Saturday, December 5, 2015

Bond Market Bubble Ending Has Massive Ramifications

Is The Bond Market A Bubble?
Never before do I remember seeing so many predictions of interest rates remaining low forever and a day. currently, it appears the whole world is trapped in an easy money low-interest rate environment with no way out. This is a sign that in the future a massive problem is developing and it holds huge economic ramifications and major risk. Many of us think the bond market is a bubble and when it pops it will leave a massive path of destruction in its wake, yet it is clear the general public is totally unaware of the ramifications it will have, these even extend down to reduced payouts on pensions.  A lot of money has rushed into government bonds in a flight to safety, and this has sent yields lower and lower. This may be part of a conundrum created by the reality of too much freshly printed money floating around and people needing someplace to stash it. In the world today investors look for large markets to park their money because it implies a degree of liquidity that insures a quick exit if necessary.

Many people have been caught off guard by the collapse of oil prices and the havoc they are causing in many markets. Even more of a concern should be a focused on what happens if a popping of the bond market bubble occurs. The idea of money quickly leaving the bond market should be a big concern to all governments. Bonds are not just issued by America but by countries all around the world. While some forecasters predict America is now set to grow at the fastest pace in a decade debt investors are signaling their skepticism as commodities plunge and slowdowns in Europe and Asia threaten the U.S. recovery. Recently the bond market's outlook for inflation over the next three decades fell below 1.9 percent annually. Investors’ expectations for consumer-price increases have diminished as the Federal Reserve debated how soon to raise its benchmark interest rate which has been held close to zero in an effort to support demand in the economy. It is hard to know if this is an indicator the marketplace feels comfortable that inflation is going to remain tepid or if concern for safety is driving this market, but I contend it is the later coupled with an influx of foreign capital and a strong dollar.

Many of us have a problem lending hard earned money out for a long period of time and we should be wary. Rates are based on predictions of future government deficits and events around the world that may or may not unfold as expected. It is not reassuring to know these forecasts are often formed and made on assumptions based on rosy scenarios or politically skewed to benefit those in power. Knowing of the effect that interest rates have on the value of bonds in the secondary markets, one might deduce that the 30-year bull run on bonds will have to come to an end the moment rates clearly signal they are about to rise. To give you a sense of what this may mean to U.S. Treasury Bond investors a 10-year treasury bond issued at a 2.82% interest rate could see a 42% loss in value from a mere 3% rise in interest rates. This means if you’d held $100,000 in these bonds prior to the rise in rates, you would only be able to sell those bonds for $58,000 in the secondary market after the 3% rise. Please note the $58,000 you get back would be before factoring in the loss of purchasing value lost from inflation.

A theory I have put forth in the past is that in light of rapid growing global debt it might soon become apparent that storing your wealth in any kind of  "paper promise" is a bad idea. The term "liquidity trap" that has been used by Allen Greenspan and others can be difficult to understand. The result of such a trap can be that all the additional money poured into the system, even when coupled with lower rates, can no longer drive the economy forward. This would most likely happen when people realize the return on loaning money is simply not worth the risk!  Why do you want to loan money if most likely you will never be repaid or repaid with something that is totally worthless? When this happens the only safe place to store wealth will be in "tangible assets" and other than those who print the money that nobody wants the only lenders will loan money for very short periods at super high rates. When this happens we are at the end game, the collapse of the economic efficiency of credit has powerful implications because credit is the lubricant that greases the wheels of commerce.

We should consider the possibility that inflation has been kept in check primarily because we as a society have invested a large percentage of our wealth into intangible products or goods such as stocks, bonds, and even currencies. If faith drops in intangible "promises" and money suddenly flows into tangible goods seeking a safe haven inflation would soar and this would drive interest rates upward. Like many of those who study the economy I worry about the massive number of promised being made and the debt being accumulated by governments, this all ties into the pace at which central banks have expanded the money supply. The timetable on which economic events unfold is often quite uneven and this supports the possibility of such an inflation scenario.  The current subsidizing of the auto, housing, and financial industry with an ad hoc disregard for basic economics produces a very flawed kind of growth. For years the ECB has manipulated bond rates lower for countries undeserving of such, as a result, Italy, and others have kept their debt service cost in check, but the fact is artificial rates from central banks mask and perpetuate a debt problem that will come back to haunt them.

The idea that markets are always efficient is a myth manufactured by so-called experts such as Paul Krugman in the ivory towers of academia. Disconnected from the real world those responsible for guiding our banking institutions often fail to see potential second and third order effects of debt monetization. In many ways, they pose one of the greatest threats to the stability of our economic system. A policy of blindly trusting anyone who claims to be an expert has disaster written all over it. If the bond market is indeed a bubble the implications of its collapse will be massive and such an event will not only affect bondholders but will test the economic foundations of both the country and the world. Not only will bond holders be stripped of wealth but soaring interest rates will magnify the nations debt service and rapidly impact our deficit in a negative way. It should never be forgotten that debts can go unpaid and promises are often left unfilled, the general impression that many people hold that it will be different this time will surely be tested. 


