- The Washington Times - Sunday, July 13, 2014

Could the Federal Reserve’s loose-money policies be fueling another financial market bubble like the one whose abrupt and painful end ushered in the last recession?

A growing number of financial analysts believe that’s the case. After nearly six years of the Fed holding interest rates close to zero, critics note that the central bank has largely failed to spark the stronger growth it seeks in the economy while the U.S. stock and bond markets are increasingly exhibiting the kind of “irrational exuberance” that signaled market bubbles in past decades.

“Central banks got what they wanted — investors are acting as if there were no longer any risk,” thanks to the “tsunami of central bank-created money that is crashing ashore in various asset markets,” said Pater Tenebrarum, a financial blogger. He said the U.S. is in an “echo bubble era” exhibiting eerie similarities to the market trends that led up to the global financial crisis of 2008, a crisis fed in part by low interest rates.

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While many markets, from stocks to collateralized loan obligations, are exhibiting frothiness, “one can make an educated guess as to where lightning will likely strike next,” he said. “It is likely corporate debt where trouble will rear its head” as corporations issuing junk-rated bonds have been among the biggest beneficiaries of the latest market craze.

A report late last month from a top financial watchdog group made the case that the Fed and other major central banks are inflating the beginnings of a bubble in many stock and bond markets worldwide. It asserted that the stellar performance and ever-upward march of stock indexes into record territory in the U.S. and elsewhere in the past two years seem disturbingly out of sync with the sobering levels of elevated unemployment and modest growth seen in the Main Street economy.

“Global financial markets are under the spell of monetary policy,” the report from the Swiss-based Bank for International Settlements proclaimed, noting that the ultralow interest rates maintained by the Fed and its counterparts in Europe and Japan have encouraged and even forced investors to take on increasing leverage and greater risks in their search for higher yields.

In their stampede to lock in higher returns, investors have routinely ignored bad news such as the nearly 3 percent contraction in the U.S. economy at the beginning of the year and the outbreak of civil war in Iraq and Ukraine.

“Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally,” said Claudio Borio, monetary analyst at the Swiss bank.

Playing the Fed’s game

Bill Gross, the manager at Pimco, the world’s biggest bond fund, recently explained the dilemma for the world’s savers and bondholders created by the Fed’s suppression of interest rates. The Fed is intentionally giving a strategic advantage to debtors to try to spur greater growth through expanded credit and risk-taking in the economy, but in the process it is punishing savers with meager returns on their bank deposits and other investments.

The Fed’s low-rate policies have made it unprofitable for retirees and other savers to buy and hold long-term bonds such as 10-year Treasurys, which currently yield little above the long-term 2 percent rate of inflation. Short-term securities provide even more paltry returns. Thus, to augment returns, Mr. Gross said, Pimco and other fund managers are “fighting back” by going deeply into debt, taking on short-term loans at near-zero rates so they can take massive positions in long-term bonds and pump up the yields on their investors’ funds.

Such a strategy can prove disastrous when the Fed eventually raises interest rates because it forces investors to cash in their investments all at once to avoid paying higher rates on their loans, leading to a crash in the credit markets. Many such highly leveraged investments unraveled during the 2008 financial crisis, contributing to the market turmoil. In previous decades, highly leveraged buying strategies created market bubbles that ended badly, resulting in such debacles as the bankruptcy of the overleveraged government of Orange County, California, in 1994.

But Mr. Gross downplayed the danger, insisting that although investors need to be cautious and keep a close eye on the Fed, the central bank will want to avoid upsetting the apple cart and will keep interest rates low for many years to come as it wants to avoid burdening the economy or roiling the markets.

With so many investors borrowing heavily in their search for yield, Mr. Gross and others on Wall Street have been soothed by the Fed’s assurances that it won’t start raising interest rates for at least another year. The Fed’s very gradual approach to raising rates means it could take years to return rates to historically “normal” levels — a prospect that has prompted many investors to load up even more on debt so they can take leveraged positions in such risky investments as junk bonds, put options, technology and emerging-market stocks.

In light of the outsized effects the Fed’s easy money policies are having on financial markets, the Swiss watchdog group in its report urged the Fed and other central banks to focus less on trying to accelerate the rate of economic growth and more on being mindful of what’s going on in the markets. It noted that the economic devastation and destruction caused by major financial booms that turn into monumental busts, like the one in 2007-2008, are far greater threats to citizens, democracy and the economy than the bane of sluggish growth.

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