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Monday, November 23, 2009

The Asset Bubble is Forming

The latest piece in the rapidly forming asset bubble is now in place. Short term treasury bills are now below zero.

For the first time in seven decades, Treasury bills are paying no interest while stocks continue to appreciate -- a divergence in U.S. financial markets that might be perilous if Federal Reserve Chairman Ben S. Bernanke didn’t know all about 1938.

That’s when the Standard & Poor’s 500 Index climbed 25 percent even as bill rates tumbled to 0.05 percent from 0.45 percent. As 1939 began, stocks began a three-year, 34 percent decline after the Fed increased borrowing costs prematurely to stymie inflation that never materialized.

In my mind, the difference between inflation and a bubble is this. During periods of inflation, all prices go up. During a bubble, the prices of one area goes up extraordinarily. Often the forces that set each in motion are the same. It's only a matter of how those forces spread through the economy.

Right now, equities are zooming at the exact same time that short term bonds couldn't be trading any better. Keep in mind, if you were to buy a three month T Bill, you would get near a negative rate. That means you'd get less money back then when you started. Yet, investors are buying them in bunches.

Such anomoles are almost always a sign that there's trouble ahead. Throughout 2006, we had what's called an inverted yield curve. By that, short term rates were higher than long term rates. That caused ARM's to go out of style since they were worse than the regular fixed mortgages. (in other words an adjustable rate mortgage actually had higher rates than fixed rates, meaning there was no reason to get them) That was a sign of upcoming recession. That's exactly what happened.

Now, we have nearly zero yields on very short term rates and a massive yield spread. The yield spread is the difference between the two year U.S. Treasury bond and the ten year U.S. Treasury bond. That's been bouncing but it's often, over the last six months, between 2.50%-2.70%. That's near a record of 2.75% set in June. This is a sign of upcoming inflation.

We're alread seeing signs of upcoming inflation. The Dow is skyrocketing. Gold is skyocketing. Oil is zooming up. Even emerging market assets are zooming up. All of it is coming at the expense of a weak dollar. The weak dollar is entirely caused by both irresponsible fiscal policies and loose monetary policies, which are financing the irresponsibility. With massive debt, and a massive creation of new dollars, both those have combined to weaken the dollar.

Inflation is defined as too many dollars chasing too few assets. I define a bubble as assets being enticed into an industry by outside forces rather than fundamentals. So, if the weak dollar is forcing investors into equities, commodities, and emerging markets, then what we have is a bubble forming. In fact, there isn't necessarily a long term correlation between a weak dollar and strong equities. That's because in the long term equities trade based on fundamentals not the strength or weakness of the dollar. Now, people are rushing to get dollars cheaply and take advantage of that weakness. By that, we have a bubble forming.

People aren't buying because the fundamentals in the market are strong. We have 10% unemployment, record foreclosures, record deficits. Those aren't necessarily fundamentals for strong growth. People are buying because they can get the dollar cheap.

That won't last forever. At some point, the Fed will have to reverse itself. It will have to contract the money supply. That will strengthen the dollar. All those that rushed in to get their assets cheaply will rush out to cash out of the strong dollar. That's how bubbles that form burst. That's what we have.

It's happening again because the Fed, again, has caused the next crisis by fixing the current one. The Fed saw the internet bubble forming so it popped it by increasing rates. That lead directly to the recession. So, it lowered rates, TOO MUCH. That lead directly to the housing bubble. Now, it's lowered rates again to expand growth. This is leading to the next bubble.

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