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 a great deal of 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 rapidly 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 bondholders 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