Will the deflating bond bubble cause housing to crash again?

With as difficult as it is to predict interest rates, why are people so sure interest rates will go up? Well, the basis of all interest rates is the federal funds rate controlled directly by the federal reserve. This rate is not just at a historic low, it’s at zero. It can’t go any lower unless the federal reserve starts paying people to borrow money. This strongly suggests that interest rates will go up.

The federal funds rate has been at zero for nearly four years now. When short-term rates are very low, investors looking for higher returns are forced to buy bonds with longer maturities. This flattens out the yield curve. At some point, investors start to worry about inflation, and they don’t want to be stuck holding long-term debt at very low yields if inflation is likely to eat away at its value. When those investors start to sell, the yield curve gets steeper, and interest rates begin to rise.

The only tool available to the federal reserve to fight inflation is to raise interest rates. Of course, if they start raising the federal funds rate to curb inflation, it may stop the panic at the long end of the yield curve, but it will force short-term rates to rise in response. Either way, interest rates go up.

As you can see from the long-term chart, during the 60s and 70s, the federal reserve was forced to raise rates to fight inflation, but each time they did, they plunged the economy into recession which prompted them to lower interest rates again which reignited inflation. This battle between economic growth and inflation is the same battle which will describe our economic future over the next 30 years.

Bond bubble may be closer to popping

By Paul R. La Monica — March 12, 2013: 12:31 PM ET

The Dow is at a record high and the S&P 500 is this close to joining its blue chip brother. But as investors become more and more giddy about stocks, bonds have suffered collateral damage.

The yield on the 10-year U.S. Treasury note is currently hovering at a level just north of 2%. While that’s still extremely low by historical standards, it’s an 11-month high. And yields, which rise when bond prices fall, were as low as 1.56% as recently as early December. So bonds have sold off pretty dramatically in a period of three months … the same time stocks have surged.

The 10-year Treasury Note is particularly important to housing. Mortgage interest rates strongly correlate with the yield on the 10-year Treasury Note. If yields on these notes keep going up, mortgage interest rates will surely follow.

As long as the U.S. economy continues to show gradual (albeit tepid) signs of improvement, investors will likely continue to buy more stocks and start to sell more bonds since there is no need to act as conservatively.

Now, there is no reason for panic in the bond market disco yet. But this could be the beginning stages of the bond bubble finally starting to burst.

“While not yet the end of the world, the 2%-2.1% range has marked the top end of a year-long trading range for Treasury bonds,” Dearborn Partners managing director Paul Nolte wrote in a recent note. In other words, if the 10-year is finally able to bust through 2.1%, it may have no problem heading higher.

That would not be good for housing. Future housing markets will be very interest rate sensitive.

But what about the Federal Reserve? Isn’t it still committed to keeping rates low? And aren’t investors taught not to fight the Fed?

Well, the Fed may have done all it can at this point.

Each round of quantitative easing has less impact on the economy.

Nolte noted that “economic growth, erratic as it is, is likely to impact the bond market well in advance of the Fed deciding to pull liquidity from the system and begin a campaign of raising rates.”

Some of the more inflation-obsessed members of the Fed have already been calling for the central bank to start thinking about pulling back on the extraordinary stimulus measures that have been in place since the financial crisis four years ago.

Bernanke wants to give investors assurance that interest rates will remain low through 2015, but investors don’t believe him. There is dissension at the federal reserve, and with Bernanke facing reappointment in 2014, and it’s likely he won’t be reappointed, there is no telling how federal reserve policy might change.

And while it’s unlikely that the Fed will make any major policy changes anytime soon — Fed chairman Ben Bernanke and vice chair Janet Yellen are still more worried about the sluggish labor market than inflation — it seems safe to say that the Fed is not going to increase its quantitative easing bond buying program either.

