Fed’s Quantitative Easing Plan May Burst Growing Treasury Bubble

FOMC's decision on Tuesday revives long-dormant inflation fears

Federal Reserve policymakers' decision on Tuesday to buy more Treasury debt as interest rates stay at historic lows may give the U.S. economy the stimulus it needs, but it also may help contribute to a growing Treasury bubble that analysts fear will lead to the next market collapse.

Thomas Hoenig, the lone dissenter against the Federal Open Market Committee's decision, has spent the summer expressing his view that the FOMC's policy of keeping interest rates at exceptionally low levels is no longer necessary. Fed Chairman Ben Bernanke and most FOMC members, on the other hand, anticipate that economic conditions, including low resource utilization and stable inflation expectations, require "exceptionally low" interest rate levels for an extended period.

"Given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve's holdings of longer-term securities at their current level was required to support a return to the Committee's policy objectives," said the FOMC's Tuesday statement.

In other words, Hoenig is worried that the record low fed funds rate of zero to 0.25% is too low because the nation's economy is in a modest recovery. Plus, the FOMC's plan to inject liquidity into the economy by buying more Treasuries and printing more money is flawed, he believes, because it will lead to inflation.

Possible $1 Trillion Price Tag on Quantitative Easing

Yes, inflation. Although deflation worries have ruled the financial news this year, the new buzz among economists and other Fed followers is that the next big market disaster could very well be a rise in inflation fueled by a growing Treasury bubble that eventually collapses under its own weight.

That bubble, they say, is now in the process of being created because the Fed may soon resort once again to using something called "quantitative easing," which means using repayments on debts such as mortgage-backed securities to buy long-term Treasuries--to the tune of $1 trillion.

"Ben Bernanke knows the ball's in his court. His tool is quantitative easing," said Thornburg Value Fund co-portfolio manager Edward Maran in a talk about the domestic and international stock markets Wednesday at the 21 Club in midtown Manhattan. "We've got a reflationary environment coming, so with Ben Bernanke, it's going to be shock and awe. Expect to see trillions rather than billions. It's going to be substantial."

Maran and other analysts expect the Fed's major asset buyback to happen sometime around year-end 2010 or early 2011.

Jeff Kleintop, chief market strategist for independent broker-dealer LPL Financial in Boston, agreed with Maran's assessment, putting the quantitative-easing price tag at somewhere between $500 billion to $1 trillion.

Big Money Required 'To Really Move the Needle'

"The price of money is essentially at about zero," Kleintop said. "You almost have to have it so large to really move the needle. Remember, businesses and banks have a lot of cash on their balance sheets. So in order to add significantly to

that to compel more investment and to compel companies to take the step toward additional growth, you've got to make another significant increase. Already the Fed's balance sheet of securities is about $2 trillion, so we would expect them to expand that by another 25% to maybe 50% to really have an impact on driving additional stimulus through banks and businesses."

A complicating factor comes from the fact that the Fed already invested in a huge round of quantitative easing last year, when it introduced a program of buying $1.4 trillion in mortgage-related securities and $300 billion in Treasury debt that the government is still paying off. And this leaves aside the issue of the U.S. government's current efforts to weaken the dollar against the Chinese yuan. History shows that a falling dollar leads to higher inflation.

All this uncertainty has led to a lack of market activity. Investors are seeking safe havens in bank deposits, companies are sitting on a pile of cash, and big deals are not getting done.

"The entire investment world is sitting on a Treasury bubble," said Greenwich, Conn.-based Renaissance Capital Principal Kathleen Shelton Smith in a recent interview with AdvisorOne about the frozen pipeline of initial public offerings. "No wonder investors are sitting on their hands and companies don't know what kind of profits they're going to see. We've got the worst kind of scenario happening right now."

Easing May Be Good News for Stocks

The good news in quantitative easing and a rise in inflation is a possible return to stock market strength. As investors move higher up the fixed-income ladder to get higher return from longer-term bonds, they will jump back into stocks, Maran predicted.

"We can understand why the FOMC has taken this approach, and at this point I can't see them making any change," said Tim Courtney, chief investment officer of independent RIA Burns Advisory Group in Oklahoma City, in an e-mail just after Tuesday's announcement. "I think this will continue to encourage investors to buy stocks and market capitalizations."

The Thornburg Value Fund, based in Santa Fe, New Mexico, is positioned to profit from its contrarian view that the stock market will come roaring back by late 2010, noted Connor Browne, co-portfolio manager of the fund along with Maran.

"We're bottom-up fundamental stock pickers," Browne said.

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