Debt Bubble Stretches to Breaking Point

Should we stop worrying that the debt bubble created by the Federal Reserve since the 2000 market crash could still burst?

No way. Just the opposite, in fact. My three rules of bubbles, identified and explained here, say we're approaching the most dangerous period in the life of any bubble: the time when it is most in danger of breaking.

I know it's tempting to stop worrying about the debt bubble that was created as the Fed tried to moderate the effects of the market crash and the terror attacks of Sept. 11, 2001. The parts of the U.S. economy most sensitive to interest rates are showing few signs of crumbling in the face of the huge increase in 10-year Treasury yields since March 12 (the yield Friday was at 4.66%), and amid increasingly clear statements from the Fed that it will raise its target interest rates this year.

Sales of existing homes are running near a record pace. Consumer spending keeps chugging along, at an annualized rate of 5% in April, and retail sales climbed by an annualized 4.5% in the first three weeks of May. Even car sales are holding up; in the first four months of 2004, auto sales were up 3.1% from a year ago.

But the Three Rules of Bubbles tell me that it's too soon to stop worrying. We've hardly begun to correct the distortions that cheap money has created. Instead of deflating gradually as interest rates have started rising, the bubble has continued to swell in many sectors. The level of financial risk in the economy is still climbing.

So what are these three rules?

1. A bubble expands far longer than anyone expects. Let's look at home sales. Logically, higher mortgage rates -- rates on a 30-year fixed-rate loan are now about 6.3%, up from the low of 5.1% in June 2003 -- should slow the pace of sales and start to bring down home prices. So, again logically, the home-mortgage bubble should be starting to deflate.

But exactly the opposite is happening. Sales of existing homes grew by 2.5% in April to a seasonally adjusted annual rate of 6.64 million homes. The price for a house nationally climbed to an average $176,000 in April, up 7.3% from a year ago. Instead of cooling the housing market, higher rates actually have created a flood of new buyers who fear getting shut out of the market if rates rise too high.