Bond Bubble Threatens to Destroy U.S. Financial System
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When you think about it, considering historically low rates, there are really only two places for bond prices to go - they could go nowhere or they can go up. The first case is a non-event, the second case, however, will be a complete disaster.
Many economists are predicting long term low interest rates in the U.S., and they might be right. This is a very real possibility. For example, in Japan 10-year bonds yields have remained below 2 percent since 2006. If massive quantitative easing efforts in the U.S. are ignored along with America's massive foreign-financed debt, then sure, it is very possible to assume the U.S. will go the way of Japan. On the other hand, the U.S. could go the way of Spain, who at present has to pay nearly 7 percent to finance debt on its 10-year bonds.
Obviously the U.S. isn't Spain with its banking and budget problems, but it isn't Japan either. The U.S. is unique when compared to both. It is also unique because it is at the heart of the global economy. Not surprisingly it has also been the epicenter of several bubbles in just the last 15 years. In any case, there could be, and probably will be, a collapse in bonds prices and a spike in yields in the U.S. at some point down the road. It is inevitability. The only real question is when.
It should also be stated - and I think this should be obvious based on recent experiences with both the tech bubble and the housing bubble – bubbles are nearly impossible to time. The point of this discussion is not about the timing of the bond market collapse, it is about the effects.
Consider this. How many retail investors own bond mutual funds? Wait, scratch that. How many retail investors even know what a bond mutual fund is? Most probably do, but I can assure you that some do not. All they know is that they have "safe" investments, or as the industry calls it, a "conservative allocation" . . . in other words, they own bonds, including longer dated bonds.
Let us say, hypothetically, that interest rates on U.S 10-year treasures spike back above 2 or even 3 percent. Let us also assume that a hypothetical retail investor opens up their quarterly statement and sees red. How would they react? There is a pretty good chance that a "conservative" retail investor would panic if they saw a sizable drop in their "safe" 401(k) investments. There is also a pretty good chance they will go into cash within sort order.
Now, repeat this a few million times and a few trillion dollars, accounting for pile-on, panic, hedge funds jumping into the trade, and the effects of some guru swearing up and down that the rise in yields signals the end of America as we know it, and suddenly we have a real crisis on our hands. Suddenly operation twist doesn't look like a good idea. Suddenly, well, you get the point. It could get ugly.
Any discussion of bonds in the U.S. has to include a discussion of the Fed, since they are in effect controlling the market by artificially keeping yields low by driving down key rates and, more recently, buying longer dated bonds through operation twist. So far the Fed has had an easy time of it since sentiment is on the Fed's side, with huge demand for U.S. bonds coming from foreign and domestic investors. The Fed is also benefits from having a multi-trillion dollar balance sheet and "unlimited capital." But there are limits to what even the Fed can do, and assuming they had their hands tied fighting inflation, their ability to depress rates would be limited. In that case, not even the "buyer of last resort" could stem the tide of bond selling, and the result could be catastrophic.
Keep in mind, this is not a prediction. It is an observation of the potential affects of ultra lower rates in the U.S. As the Euro and the housing crisis illustrated, even the best intentions by governments have consequences. And with regard to the financial crisis in the U.S., the final shoe to drop could be the most dangerous – bond prices.
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Many economists are predicting long term low interest rates in the U.S., and they might be right. This is a very real possibility. For example, in Japan 10-year bonds yields have remained below 2 percent since 2006. If massive quantitative easing efforts in the U.S. are ignored along with America's massive foreign-financed debt, then sure, it is very possible to assume the U.S. will go the way of Japan. On the other hand, the U.S. could go the way of Spain, who at present has to pay nearly 7 percent to finance debt on its 10-year bonds.
Obviously the U.S. isn't Spain with its banking and budget problems, but it isn't Japan either. The U.S. is unique when compared to both. It is also unique because it is at the heart of the global economy. Not surprisingly it has also been the epicenter of several bubbles in just the last 15 years. In any case, there could be, and probably will be, a collapse in bonds prices and a spike in yields in the U.S. at some point down the road. It is inevitability. The only real question is when.
It should also be stated - and I think this should be obvious based on recent experiences with both the tech bubble and the housing bubble – bubbles are nearly impossible to time. The point of this discussion is not about the timing of the bond market collapse, it is about the effects.
Consider this. How many retail investors own bond mutual funds? Wait, scratch that. How many retail investors even know what a bond mutual fund is? Most probably do, but I can assure you that some do not. All they know is that they have "safe" investments, or as the industry calls it, a "conservative allocation" . . . in other words, they own bonds, including longer dated bonds.
Let us say, hypothetically, that interest rates on U.S 10-year treasures spike back above 2 or even 3 percent. Let us also assume that a hypothetical retail investor opens up their quarterly statement and sees red. How would they react? There is a pretty good chance that a "conservative" retail investor would panic if they saw a sizable drop in their "safe" 401(k) investments. There is also a pretty good chance they will go into cash within sort order.
Now, repeat this a few million times and a few trillion dollars, accounting for pile-on, panic, hedge funds jumping into the trade, and the effects of some guru swearing up and down that the rise in yields signals the end of America as we know it, and suddenly we have a real crisis on our hands. Suddenly operation twist doesn't look like a good idea. Suddenly, well, you get the point. It could get ugly.
Any discussion of bonds in the U.S. has to include a discussion of the Fed, since they are in effect controlling the market by artificially keeping yields low by driving down key rates and, more recently, buying longer dated bonds through operation twist. So far the Fed has had an easy time of it since sentiment is on the Fed's side, with huge demand for U.S. bonds coming from foreign and domestic investors. The Fed is also benefits from having a multi-trillion dollar balance sheet and "unlimited capital." But there are limits to what even the Fed can do, and assuming they had their hands tied fighting inflation, their ability to depress rates would be limited. In that case, not even the "buyer of last resort" could stem the tide of bond selling, and the result could be catastrophic.
Keep in mind, this is not a prediction. It is an observation of the potential affects of ultra lower rates in the U.S. As the Euro and the housing crisis illustrated, even the best intentions by governments have consequences. And with regard to the financial crisis in the U.S., the final shoe to drop could be the most dangerous – bond prices.
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