Is the Fed fueling a bond bubble?

at 11:20 AM ET, 04/23/2012

Sheila Bair isn’t one to hold her tongue. As chair of the FDIC, she warned Bush that the housing bubble was about the burst and Obama that his recovery efforts wouldn’t be enough to mop up the mess afterward. Now the former banking regulator believes that there’s another bubble on the horizon — one that the government itself is fueling.

(Manuel Balce Ceneta - Associated Press)
In a new column for Fortune, Bair warns that the Federal Reserve’s policy of keeping interest rates at historic lows has inflated Treasury bond prices, creating a bubble that will eventually burst. The Fed has kept interest rates low in order to stimulate lending and refinancing in the midst of the economic slump. As a result, investors have been piling into the Treasury market. Even as worries have grown about the United States’ ability to deal with its short- or long-term economic problems, the U.S. bond market has continued to be a safe haven for investors fleeing the euro zone crisis.

Bair argues the Fed’s low rates have fueled irrational exuberance in the bond market:

[Y]ield-hungry investors are taking on more and more risk. Pension managers are investing in hedge funds, and gullible investors are buying up junk bonds. Meanwhile, low-yielding assets pile up on the balance sheets of more risk-averse banks. If interest rates suddenly spike, bankers may find that the paltry returns on their loans are insufficient to cover interest on their deposits.

As such, Bair concludes that our nascent recovery, though still fragile, should be enough for the Fed to “declare victory and not intervene if the market wants to push rates up a bit. Start deflating the bubble before it pops.”

To be sure, there would be a significant downside to raising interest rates as well: It would make mortgage refinancing more expensive, for example, which could hold back the housing recovery even further. But in fact, not enough homeowners have been taking advantage of the low-interest rates to refinance, despite the Fed’s efforts. So it’s conceivable that the threat of increased rates might actually increase demand for mortgages and refinancing “as new buyers come into the market to lock in the low rates,” Bair argues.

The Fed, for its part, said in January that it plans to keep interest rates low until late 2014.

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