|What Happens If The Bond Market Pops?
The idea of money quickly leaving the bond market should be a big concern to all governments. Bonds are not just those issued by America but by countries all around the world. While some forecasters predict America will grow at the fastest pace in a decade during 2015 debt investors are signaling their skepticism as commodities plunge and slowdowns in Europe and Asia threaten the U.S. recovery. Last week, the bond market's outlook for inflation over the next three decades fell below 1.9 percent annually, the lowest in three years. Investors’ expectations for consumer-price increases are diminishing as the Federal Reserve debates how soon to raise its benchmark interest rate which has been held close to zero in an effort to support demand in the economy since 2008. 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. I contend it is the later and an influx of foreign capital has been driving this market.
Anyway you look at it I have a problem lending my hard earned money out for a long period of time based on predictions of future government deficits. These forecast are often formed and made on assumptions based on rosy scenarios or politically skewed to benefit those in power. Knowing what we know about 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 are expected to go up. 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 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 the only lenders will be those who print the money that nobody wants. When this happens we are at the end game.
Another concept that should be considered is the primary reason that inflation has not raised its ugly head to become a major economic issue is because we as a society are pouring such a large percentage of our wealth into intangible products or goods. This includes currencies. If faith drops in these intangible "promises" and money suddenly flows into tangible goods seeking a safe haven inflation will soar. Like many of those who study the economy I worry about the massive debt being accumulated by governments and the rate that central banks have expanded the money supply. The timetable on which economic events unfold is often quite uneven and this supports the possibility of an inflation scenario. The current subsidizing of the auto, housing, and financial industry coupled with an ad hoc disregard for both the rule of law as well as basic economics produces a very flawed kind of growth. We need to start thinking beyond propping up failed corporations by running up our national debt because this course is unsustainable.
Markets are not always efficient and the idea that they are 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 with 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 ready to pop its collapse will be full of ugly ramifications that will not only effect bond holders 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 is important to remember that debts can go unpaid and promises be left unfilled. If this happens where does it leave us?