Zurich, Switzerland

The odds were always high that one or more central banks would eventually bungle monetary or fiscal policy in the post-2009 credit crisis recovery environment. In the context of the most formidable and extensive unorthodox monetary operations since the 1930s, the Federal Reserve has seemingly pulled almost every rabbit out of its hat since August 2007.

Did investors really believe we’d get through this mess without a hiccup?

Another liquidity trap might be at the cusp of testing the Fed this summer as Treasury bond prices surge and risk assets commence another leg south.

Two-year notes are approaching record lows and suggest the Fed needs to act. Long-term rates, as measured by the benchmark ten-year T-bond, have seen yields crash from 4% in April to 2.72% this morning. This action is a warning shot for the Fed as the economy continues to cool since May, compounded by credit stress in bank lending and a deep bear market in the housing sector.

It’s been a rough year for most investors outside the confines of fixed-income securities as wild gyrations in equities, commodities and currencies challenge even the best hedge funds in the business.

After a strong bounce in July most indexes are now down again in 2010 following a sobering Wednesday whereby the averages fell about 2.5%. As Dugald pointed out yesterday, the U.S. broader market looks like it’s rolling over again; but we’ve already seen two similar breakdowns since May with neither bulls nor bears really making any serious money amid a volatile trading range.

The Fed, acting as the printing machine of only resort, announced QE2, another round of quantitative easing, this week as the central bank takes the interest from its vast pool of mortgage-backed securities and begins buying the long-end of the Treasury market. The Fed wants to keep long-term interest rates down. By throwing another few hundred billion dollars at the curve, the Fed is expanding its bloated balance sheet again in its effort to grow liquidity in areas of the economy that need it most.

Banks in the United States don’t seem bullish on lending. And the best customers don’t seem too bullish about borrowing. Companies outside of the financial sector are sitting on roughly $1.8 trillion dollars of cash and, outside of technology spending, aren’t doing very much with that cash. Some have boosted buybacks and raised dividends; overall, the flow of cash is stuck in Treasury coffers at most businesses, including the biggest banks, which continue to purchase Treasury bonds.

The bond market is now entering the gates of its “last hurrah.” The grand 1981 to 2010 bond market super-cycle is nearing an end. Yields are likely to take out the December 2008 low of 2.2% on this rally and, possibly, break 2%. I would not buy bonds at these overbought levels. I’m pretty confident the Fed will pour more money into the financial system and, at some point, will get its wish – higher inflation that’ll be difficult to cork once it’s out of the bottle. Helicopter Ben is coming back in 2010.

I’ll be in-transit tomorrow from Europe and will be back on Monday. Have a nice weekend.