Remember back in March when the Federal Open Market Committee made a surprise announcement that it would spend Treasury funds to support long-term government bonds?

This announcement rocked the world. The 30-year Treasury bond futures jumped almost 8 full basis points ($8,000 per contract), sending rates crashing lower with the yield on the widely followed 10-year note down to 2.5%, from over 3% in one day. As a direct result, the dollar was smacked down nearly 500 pips ($5,000 per contract), versus the euro currency.

This last-gasp financial plan to purchase and support the Treasury market was and is, at best, a short-term fix to prevent the bubble of all bubbles from bursting.

If we flash back to last fall, the stock market panic was driving some investors to guarantee a negative return on their money for the safety of the full faith and credit of the Federal Reserve.

That same money that ran to bonds in order to escape equities is in danger of unwinding and going on the move again - after all, money goes where it is treated best.

Don't believe me? Just ask Warren Buffett.

In his 2008 letter to shareholders Warren Buffet described the situation this way, "When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the US Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."

The Fed's action follows similar tactics used by the Bank of England, which pledged up to 150 billion pounds toward buying its government bonds. This quantitative easing of buying debt with newly printed money expands the deficit and, most importantly, is the match lighting for inflation.

According to Edward Chancellor's skeptical commentary in the Financial Times:

There is no question that a determined central bank can get rid of deflation. It is simply a question of printing enough money. Economists have another term to describe the monetization of government debt. The history of "seigniorage" goes back to the debasement of the coinage under the Roman emperors. Seigniorage is really a tax on holders of money and government debt which is paid via inflation. When carried to excess, it leads to hyperinflation.

This leads to the eventual sale of accumulated bondholding by the government and the impending pop of the bubble, leaving greater financial issues in the long run. Unnatural forces at work in the market can only serve to exacerbate the problem.

As witnessed by the market action in May, restless investors are searching for higher returns on their money than the pittance they chose to accept last fall for safety.

At that time, the dollar and Treasuries sold down to lows not previously seen in the last six months. More selling is in the cards as an appetitive need for risk increases with general global market confidence.

Human nature will lead some to move money out of safety and chase higher returns in the fear of missing out on a stock market turnaround. Emotion can be a great detrimental force and can disrupt a sound disciplined investment plan. Don't miss this flow of funds! How? By positioning yourselves in hard assets.

The unprecedented movement of funds into Treasuries was and is a concern - but it's also a huge opportunity when that money comes back into the market. The numbers will be staggering. The gold market moved over 40% with just the spillover money seeking safety in the financial chaos.

When even a small portion of that moves into hard assets, the commodities bulls will be on the stampede again...for oil, gold, soybeans, silver, wheat, coffee, and more.

People will continue to drive, heat, eat, produce goods and services, and put the "consume" in "consumer." Conspicuous consumption may be out, but pent-up demand for goods we need has only been delayed, occasionally to extreme consequences. Consider this example from the Associated Press:

Store Owner Gives Would-be Robber Bread and $40

SHIRLEY, N.Y. (AP) - A Long Island convenience store owner who was confronted by a bat-wielding would-be robber has shown mercy on the man by giving him a loaf of bread and $40. Convenience store owner Mohammad Sohail pulled a rifle to defend himself against the would-be thief, who then dropped to his knees and begged for forgiveness.

The man explained that he was battling economic hardship and was just trying to feed his family. Sohail put down the rifle and gave the man $40 and a loaf of bread.

Another sign of economic transition was the jump in short-term rates a week ago, pricing in a quarter-point rate hike down the road. In Agora Financial's Resource Trader Alert we've been concentrating on the bond sell-off described above, and have been doing quite well with the Treasury unwinding. However, the market is now acknowledging that rising rates are also something worth watching closely.

Keep an eye on movements in the dollar. The dollar index weakness down to the December lows at 78 was not calmed by a rise in long-term yields. The inevitability of the Fed eventually raising rates to address inflation fears strengthened the greenback back above 81.

Stocks continued to extend their upward run 11 out of the last 13 weeks. The major indices have been in the positive for 2009. Some consolidation and profit taking will likely take place after these new relative highs.

This next step forward will include some global demand rebound as life continues on for the billions around the world who are not money managers, bankers, or insurance executives mired by overleveraged portfolios and bad bets.

Commodities and things of real value should do very well. This new upward phase in the asset market is taking place after a bottoming from the recent and unnatural price depression of vital resources that are consumed every day.

It all comes back to commodities.

