(Recasts, adds comments on Fed interest rate outlook, corporate bonds, big banks)
By John Parry
NEW YORK, Dec 7 (Reuters) - A "speculative fervor" has returned to markets after the global financial crisis, causing a bubble to form in commodities and creating risks for the dollar, veteran Wall Street economist Henry Kaufman said on Monday.
But Kaufman, who became known as "Dr. Doom" for making the right call on higher inflation and interest rates when he was chief economist with Salomon Brothers in the 1970s and 1980s, was largely positive in his outlook at the Reuters Investment Outlook Summit in New York. He played down the risks of inflation and said that financial markets will not be derailed if, as he expects, the Federal Reserve raises interest rates from ultra-low levels by the second half of 2010.
Because commodity markets are small compared with some other financial markets, comparatively modest shifts out of other assets can raise the risks in commodities, he said.
"There are bubbles in commodities," and probably in the gold market as well, Kaufman, president of financial consulting firm Henry Kaufman & Co Inc in New York, said. He cited the return of leveraged bets as one driver.
Kaufman also cited some risks to the U.S. dollar and said it is debatable whether the dollar is bottoming, though he noted that the currency's retreat has so far been orderly.
"I don't think inflation is a problem for the foreseeable future," he said, because there is still so much slack in industrial capacity and the economy as a whole.
The "speculative fervor" where participants are borrowing heavily in short-dated markets, however, "might be a risk for the dollar," Kaufman said.
Investors, spurred by U.S. interest rates near zero percent and the easy availability of funds, have borrowed huge sums of money in the low-yielding dollar in recent months to purchase higher-yielding assets in a strategy known as "the carry trade."
Kaufman said he did not expect the U.S. government to take any action to stabilize the dollar.
Longer term, if the U.S. economic recovery is more anemic
than in some other major economies, that would weigh more on
the dollar, he added, calling the area between 80 and 85 yen
per dollar
Despite some analysts' concerns that the huge amount of
U.S. government debt issuance will ultimately pummel the dollar
and push U.S. government bond yields sharply higher, Kaufman
expects the 30-year Treasury bond's yield will rise only
moderately to about 5.5 percent by early 2011, from about 4.4
percent now
If longer maturity government bond yields don't rise sharply, that would spare the already battered housing market from being dealt another blow from more expensive mortgages, whose rates are tied to the Treasury market.
Asked about his favored investments for 2010, Kaufman cited high-quality, intermediate maturity corporate bonds because they still offer enough additional yield above Treasuries to be attractive.
By the second half of 2010 the Federal Reserve will probably raise interest rates from the current near zero level to about 50 basis points, said Kaufman, who is known as an expert on the Federal Reserve.
Although such a shift would initially make markets nervous, even a 1 percent federal funds target rate would still be "exceedingly low" in historical terms and financial markets would soon take such a rate increase in stride, he said.
Kaufman also advocated that the U.S. central bank continue in its role regulating financial institutions, despite the Fed's missteps in being slow to spot and curb the explosive growth of exotic credit instruments that contributed to the global financial crisis.
To strip regulatory power from the Fed wouldn't make sense because monetary policy and the flow of credit are so closely linked to the role of financial institutions, he said.
"Just because the Fed's performance has not been the best in the last 20 years, that still does not mean we should have a separate supervisory authority" to regulate banks, he said.
Kaufman has long advocated a new regulator for institutions, provisionally called the Federal Financial Oversight Authority, which would be under the Fed's umbrella.
The chairman of that agency should be a voting member of the Federal Reserve's policy-setting Federal Open Market Committee, he said.
A key challenge now for the government and the Fed is to downsize large banks considered too-big-to fail because of the risks they could pose to the financial system, so that these behemoths don't increase market volatility and raise the costs of doing business, he said.
(For summit blog: http://blogs.reuters.com/summits/) (Additional reporting by Gertrude Chavez and Ros Krasny; editing by Leslie Adler)