The Absolute Return Letter - April 2010: When the Facts Change

We are currently in what I like to call echo bubble territory. I assume that most of our readers are familiar with the DNA of an asset bubble (even if Greenspan isn’t). Echo bubbles are children of primary asset bubbles and are usually conceived when monetary authorities respond to the bursting of an asset bubble by dramatically reducing policy rates.

In the current situation, banks have suffered the worst; low policy rates help banks rebuild their damaged balance sheets as they benefit from the steep yield curve. The dilemma now facing policy makers is that the extraordinarily low interest rates we currently enjoy are encouraging another bout of excessive risk taking before bank balance sheets have been restored and the economy is back on its feet again. If monetary authorities were to raise rates now in order to avoid the formation of echo bubbles, it would almost certainly kill the fledgling recovery. The pressure is therefore on them to keep rates low and for that very reason asset bubbles are often followed by echo bubbles.