The Federal Reserve and a bond bubble

When you hear the words Federal Reserve, do you think of a government agency that faithfully backs the U.S. dollar? If so, you would be wrong. The Federal Reserve, or the Fed, is private.

The Fed now presides over what could be the greatest bubble ever, one that could literally collapse world economies. We are facing a massive collapse of bonds. Many are predicting this, most notably extremely successful macro-trend investors Peter Schiff and Jim Rogers. Neither has ever missed a major economic prediction. More on that, but first some history is needed to understand the problem.

A secret meeting of government and financial leaders was held at the now aptly named Jekyll Island, Ga. That meeting, after three prior failed attempts by major banking interests, resulted in the Fed being created in 1913 by the first Socialist president, Woodrow Wilson.

The Fed operates with virtual impunity. They are never externally audited and have sole control of our money supply. No one but them knows what they actually do or their fiscal soundness. The only control over them is Congressional approval of the chairman. They are do not guarantee the dollar.

It has been stated by honest historians that bungled Fed monetary policy in conjunction with Roosevelt’s interventionist policies added at least three years to the Great Depression. The late Milton Friedman, in my opinion the best modern free-market economist, observed that the Fed never makes the same mistake twice but manages to find new ones.

It is also important to have a basic understanding of bond value. When you buy a bond, you are lending to the issuer. A bond is bought at an interest rate. You can keep the bond to maturity, receiving interest and being repaid your purchase price, or you can sell it for cash.

If you sell it, its value is determined by the rates on new bond issues. If the rate on new issue bonds goes down, you can sell your bond for more than you paid. Conversely, if rates go up, your bond is worth less. If rates double, your bond is worth half what you paid. Experienced bond investors know there are other factors, such as time, affecting your bond value but I am trying to stay very basic with this concept.

The concept of rate versus value is important. In a free market the bond rate is determined by the issuer’s desire for the lowest rate possible and the buyer’s assessment of risk associated with the issuer. The eventual rate is a meeting of the minds between the two.

The Fed has for the last five years engaged in Quantitative Easing, or QE. They have interfered with the free market by buying $85 billion per month of U.S. Treasury Bonds to keep the interest rates artificially low at nearly zero.

Therein lies the problem. The Fed balance sheet has gone from $900 billion to $4.1 trillion in five years. Most of that is apparently in U.S. bonds. If they allow rates to increase, their asset value drops. In order to keep rates from increasing, they must keep buying bonds. They are in a no-win dilemma.

Every time the Fed hints at reducing QE, the stock market drops. There is intense pressure to keep the trough full for stock investors. They have thrown the small saver, retirees, and pension funds (restricted in what they can invest in) under the bus. There is no incentive to save at a near zero return, negative if you factor in inflation.

At some point the Fed will no longer be able to influence rates. When, not if, that happens the results will be catastrophic. The total bond market is huge when corporate and municipal issues are included.

When rates start to climb, a tremendous amount of value will be lost. Retirement funds, already shelling out more than their investments return, will see principal assets lost. Savers will lose. No one will want new issues because rates may be higher tomorrow, further increasing rate pressure.

No one knows what the trigger might be. It might be a war action, natural catastrophe, large bank or insurance company failure, or some seemingly innocuous event.

The Fed has caused this dilemma. The only escape they have is to inflate the dollar. Otherwise new Fed Chair Yellen could preside over the largest bond default in history and the Fed could go broke.

This is a simplified writing on a complex issue. Just be aware all is not well.

Tom Riggins column appears every other Friday.