Alan Knuckman
for The Daily Reckoning Australia

• Fed Announced it Would Buy up to $300 Billion in Treasury Bonds
• Deflation is on the March
• China Reduces Holdings of Treasury Securities
• U.S. Bonds Better than Greek or Other Sovereign Bonds
• Everyone We Know Expects a Fairly Quick Up-move in Inflation

Yes, you read that right. "Bubbles" just occur spontaneously. They have no cause or explanation. We need government to identify and destroy them.

Sometimes I wish our overlords would get their stories straight. First, Alan Greenspan - whom the New York Times once described, in its typical toadying, totalitarian fashion, as "the infallible maestro of our financial system" - told us it was impossible to tell if a bubble existed at any given time. Now we have Barack Obama insisting that not only can we detect bubbles, but we can also deflate them with sufficient dispatch to prevent them from causing any serious economic disturbances.

How are we peons to decide between the competing views of our infallible maestro on the one hand and the man who would be FDR on the other?

I shouldn't be so cynical. It is not for us to question how our overlords intend to distinguish between genuine growth in some industry on the one hand and bubble conditions on the other. Just to be safe they may have to quash all rapid growth wherever it occurs. Perhaps they can cut off credit to an entire sector of the economy, or levy industry-specific taxation. (Anyone who thinks this type of discretion and micromanagement might be exercised with political motivations in mind, or for any purpose other than the common good, is almost surely a good candidate for surveillance in our progressive commonwealth.)

In their quest to free us from economic instability, our betters may find it necessary to institute new rules. It is our job to accept these new rules with docility and thanks. These rules might have to be kind of sweeping, perhaps on the order of nobody may do anything. In liberal times that could perhaps be modified to nobody may do anything without asking permission. True, we could then wind up with a lengthy debate about whether asking permission itself counted as doing something, such that we'd need to ask permission in order to ask permission, in an endless regress. We'd then be back to the original nobody may do anything, which is probably the safest place to be anyway.

Or perhaps our rulers could shut down the electrical grid from time to time. I'd like to see those greedy fat cats inflate a bubble without any electricity!

Now the possibility that the government itself could be the primary culprit in the generation of asset bubbles is of course not merely rejected; the very idea cannot even be entertained. The great progressive institutions of government and central banking the causes rather than the solutions to our problems? Impossible!

Everyone knows Bad Things happen in the economy because of wicked speculators and grasping businessmen. If someone were to ask whether the Federal Reserve's creation of $8 billion out of thin air every week on average for four solid years might have had a tiny bit to do with the housing bubble, well, we'd have to remind such a cynic that the Fed was created in order to give us macroeconomic stability. Our present crisis was caused by excessive "leverage," you see - though we won't bother asking where major economic actors managed to get all this credit in the first place. That might lead people to ask hard questions about the Fed yet again, and as we've seen, the Fed is our Wonderful, Stabilizing Friend.

It is true that Anna Schwartz, the famous monetarist (and not an Austrian economist), recently observed that asset bubbles cannot form without loose monetary policy by the central bank to fund them.

"If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset. The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses."

(Schwartz also rejects former Fed chairman Alan Greenspan's "attempt to exculpate himself" for the housing bubble.)

Schwartz is here echoing what Austrian economist Ludwig von Mises said decades earlier. A sudden drive for a particular kind of investment will raise the prices of complementary factors of production as well as the interest rate itself. In order for a mania-driven boom to persist, there would have to be an increasing supply of credit in order to fund it, since investments in that sector would grow steadily more costly over time. That could not occur in the absence of credit expansion. The dot-com and housing bubbles can both be explained by artificial credit expansion, say such economists.

If we are to believe these economists, the best way to prevent future asset bubbles would be to stop the Fed from creating so much money out of thin air in the first place. Better still, we should abolish the Fed altogether, since in the view of these economists it is entirely superfluous to a market economy.

Again, though, our trust should be in princes. After all, Austin Goolsbee, an economic adviser to the president, assures us that Obama will be on the lookout for both bubbles and busts.

The president, Politico notes, is

"...prepared to intervene to make sure that kind of red-hot growth doesn't occur. And he's willing to do it with added government regulation if needed to prevent any one sector of the economy from getting out of balance - the way the dot-com boom did in the 1990s and the real-estate market did earlier this decade."

See, those things just happened! No cause. They just happened. And government will protect us from them.

Mark Zandi, a former economic adviser to John McCain, adds that "policymakers always intervene in a downturn. So it is necessary for policy makers to take action against bubbles. You've got to be symmetrical in your policy." What we need, says Zandi, is a "systemic regulator" who will decide whether or not bubbles exist and then take appropriate action. (See how much different a McCain administration would have been on the economy?)

