Tuesday, December 16, 2014

Bond Market Bubble Has Ugly Ramifications

What Happens If The Bond Market Pops?
Many of us think the bond market is a bubble, if so when it pops it will leave a massive path of destruction in its wake. 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 popping of the bond market bubble. This is a disaster waiting to happen with the general public totally unaware of the ramifications it will have even extending down to reduced pay outs on pensions.  Money has been rushing into government bonds in a flight to safety that has sent yields lower and lower. This may be part of a conundrum created by the reality that when you simply have too much freshly printed money floating around people need 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.

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?


  1. Yes, look what has just happened in Russian interest rates. They are not as financialised as the west so the population is resilient but exposed investors will take enormous losses. Imagine what can happen if a black swan spreads its wings in Japan, Europe and USA, especially the latter two where more than 50% of populations are already stressed and currently have high expectations that they will be looked after. USA bludgeon policy and Euro self serving compliance may backfire big-time in this interconnected debt ridden mad world of digital arrogance.

    1. Very true, and it does not appear they are ready to stop the madness anytime soon. The swift rise of interest rates in Russia is the perfect example of why you don't want to be in bonds..

  2. The FED has created an almost perfect closed loop system. Thru proxy buyers they are able to keep the bond market and other securities inflated (stealth QE) and export a large amount of the financial pain to other parts of the globe while pushing other parts of it down to the American middle and lower classes. Demand for dollars remains because of taxation and other fees/fines and although they are shelling out large amounts of dollars to keep the markets floating those dollars are not finding their way down to create massive runaway inflation, in fact in most cases like commodities it is having the opposite effect.

    Foreign governments have been dumping dollar backed securities but the FED is buying them up and hardly noticing. Dollars are not rushing back into the US because there is little the world wants in tangible assets here. Oh sure some Billionaires buying some real estate and such but on the grand scale the dollars coming back have nothing to buy.

    Americans are flat out trapped. They cannot abandon the dollar and foreign business must keep selling in the US because there is no other market to shift to, although they have been trying. At this point it is simply a case of the last man standing as the US exports the financial pain until something falls that send repercussions back down the system.

    We can only guess what/whom that will be.

    1. Well said, it seems we are forced to engage in this giant Ponzi scheme until the end. Stay safe out there!

  3. It is the vast perception of wealth that leads people into auction markets to bid up prices for--yes, you guessed it--the same crap that forms the basis of their perception of wealth.

    It's a positive feedback loop, and we know what happens when you regulate a system with positive feedback. It blows sky high.

    The "thing" keeping all prices where they are, pinned to the stratosphere, is this perception of wealth. When nature reverses this 40 year trend, that wealth will simply evaporate. Rates going up causes the value of those bonds to disappear. Only a tiny fraction of bond owners will get out (to some other asset class, but it too should be collapsing in value), most will simply wake up poorer, day after day, just as happens in the stock market. It is the marginal transaction that governs price (& yield.)

    For this reason, all roads appear to lead to a collapse in wealth as measured in dollars, a collapse in willingness to enter the market and bid ANY dollar price higher, then a collapse in the ABILITY to enter the market at all. Dollar inflation should not even be possible until one of two things occurs: the ocean of IOU's is evaporated down to a puddle in which people can resume their collective trust, or somewhere along the line the monetary authorities begin to print banknotes of ever-larger denomination, in vast quantities.

    I do not think a credit-dominated monetary system can experience hyperinflation, and a credit bubble must end in a credit-collapse/deflation of the money supply. Even Japan is discovering they can debase the yen endlessly via a closed loop only if they're willing to see the yen utterly destroyed on the world market, something they can't survive given they are as far from autarky as imaginable.

  4. This is the reason for preparing the public for controls on cash. A Federal Reserve Note, AKA banknote cash, is the only dollar-based wealth that does not need to pass through a transaction in order to BE a dollar.

    All other US "wealth" is thought of in dollar terms, but unless it can and HAS passed through that transaction, it's not a dollar. Once the hydrogen gas credit of the Greatest Credit Bubble EVER begins to burn, running from bonds to stocks to commodities to artwork to gold to land.....nothing will protect the value of dollar wealth for long as the conflagration spreads from asset class to asset class, the herd stampeding left, then right, then back, then off the cliff.

    The only refuge will become apparent, but All the King's Horses and All the King's Men will be doing EVERYTHING they can to stop the contagion of selling as it burns down the very foundation of their power. The easiest way to stop the selling, they'll think, is to outlaw it. The "ultimate sale" i.e., "going to cash" is withdrawing your wealth in the form of banknotes.

    Preventing people from actually physically cashing out to banknotes will look as attractive as halting the trading of stocks to prevent crashes. Of course, it doesn't work; the "crash" is a shared mental state and closing down trading (or preventing cash-outs) only adds to the shared mental panic.

    If political authorities actually outlaw cash (worse than even placing withdrawal limits) they'll insure coming levels of political chaos we can't begin to imagine, akin to locking a herd of cattle in a burning building.