Why I believe the FED is Not Out of Bullets & the Bond Market is Becoming High Risk

For the record I strongly disagree that the FED is "out of bullets." This FED chairman has spent much of his life studying the Great Depression and has long made it clear he regards deflation as the number one threat to a healthy economy. The FED absolutely has the means (though perhaps not yet the will) to break a deflationary spiral. If banks are not lending the FED can bypass them. Another round of QE is I believe inevitable and it will probably be far more dramatic than the last one. The FED can lend money at very generous rates to near bankrupt states that are laying off employees at alarming rates. It could in theory even take extraordinary measures to directly inject money into the economy. Recall Ben Bernanke's nickname of "Helicopter Ben." He has that moniker for a reason.

IMO the current panic over deflation is shortsighted. Yes it is a legitimate threat. But it is a short term one. This is not the 1930's and the FED is not about to raise interest rates by double digits. Bernanke for all of his faults is probably the one central banker who is prepared, by any means necessary, to wage total war on any threat of deflation.

With bond yields at their current record low levels, I am far from bullish. Those who think the Bond Market can go even deeper are essentially betting on a prolonged deflationary depression. Any other scenario spells severe losses for anyone buying bonds right now. And that is a bet I am not willing to take. My money is on Helicopter Ben. Deflation may be a current risk, but I don't see it lasting far into next year.

And here is the risk or downside to the bet that the deflationists are making. If Ben is successful and breaks the deflation, with bond yields at their current level, even a very modest reflation will start a panic in the bond market. The minute anyone even sniffs a hint of interest rates rising, there is going to be a mad rush for the exits.

Right now I am looking at the bond market today in the same light as the NASDAQ in 1999. It is HUGELY overbought. It is time to take profit and move to cash or buy some battered asset classes. Why own 10 yr Treasuries when you have some very conservative stocks that are paying nice reliable dividends over 5% right now? The potential upside, with IMO no greater risk, greatly outweighs bonds.

And we won't event discuss what might happen if the FED overshoots and actually causes more inflation than they are looking for. Take a look at what's going on in Great Britain where the Bank of England just admitted that they are going to have higher than projected inflation for the foreseeable future. Remember there is already a ton of money out there, and printing money by the way is inflation. Rising prices are simply a symptom of inflation, and one that often shows up rather late and suddenly. Once the floodgates open and the money starts to move we could see a very rapid rise in CPI and interest rates.

To the extent that anyone wants to stay in bonds I would certainly encourage them to heavily salt their portfolio with foreign debt. I like Australian and Canadian dollars, Norwegian Krone and Swiss Francs.

But right now I think the US Bond Market is high risk and low return. It is flashing a giant neon "SELL!" sign. Is anyone paying attention?

-Ad Orientem