Naysayers may point out that the Fed's own economists denied that a housing bubble existed, and that, as we observed earlier, Greenspan himself believes it's impossible to detect bubbles at all. But surely one more regulator, a big, giant, super-duper regulator, should be able to get things right.

Some people say the market is the best regulator. After all, the free market doesn't pump up the money supply and push interest rates down to levels that promote unsustainable bubbles. The free market punishes reckless risk takers, while it is government that bails them out (and thereby encourages them to take greater risks in the future). It was the Fed, not the free market, from which the "Greenspan put" - the implicit promise to bail out major Wall Street players - emerged. The Financial Times warned that these guarantees were encouraging dangerously risky investments. The free market makes no such guarantees, and thereby cultivates a more cautious class of entrepreneur.

But enough with these naysayers. I for one welcome our new overlords. Every American citizen could stand to learn from that model of filial piety, Britney Spears, who urged, "I think we should just trust our president in every decision he makes and should just support that, you know, and be faithful in what happens."

Amen.

Thomas E. Woods, Jr.
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• Fed’s Aggressive Attempts to Put More Money and Credit in Circulation and the Asset Bubbles
• Can China Change the Rules of Global Capitalism?
• No Great Slump, but Stagnant Inflation Looms
• The Fight Between Greed and Fear, Boom and Bust, Expansion and Contraction

“Investors increase bets on US rate rise.”

Anticipating a rise in rates, rather than another cut, investors sold gold, bonds, and oil. The black goo lost $4 a barrel. Gold got slammed for a $23 loss, while yields on 10-year Treasury Notes rose over 4% (yields rise as prices fall).

Why would the Fed put rates up? Ah...that’s our story for today. It’s a story of numbskullery, tomfoolery, and chicanery...of vigilantes and blazing saddles...of war and forgetting. In short...it’s a typical financial tale, where nothing goes as hoped for...and everything goes as it should.

Let us back up.

Last year, we were writing about a ‘battle’ between inflation and deflation. The markets were deflating...but the feds were inflating. Who was going to win?

Actually, it was a mixed-up, woebegone war...with casualties all over the place and the average American household caught in the crossfire. The poor lumpenconsumer has been taking incoming from both sides for more than a year. His house sustained a direct hit from deflation. Then, his income got whacked by shrapnel from the dollar’s blowup.

Meanwhile, inflation blasts him with higher costs for just about everything – notably the essentials, fuel and food. What can he do but keep his head down?

And pity the poor guy who was lured out to a distant, new suburb by a big, new house with a big subprime mortgage! Now, he’s got to pay $4 a gallon to drive to work, while his house payment goes up and his house value goes down.

Naturally, the feds rushed to help the guy. His real problem was that he had too much credit...but didn’t stop them; they tried to give him more.

Still, when a bubble pops, it is almost impossible to pump it up again.

Henry Kissinger explains why in today’s International Herald Tribune:

“...the role of speculative capital has magnified. For speculative capital, nimbleness is the essential attribute. Rushing in when it sees and opportunity and heading for the exit at the first sign of trouble...”

Speculative capital is what the Feds create when they lend money below the inflation rate. It does not go out and invest in long term projects like steel mills. Instead, it looks for the hot, rising market...the one that will give it a quick payoff. The guy with the big house and the subprime mortgage was not really buying a house...he never paid for it. He was just speculating.

And now his speculation has gone bad...and all the Fed’s hot air goes into a new bubble. When the tech stock bubble popped, for example, the next big thing was a bubble in housing and housing-related debt. When the housing and subprime bubbles popped we guessed that the authorities would pump hard to try to reflate them...but that the Fed’s inflation would go into new bubbles – in commodities, oil, and gold. So far, so good. Oil slid up past $135. Gold shot up over $1,000. And food? Food prices are so high they’ve set off riots all over the world. The OECD says high food prices are here to stay. And farmers in Argentina are setting up roadblocks, again, to try to starve the capital into submission.

Getting back to oil...British truckers clogged up London earlier this week, demanding relief from high fuel taxes; truckers in Marseille shoved against riot police...again, complaining about the high cost of diesel fuel, which is running about $9 a gallon in France. We’re pleased to report than no mobs are forming to demand cheaper gold...but surely some bubble is in the yellow metal is bound to inflate sooner or later.

At the heart of the discontent is a very new, very disturbing, and very predictable fact: these new bubbles are not nearly as nice as the old ones.

*** The bubble in residential property made people feel good. They thought they were wealthy and thought they could ‘take out’ a little of that wealth and spend it. A bubble in oil is an entirely different matter. It makes people feel poorer every time they fill up their gas tank. And it forces them to cut back on spending rather than increase it.