Footnote; A bond bubble is a subject I wrote about a year ago and nothing has really changed since that time except debt has grown as growth remains tepid. If history has taught us anything it might be nothing stays the same forever. Below is a prior post concerning how in 1980 the Fed turned bonds on their ear by raising rates to 20% if you have the time it takes you down an interesting look at how we got to where we are today. As usual please feel free to explore the blog archives and as always you comments are encouraged.
 http://brucewilds.blogspot.com/2015/04/interest-rates-inflation-and-debt-matter.html

7 comments:

  1. I think you hit the head of the nail when you mentioned central banks manipulating the Bond market. Personally I agree with you and think the various central banks are intentionally taking losses to keep the bubble going. This really all boils down to how long the various central banks want to keep taking these losses. Since it's funny money they created technically they can keep eating losses forever which from our point of view isn't a loss anyway it really amounts to them only making 1 trillion when their books show they made 1.2 trillion.

    By all rights the bond bubble should have exploded the minute the courts shafted the bond holders from the Detroit shenanigans. I think ever since that time the only real investing into Munni and other government bonds have been basically by large funds and insular groups supporting each other and being directed by the Fed.

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  2. Very interesting, thank you for publishing interesting thoughts on the subject of economy and finance. I slightly disagree with the criticism of the free market not always being rational - in my experience it is always rational providing that it does exist!

    Predicting the imminent bond crash based on rational argument of the need for interest rate to rectify upwards to reflect the real risk of capital lending, is fraught with danger. It reminds me of some other poster who joked that he "predicted" eleven out of the past four bond crashes 8-:) I used to be in that category too, I even used to buy yield-positive ETFs.

    The reason rational economic forecast fails is because it ignores the role of individual manipulation of the "market" by the financial elite. The oligarchy will not allow interest rates to go the way (up) that would reduce the collateral value of all their assets and all their wealth holdings! Instead they will push the rate even lower, it may even go below zero like in Sweden, Denmark or Switzerland. You will probably see it here soon ...

    There is also another aspect that nobody seems to realize - that the relation between the interest rate and inflation is non-linear in time as well as in magnitude. Lowering of the interest rates is inflationary and stimulating (production, consumption and boosting the assets value) only in the short term (about a year), but strongly deflationary in the long term (due to overinvestment and overcapacity effect). Thus the financial elites have painted themselves in the long term deflationary corner out of which they cannot escape without suffering very heavy losses to their own wealth!

    On the other hand, an increase in the interest rate would have had an immediately recessionary & asset-deflationary effect in the short run but would have had an inflationary and economically stimulating effect in the long run. This is why Volcker's 18% rate (around 1981) created a 2 year deep contraction but at the same time triggered a 20-years long high tech boom of the 1980-ties and 1990-ties .

    Stan Bleszynski

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    1. Stan, I want to thank you for a very interesting comment.

      I think we may be closer in agreement than you think when it comes to getting a rational reaction in a "free market." My comment as to how the market "always being efficient is a myth" was mainly tied to manipulation or it that it often shows more lag time than we might like.

      In the past I have made reference to Paul Volcker's actions in 1981 acted as a reset that has served us well, it is difficult to say where we would be today if he had not acted, below is a link to that article.

      As for inflation this time around a lot of new global factors will feed into what happens. I think we should not underestimate how it could take off if enough money escapes the collapse and flows into hard assets.

      Thanks again and best of luck

      http://brucewilds.blogspot.com/2015/04/interest-rates-inflation-and-debt-matter.html

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  3. It puzzles me that so many people who claim to want security invest in bond FUNDS, instead of simply buying bonds. There is all the difference in the world between the two. Bonds cannot exactly crash. Bond funds can.

    The only way you lose on a bond is if the individual entity that issues the bond crashes and burns; but if that entity is the United States, that would mean the entire nation goes bankrupt. While that can happen, it doesn't really matter what you are invested in if things get that serious because when the largest economy in the world goes bankrupt, all bets are off for all investments anywhere in the world, as that is such a huge and disorderly collapse that who could ever say what would be safe and what would be crushed?

    Bond funds, on the other hand, can crash for lack liquidity. Since many people buy into the fund and can ask to get out, the fund manager can be forced to sell of bonds at a time when the market rate for trading those bonds is least favorable. You can, then, get a run of people trying to get out of that fund to where the fund cannot pay them all off, so it crashes.

    If you want security, buy actual bonds from the actual issuer and hold them to maturity. They are always worth what they say they are worth unless the issuer, itself, declares bankruptcy; but (if the courts function as they are supposed to), stockholders lose all their value first before bond holders lose anything.

    This manner by which bonds are secure seems to have been forgotten by the entire world as bonds have become an instrument of nothing but speculation. If you want your money secure, by US bonds with differing maturity dates and hold them to maturity. If the whole country goes bankrupt, nothing is secure, not even gold. The government, remember, confiscated all gold bullion in the days of FDR. It can do so again. Central banks own huge hoards of gold so they can manipulate the price of gold in order to stem a run their own currency, which is worth vastly more to them than is gold because it is their protected monopoly over the entire economy.

    Unfortunately, 401s don't allow you to own actual bonds. In that sense, our retirement industry is also rigged toward speculators and money managers ... if you want the tax breaks.

    --Knave Dave
    The Great Recession Blog

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  4. It's all very complicated, and different investors have different needs. While being reminded of the problems of bond investments, (recalling the historical events that scream, "Watch out! Liquidity trap dead ahead!") is an important heads up, I have to wonder what percentage of bond holders are still driving blindfolded.

    This is the real problem in the bond market. The smell of panic is in the water. Keep your wits about yourself, and your powder dry. Opportunity abounds.

    The free market works. Don't fight the Fed.

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