Does QE3 Mark the Beginning of the End of the Bond Bubble?

With savings rates at historic lows and budget deficits at historic highs, it makes little sense that interest rates should remain this low for this long. While the Federal Reserve has received much praise for keeping rates low with its Quantitative Easing program, the congratulations rightfully belong to the European debt crisis. It is certainly true that the Fed can force interest rates lower when it creates Dollars out of thin air to buy bonds, but this is only true in the short run. Eventually interest rates must rise if for no other reason than that bond holders wake up and realize that the Dollars paid back to them are worth less than the Dollars they lent. This is why interest rates went north for the winter when the Fed announced QE2 on November 3, 2010. By February, the interest rate on the closely followed 10-year Treasury bond rose 1.12 percentage points to 3.75%. Though, as the Eurozone crisis unfolded, foreign investors rushed to the misperceived safety of U.S. Treasuries and the rate on the 10-year fell to an all time low of 1.43% in July this year.

But the Euro crisis has since rescinded, at least for now, and attention is beginning to turn back towards America’s debt problems, which are far worse than Europe’s. Moody’s credit agency recently announced that it would follow the steps of Standard & Poor’s in cutting the U.S. Treasury’s AAA bond rating in January if Congress fails to reduce future deficits. This news will likely gain traction as Congress prepares to avoid the Fiscal Cliff, a hyped-up tragedy of its own making. In order to resolve last summer’s debt ceiling debacle, Congress passed a resolution to automatically enact spending cuts and tax hikes in January to reduce the deficit. However, it is the Fed’s announcement of the open ended QE3 that will likely initiate the implosion of the bond market.

Fed chairman Ben Bernanke announced that the Fed would continue to buy up mortgage-backed securities until unemployment falls substantially, and will buy up other assets, i.e., U.S. Treasuries, if the so called economic recovery continues to lose steam. If that comes to pass, the Fed will never stop recklessly inflating. The sole reason the economy has failed to begin recovery is because of the Fed’s inflationary policies intended to prop up the housing industry and financed government spending at the expense of the rest of the economy. Regardless of whether investors fully realize this or not, they are beginning to understand that there is no end to the money printing and therefore bonds cannot be a safe haven forever. As evidence, Bill Gross, manager of the world’s biggest bond fund at PIMCO, reduced his company’s Treasury holdings by a third just before the Fed’s announcement of QE3. And while interest rates are currently lower since the announcement of QE3 after an initial jump, the bond bubble will inevitably pop. Most economists believe that interest rates will remain low for years to come, but these are the same economists who believed that housing prices would never fall.

Devin Roundtree received his M.A. in economics from the University of Detroit Mercy.

image: flickr.com/djmccrady

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