Earlier this week we reported an historic downturn in Americans’ driving habits. For the first time since the ’40s, they’re seeing considerably less of the U.S.A. in their Chevrolets. This morning, comes this headline from Bloomberg:

“Sears posts net loss as consumers slow spending on clothing.”

They’re spending less on imports too – bringing the U.S. trade deficit to a 5-year low.

Remarkably, despite these huge victories for the forces of deflation, the U.S. economy is still growing and the stock market is not falling apart. The latest numbers from Washington tell us that GDP grew 0.9% in the last quarter, rather than the 0.6% previously reported. Knowing how the Labor Department suborns its numbers, however, we would want a good cross-examination before we believe them.

After the Fed intervened to save Bear Stearns, it looked for a while as if they had done the trick – as if they had succeeded in re-inflating the bubble in the financial industry. After the panic, the bank index rallied 22%. But now it’s given up almost all that gain. Banks are about 40% down from their high...amid talk of more pain and suffering in the industry. Wall Street, for example, said it had more layoffs coming later in the year.

Instead of pumping up the bubble it wanted...the Fed pumped up a bubble with a chip on its shoulder. A higher oil price doesn’t have the same agreeable effects as a higher house price. As we explained yesterday, we now have a group of “crude oil vigilantes” who race to buy oil in response to the Fed’s loose money policies. Then, higher priced energy hits the economy like an exterminating devil...it drives up prices for everything, effectively preventing the Fed from further inflating.

That’s what that headline in the FT is about; investors are betting that the Fed is going to change course...that with the economy still growing, it is going over to the other side...that it is going to turn its guns on inflation, rather than deflation.

There are three “vicious cycles” that the U.S. economy must face, former treasury secretary Larry Summers told the Financial Times . The first is a liquidity cycle, a kind of wash cycle in which unreasonably high asset prices are laundered out of the system... People are forced to sell...thereby sending prices down further. The second is a “Keynesian cycle,” in which a slump in the economy rinses out the habits of the bubble period. People begin to spend less...and save more. This, in turn, gives rise to the spin cycle – where, as we imagine it, people get dizzy and depressed because their incomes are going down; they can’t borrow; their costs are rising; and they’re getting poorer.

Where are we in these cycles? Probably only at the middle of the first cycle. Housing and finance have gone down. They probably have further to go. We have seen a foreshadowing of the second cycle too – people are not spending as freely as they did 18 months ago; consumer confidence is falling.

But wait...we’re not finished...

If the Fed really is going to reverse course and begin raising rates, we need to ask some questions:

Aren’t the bubbles in oil, commodities and gold going to pop?

Isn’t our Trade of the Decade (long gold, short stocks) going to go bad?

And how about the dollar? When Volcker came in and raised rates in the early ’80s, the dollar rose to a new high...while gold went into a 20-year bear market.

We remember those years.

“We have been a gold bug for the last 28 years,” we told a fund manager recently. “Only the last 8 of those years have been happy ones.”

Are we gold bugs doomed to another two decades of misery?

Anything is possible, of course. But we don’t see anything like the situation that greeted Paul Volcker in the late ’70s...and we don’t see anyone like Paul Volcker at the Fed either.

*** And speaking of former Fed chiefs, we mentioned that Short Fuse and Addison met the Maestro himself this past Wednesday, to interview him for I.O.U.S.A.

“Is it fair to say that Fed policy has had a dramatic impact on the nation’s savings rate?” was one of the things they wanted to pick Greenspan’s brain about.

“We paraphrase the rest of his response from memory,” says Addison. “In an era of low interest rates, the nation’s savings rate has been abnormally low, as well. Rather than save a portion of their incomes at low interest rates, Americans have opted to divert a portion of their income into their 401(k)s and homes. As capital gains from these two assets classes slow down, Dr. Greenspan expects the traditional “savings rate” to tick back up... as a larger portion of incomes are diverted back into savings accounts.

“He added, in the face of the dire fiscal policy of the federal government, there’s only so much monetary policy can do to shore up the currency in which people are trying to save.”

While Dr. Greenspan’s time was very tight Wednesday morning, he gave the film team an extra ten minutes – and even posed for a picture. Right away, we noticed some similarities between this photo and a TIME magazine cover. What do you think?

Short Fuse and Addison assure us there will be more to come from this interview. Stay tuned.

• Lending Rates Will Go Up With Inflation
• What’s a Consumer Economy Need in Order to Keep Growing?
• Fed’s Aggressive Attempts to Put More Money and Credit in Circulation and the Asset Bubbles
• Deflation is on the March
• Zero Percent Interest Rate Didn’t Work for the Japanese