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June 08, 2007

What Will the Fed Make of the Bond Market Panic?
by Adrian Ash

"...If US consumers and Washington can't borrow cheap at the long end this summer, then they'll just have to get cheap money at the short end instead..."

"POSSIBLY THE EASIEST act for any human being is to spend money which does not belong to him," wrote Robert L. Smitley in his 1933 classic, Popular Financial Delusions.

The only thing easier, in fact, is lending money that's not yours and earning a yield on the profit or loss either way. "Almost anyone will risk funds in an enterprise when the funds are not his own," Smitley went on during the Western world's last Great Depression. Hence today's bubble in all assets.

Over the last four years, private equity funds the world over have come to bid up shares regardless of value. Hedge funds have pushed junk bonds so high, they yielded record lows above Treasuries at the end of last month. Outstanding bets on derivatives contracts now outweigh the entire global economy eight times over, according to the latest BIS and IMF data.

What might happen if a handful of these credit-fuelled promises fails to pay up? Perhaps we got a glimpse this week, when yields on 10-year US Treasury bonds - the global benchmark for the price of money ever since gold was cut out of the monetary loop - rose above 5% for the first time since August.

That move in the medium-term price of Dollars came thanks to Treasury prices falling, of course. And with the value of risk-free investments sinking, higher-risk assets sold off fast, too.

"Everything has to do with interest rates at the moment," gasped one credit trader at J.P.Morgan to Bloomberg. "People are reducing their high-yield holdings in light of the risk-free rate at 5%."

By the close in Frankfurt on Thursday, the Eurofirst 300 index had lost 1.1% for the day. The S&P on Wall Street dropped 1.8%. Gold priced in Dollars fell 1.7% to a one-week low before sinking another $20 on Friday to undo the last three months of gains.

Over in Tokyo, Japanese real-estate trusts sank by 4.1% on Friday, driven lower by fears that the price of Yen might have to rise from its current half-a-per-cent per year. The yield on five-year Japanese government bonds, first launched 7 years ago, rose to an all-time high of 1.525% as equities plunged. Two-year JGB yields have now broken above 1% for the first time in 10 years.

But if those yields still sound absurdly low to you, just recall that until late last year the Japanese government was actually giving money away. The legacy of its "zero interest rate policy" - known as "ZIRP" as in "burp" - has helped push the Yen to record lows on the currency markets, just as the Ministry of Finance intended.

Tokyo wanted to revive Japanese export sales by devaluing the Yen. But China spotted the game, and got to work devaluing the Yuan too, keeping interest paid on deposits below 2.0% while inflation rose nearly twice as fast. The price of Euros was slashed so German exports could compete, rates on the Pound Sterling fell to a half-century low, and US Dollars went on sale at an "emergency" price of just 1%.

Hence ZIRP caused indigestion in financial assets the world over. Bloated on cheap money borrowed at no cost, anything outside the Yen looked to be a no-brainer investment - and brainless investors couldn't get enough of it.

Japan's monetary antics were extreme, but they were by no means unique. The Yen simply offers us a 'limit case' in today's worldwide cheap-money bubble. For while no other currency quite got to ZIRP, the price of money around the world remains "benign" even after the Fed's 17 hikes in the cost of Dollars. J.P.Morgan Chase now puts global interest rates just below 4.7%. Based on the rates charged by 31 central banks, that figure stands well below the 7.02% level of seven years ago.

Spooked by that peak in the cost of money in Nov. 2000, global economic growth slowed by one-half - and we all know what happened to stocks.

So too, of course, does Ben Bernanke.

What will the Fed chairman make of this week's panic on Wall Street? Well, inflation expectations are "well contained" said Michael Moskow, president of the Chicago Fed, in a CNBC interview Friday morning. But "that doesn't mean we're not concerned about inflation. It doesn't mean that we don't think inflation is the predominant risk going forward."

Put Moskow's comment into context - the context of this week's bond-yield panic - and you'd be forgiven for thinking the Fed is happy to see Wall Street hiking long-term rates at last.

After all, no one believed Bernanke was serious when he raised short-term rates 17 times in two years - least of all bond investors, leveraged hedge funds, and speculators in the gold market. Only the sub-prime mortgage market fell for the Fed's "tough on inflation" play-acting. Now the bond market's caught up, however. Should the sell-off in 10-year US bonds continue next week, the yield curve threatens to flip itself right-side up - and stay there - with a vengeance.

The yield curve might even steepen, in fact - making long-term money much more expensive than short-term debt. Most especially if the Fed seizes this chance to start cutting short-term borrowing costs once again.

"Our objective is to have maximum sustainable growth and price stability," Moskow went on. "We look at the entire economy. We look at the financial markets as part of that.

"We look at all this data and then decide what's best for the American people."

You won't have the Fed to kick around, in other words, if it was the bond market that raised the cost of borrowing. And now that all the cheap money's piled up - on Wall Street, in home prices, junk bonds, fine art and mortgage-backed notes - what's best for the American people will soon come to look like lower Fed rates. Because if Washington and the US consumer can't borrow cheap at the long end, then they'll just have to go to the short end for cheap money instead.

And as the Fed gets busy destroying what's left of the Dollar, gold below $650 today could soon come to look like the sale of the century.

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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