That means that long-term rates should keep climbing. In a report Tuesday, Columbia Management senior interest rates strategist Zach Pandl wrote that “the Fed’s unconventional monetary policy isn’t aging well — bond yields will rise without new stimulus.”

We’ve reached the end of the road for quantitative easing. The economy is responding less and less to the stimulus, and there is mounting pressure on the federal reserve to stop it. We are at the bottom of the interest rate cycle, and rates have nowhere to go but up.

Peter Schiff And The Coming Housing Collapse: The Fed, Instead Of Lehman, Owns The Mortgage Market

Agustino Fontevecchia — 3/05/2013 @ 2:10PM

This is irrational exuberance, according to Schiff, as the market is fully subsidized by the Fed.  “The U.S. government is guaranteeing all mortgages, and then buying them up,” explained Schiff, “it’s an artificial market, but the Fed, rather than Lehman Brothers, owns it.”

Schiff incredibly agrees with what has become a mainstream opinion: the Fed is behind this rally, both in stocks and bonds, and even in real estate markets.  Yet Schiff differs in that, while most believe the Fed-induced rally has “training wheels” that can later come off, the Fed’s support “are the only wheels” keeping the market going, and removing them will spark a crash.

That is the big issue here. The federal reserve will stop stimulating the economy by printing so much money, and when they do, nobody is certain what will happen. If financial history repeats itself, the template of the 60s and 70s showed us that each time the federal reserve was forced to raise rates and remove the monetary stimulus, the economy sputtered. The bears believe this will happen again, and the bulls believe it won’t. Since there is rampant optimism bias among all investors and financial analysts, Peter Schiff’s more bearish view may be closer to reality than people want to accept.

Pointing to housing markets, Schiff notes that “we are building more homes than we can afford,” as hedge funds and speculators gobble up hundreds of thousands of properties being cranked out by the homebuilders.  …  The foreclosure process is stalled in several “judicial” states while banks are still sitting on massive inventories of housing.  …

The day of reckoning will come when the Fed starts to tighten, according to Schiff. “It is amazing Bernanke can admit he has no exit strategy,” he explained, noting the Fed will monetize some of its Treasury and mortgage holdings, but will have to sell a lot of both to normalize its monetary stance. Bernanke has made it clear they will telegraph the move to the market, but Schiff believes telling others they will sell “is the worst thing they can do [as] everyone will try to front-run the Fed.”

That is when “public selling will overwhelm the Fed,” Schiff says as “the big buyers are only there because the Fed is.”  While the central bank is buying a big chunk of all debt issued by the Treasury, it holds only about 15% of debt outstanding Bernanke explained, rendering it unable to stop a run on Treasuries, which would lead to interest rates rising very quickly.

That is the doomsday scenario. Right now, everyone is complacent in their faith that the federal reserve has an absolute control over interest rates. Financial markets have a way of making fools of us all.

With bond prices falling and rates surging, banks will be left with depreciating assets (Treasuries) and stuck with low yielding long-term loans.  As the “rug is pulled from under the banks,” the housing market will collapse as well, Schiff believes.  The housing market will also breakdown.

During the crisis, “the Fed kept short rates low, supporting teaser rates and allowing subprime to gain traction,” explained Schiff, “now, instead of learning their lesson, they are concentrating on the 30-year fix.”  Rising rates will make it more difficult for people to qualify for mortgages and get homes, while a cooling economy, as a consequence of tighter monetary conditions, will limit renters’ ability to pay.  As the housing market stalls, the financial system will begin to seize up, resulting in a stock market collapse and a deeper recession than in 2008.

Peter Schiff paints a pretty grim picture. Rather than focus on the man or his past history of predictions (attacks on integrity will get us nowhere), I want to hear what you think about his idea and the scenario he presents.

Could it come to pass? Is it likely? Perhaps not. Big crashes are rare, and we just had one. However, a long-term period of stagnant growth in which the economy slips in and out of recession similar to the 1970s is a very realistic possibility.

What do you think will happen?