The Biggest Risk To The Economy May Be Bonds

Bonds are in a bubble and that bubble will soon begin to deflate, or perhaps burst.  The Fed just last week voted to keep interest rates as is, and further held the course on quantitative easing and other stimulus.  However, several members indicated that they believe that stimulus, in the form of bond buyer, should end well before the end of 2013.  Bond prices have been pushed to unsustainable levels through these government bond buying operations.  As a result, interest rates have been pushed to historic, artificial lows, which is the whole point of the bond buying programs.  If that buying goes away, or even slows, bond prices will dive as investors run for cover to avoid steep losses in these investments.

Should the bond bubble burst, which is a virtual certainty – the government cannot continue to purchase billions of dollars worth of bonds indefinitely – interest rates will jump, possibly to levels that will significantly slow economic growth.  That slowing could ultimately drive us into another recession; one perhaps even deeper than the last – The Great Recession.

While stocks could benefit from the release of so much cash – as bonds are sold and investors look for new places to invest that cash – the damage to the economy could easily more than offset the positive impact of cash inflows.  More to the point, if the economy slows enough, those selling bonds will not feel comfortable investing in stocks, resulting potentially in poor stock market performance as well.

The trick for the government will be to slowly unwind their bond buying programs without spooking the bond markets – without scaring the hell out of everyone who owns bonds to the point where they panic.  That will be a good trick indeed.  Even the hint of a slowdown or end to bond purchases could be enough to send bondholders running for the hills, especially given the current extremely inflated prices for bonds across the full spectrum – municipals, treasuries, corporates, etc.

Bond owners would be wise to consider the realities of the current bond market and adjust portfolios accordingly – now, before its too late.

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