. "It's 100% wrong. It's going to make the situation worse," says Peter Schiff of Euro Pacific Capital, a brokerage in Darien, Conn. "In the short run, it does postpone some of the pain, but the economy is going to be in worse shape a year from now. Eventually we will have hyperinflation, where the dollar loses almost all its value( THAT'S THE FEAR )."

That, however, is a minority view. Most economists think that inflation is the last thing the Fed needs to worry about right now( THEY SHOULD WORRY ABOUT IT ). According to New York University economist Mark L. Gertler, who collaborated with Bernanke on research during the Fed chief's Princeton years: "We are in an incredibly dangerous situation. Now is the time to be aggressive. There's no danger of inflation. It's almost insane that people are talking about it now." Even with all the Fed's heroic measures, predicts Merrill Lynch (MER) senior economist Drew Matus, "the recession is going to be a long one, and the recovery is not going to be a big one( WHO KNOWS? )."

One reason for optimism—mild optimism, anyway—is that Bernanke has learned from the mistakes committed by the Fed during the Depression and the Bank of Japan during that nation's Lost Decade of the 1990s. In 1999, when he could afford to be undiplomatic, Bernanke asked in a book he contributed to whether Japan's monetary policy was "a case of self-induced paralysis," and he praised President Franklin D. Roosevelt's "willingness to be aggressive and to experiment."

When the economy does begin to recover, perhaps in the second half of 2009 or possibly later, the Fed will have a very different problem on its hands: how to soak up all of the excess liquidity it has created so it doesn't stoke inflation or some new asset bubble ( TRUE ). In a Dec. 17 research note, Yardeni wrote: "After one bubble bursts, the only way to get out of the resulting recession, and to avoid a depression, is to create another bubble( SORT OF )." That's not what anyone wants, but it's certainly better than the alternative—a downturn that would rival the Great Depression( I AGREE ).

Coy is BusinessWeek's Economics editor.

"I explained that the deflation hype was rather exaggerated"

Emre Deliveli also sees Inflation ahead:

"At my inaugural column last week, I explained that the deflation hype was rather exaggerated, as the two commonly-quoted signs of deflation, U.S. October inflation and yields on American inflation-protected securities, were not accurate indicators at all. However, other market prices such as weakening oil and dividend yields on stocks surpassing yields on 10-year Treasuries have been pointing to deflation as well.

It seems that the market is definitely pricing for Deflationary Inferno even if deflation itself is not very likely. However, the alternative, Inflationary Purgatorio, is still far off the the markets’ radar. While many have learned to trust markets painfully, my overconfidence stems from the ongoing and prospective firefighting. After all, as a reader rightly noted, “numbers are important, but it is government policy that will shape the future”. And both fiscal and monetary policy are pointing towards eventual inflation.

The direction of monetary and fiscal policy

Even though he has been quick to announce his Economics team, you should not expect anything on the fiscal front until Obama settles in. This means that we are not likely to see the effects of fiscal policy on the economy until the second half of 2009 at the earliest. But once the stimulus comes, it is likely to be on the larger side because as this year’s Nobel Prize winner Paul Krugman notes, unlike monetary policy, fiscal policy is inherently asymmetric: It is easier to fix too much of it with contractionary monetary policy than too little of it with another stimulus package. Therefore, when it comes, the fiscal boost is likely to have an inflationary bias.

While fiscal policy is still far away, the Fed has had its hands full for some time now. While traditional monetary easing has not been effective, it has been complemented with more unorthodox tools such as intervening directly in credit markets. As the so-called quantitative easing is now semi-official, we can expect more of such creative policy from the Fed, whose balance sheet is starting to look increasingly like a hedge fund’s. In a similar vein, last week’s announcement that it would purchase USD 100bn in debt obligations from GSEs –government sponsored enterprises- is a first step in the monetization of public debt. With the low money multipliers, Fed’s actions are having a very limited impact on money supply for now. But the mere fact that the Fed is willing to shift to the extreme of policy means that it is not worried about inflation at this point."

This is what I believe is happening as well. Purgatorio is the Mezzanine Tranche of the Afterlife.

"Market implications, risks, and short-run outlook

Crises are always marked by the breakdown of time-tested relationships, but two interesting anomalies have emerged lately: Stocks have rallied while yields on the long end of the curve have fallen and the well-known positive correlation between dollar and long-dated Treasuries has broken. The scenarios I have explained above might shed some light on what is going on.

The recent flattening of the yield curve hints that quantitative easing is well-understood by markets, but its implications are not: All that liquidity and fiscal stimulus could find its way to inflation, which would in turn raise interest rates. With a huge US and global bond supply, we could even end up with a considerable bond market crash and another recession before the recovery from the current one is completed. While this dreaded W-shaped outlook is unlikely to pose a threat before the second half of 2009, it is in line with the anomalies above and paints a rather confusing outlook for the dollar (to be continued)."

I have already posted that we might have a bond market crash, and you know my theory of why these rates are so low. I believe it has to do with an overreaction based on the fear and aversion to risk, and an accompanying flight to safety.