Why the Treasury bubble must burst.

[boneyard bill]

The value of US Treasury Bonds, (and corporate and muny bonds as well, for that matter) is inverse to the interest rate. If you own a $100,000 bond paying 5% interest, and long-term rates plunge to 2.5%, your bond will roughly double because someone can pay $200,000 for it and still get a yield of 2.5%. I say "roughly" because other factors, such as the maturity date of the bond, can come into play. On the other hand, if interest rates go up to 10%, the value of your bond would fall to roughly $50,000. (This is true if you want to SELL the bond. If you hold it to maturity, you will still get your $100,000 face value. That is why the maturity date also affects the bond price).


Investors, therefore, tend to talk in terms of bond "yields" rather than interest rates. Treasury bond yields have been declining since the 1980s, and therefore Treasury bond prices have been increasing. Presently bond yields are about 1.8%. This is extraordinarily low and as a result bond prices are extraordinarily high. In fact, of course, even the (probably understated) official inflation rate is in the 3-3.5% range. So T-bonds currently yield less than the rate of inflation. The real long-term interest rate is negative. It got that way as a result of deliberate Fed policy. Bernanke's "quantitative easing" and "operation twist" strategies have been undertaken deliberately to keep interest rates low and bond prices high? Why? Because low interest rates make it easier to finance the budget deficit but also, and more importantly, large financial institutions hold large amounts of T-bonds and if bond prices fell, they could become insolvent.

But where's the end game? That's the problem. Bond prices have to rise eventually. If we enter a recovery, interest rates will surely rise. If we "stimulate" with inflation, that might lower rates temporarily, but they will rise again very quickly due to inflationary expectations. That's how they got to be so high back in the 80's. The only other option is for things to stay just as they are which gives you a "lost decade" type of economy that has plagued Japan for the last twenty years. But that seems unlikely because the US savings rate is too low to sustain even that.

So interest rates are going to have to go up, and when they do the value of the holdings of many banks, insurance companies, hedge funds, pension funds, etc. will go down and these institutions will become insolvent.
Some are already technically insolvent. Many will go under. When banks go under, the money supply falls creating a deflationary spiral. Indeed, a significant rise in interest rates could lead the Fed itself to become technically insolvent. Not to worry, though. The Fed can print money. But even if the Fed floods the banks with liquidity, as Bernanke did in '08, it is unlikely to help the economy much since no one will wants loans with businesses failing all around them and unemployment mushrooming upward.

So the only other option for the Fed is to try to "stimulate" the economy by buying Treasury bonds directly from the Treasury Department which will create inflation. That will alleviate the problem but temporarily but at the expense of making a subsequent downturn even bigger which is what always happens when to try to rescue the economy from one bubble but creating another one.

All of this will probably happen within the next presidential term. So this election is really a booby prize because the winner is likely to be the one who will get the blame for all the hard times when the SHTF.

[Zippyjuan]

It is true that interest rates will eventually rise- and that will knock out a lot of value in Treasuries- and other bonds. The biggest reason that the yield on Treasuries has been declining since the 1980's is that the rate of price inflation has been declining since then. Inflation is a key component of interest rates. Investors want a "real" (after inflation) return on lending money so if inflation is high, they will want a higher "inflation premium" on the interest rate they charge than if price inflation is lower.

If we enter a recovery, interest rates will surely rise. If we "stimulate" with inflation, that might lower rates temporarily, but they will rise again very quickly due to inflationary expectations.

If inflation rises, it will not likely cause rates to go down, but rather to rise.

Some are already technically insolvent. Many will go under. When banks go under, the money supply falls creating a deflationary spiral. Indeed, a significant rise in interest rates could lead the Fed itself to become technically insolvent.

Rising interest rates will not cause the Fed to become insolvent. Rates have risen and fallen in the past and this did not happen. If you are a bond holder, you lose money only if you sell your bond before it matures (you have to offer a rate competitive to other bonds available in order to find a buyer so you have to eat some of your principle you paid in order to offer a higher rate than what you purchased it at). If you hold your bond until it matures, you still get back what you paid plus the interest- it will just be lower interest than what other later buyers are getting. You haven't lost money- just made less. That does not make you insolvent. The Fed typically keeps their securities until they mature. Operation Twist is using revenues from maturing Treasury notes to buy new, replacement Treasury notes(replacing shorter term ones with longer terms).

