Bubble trouble

The Fed hasn't been shy about throwing its weight around. Thanks to something called quantitative easing, the Fed has become the largest single buyer of U.S. bonds in world history. It's like the fat kid doing a cannonball off the high dive. When the Fed jumps, it tends to get your attention.

Nobody is clear of the splash zone from the Fed's latest move - another $600 billion in bond purchases over the next 8 months. It affects everybody and has sparked a growing debate over whether or not we are in a "bond bubble." Those who argue against the bubble rely on arcane definitions of what constitutes a bubble. Personally, I care less about technical definitions and more about the distortions the Fed is causing in the capital markets.

Here's a reality check: I can refinance my mortgage over 30 years at an interest rate of 4.20%. The federal government, on the other hand, pays 4.25% for 30-year money. My credit is pretty good, but why would anybody lend me money for 30 years at a rate below what federal government must pay? Such is the strange world made possible by the $2.1 trillion worth of quantitative easing we have seen so far.

In this strange world, cash has no cost and little, if any, return. If you were to invest $100,000 in a money market fund, you would earn about $100 over the course of a year. Treasury bills would pay a little better (about $250) and bank CD's a little better yet (just over $500.) With rates this low, pensioners face an income drought. Many are reduced to eating their seed corn.

If pensioners are hating life in our strange new world, corporate CFO's are loving it. New debt issuance soared in the third quarter as corporations raced to lock in historically low interest rates. Microsoft, not known for borrowing in the bond market, scored big when it issued 3-year notes bearing a coupon of 0.88%. And who's to blame them. From a CFO's perspective, it makes a lot of sense to borrow, but do we really want corporations leveraging up their balance sheets?

With these and other distortions growing in the economy, we need to be careful not to get suckered into a false sense of security about improving economic conditions. As I've written elsewhere, there is noticeable progress being made in many sectors of the economy, but a burgeoning bond bubble put its all at risk.