So the only other option for the Fed is to try to "stimulate" the economy by buying Treasury bonds directly from the Treasury Department which will create inflation. That will alleviate the problem but temporarily but at the expense of making a subsequent downturn even bigger which is what always happens when to try to rescue the economy from one bubble but creating another one.

The Fed has not been a net purchaser of US Treasury notes since June, 2011 (they have been basically trading Treasuries under Operation Twist explained above). When they do purchase new Treasury notes, they don't make those purchases directly from the US Treasury. They buy from authorized dealers on the open market via a bidding process similar to the one the Treasury uses to sell them. (The Fed declares how many they want to buy. The dealers make offers of how many they are willing to sell and at what price. The Fed pays the lowest price it takes to get all the notes they wish to aquire).

[Bohner]

Rising interest rates will not cause the Fed to become insolvent. Rates have risen and fallen in the past and this did not happen. If you are a bond holder, you lose money only if you sell your bond before it matures (you have to offer a rate competitive to other bonds available in order to find a buyer so you have to eat some of your principle you paid in order to offer a higher rate than what you purchased it at). If you hold your bond until it matures, you still get back what you paid plus the interest- it will just be lower interest than what other later buyers are getting. You haven't lost money- just made less. That does not make you insolvent. The Fed typically keeps their securities until they mature. Operation Twist is using revenues from maturing Treasury notes to buy new, replacement Treasury notes(replacing shorter term ones with longer terms).

The Fed would have to sell them if inflation starts to get out of control. Which could very well happen if the economy recovers and all that money sitting in the banks reserves floods the market. If inflation goes full retard, then the fed would be forced to flood the market with T-bonds in order to contract the money supply which could very well lead to the bursting of the bond bubble.

[Zippyjuan]

The Fed would have to sell them if inflation starts to get out of control. Which could very well happen if the economy recovers and all that money sitting in the banks reserves floods the market. If inflation goes full retard, then the fed would be forced to flood the market with T-bonds in order to contract the money supply which could very well lead to the bursting of the bond bubble.

That is one tool (and not a very effective one). A more powerful tool if they wanted to slow the economy from higher inflation and overheating is to raise interest rates- which they did in 1980- going as high as 20%. As said, the raising of interest rates would greatly lower the prices for Treasury notes- that is still correct. Same effect on the price of Treasuries just a different action.

[Bohner]

That is one tool (and not a very effective one). A more powerful tool if they wanted to slow the economy from higher inflation and overheating is to raise interest rates- which they did in 1980- going as high as 20%. As said, the raising of interest rates would greatly lower the prices for Treasury notes- that is still correct. Same effect on the price of Treasuries just a different action.

Yes, but the monetary base grew so much and the Bank has so much in it's reserves that it's unlikely rising interest rates would have an immediate effect. The monetary base is too big right now, so I doubt raising interest rates would be enough to curb inflation if it starts to get out of control.

[acptulsa]

Yes, but the monetary base grew so much and the Bank has so much in it's reserves that it's unlikely rising interest rates would have an immediate effect. The monetary base is too big right now, so I doubt raising interest rates would be enough to curb inflation if it starts to get out of control.

One wonders if it would have any effect on curbing inflation at all. The Prime was higher than 20% in the late 'seventies, yet thanks to Bretton Woods II we had massive inflation anyway. BWII and oil prices, that is--it would seem that despite all they taught us in school about the Fed's miraculous abilities to control and smooth out the economy, a price rise in one essential commodity can completely overwhelm them.

[boneyard bill]

That is one tool (and not a very effective one). A more powerful tool if they wanted to slow the economy from higher inflation and overheating is to raise interest rates- which they did in 1980- going as high as 20%. As said, the raising of interest rates would greatly lower the prices for Treasury notes- that is still correct. Same effect on the price of Treasuries just a different action.

But the way the Fed raises interest rates is by selling bonds. The Fed does not (fortunately) have the authority to tell the banks what interest rate they should be charging.

[acptulsa]

If you are a bond holder, you lose money only if you sell your bond before it matures.

There's a reason the resale value would be affected. You can suffer a net loss on bonds, if inflation is bad enough. If the value of the bond is up fifteen percent of face value, but the spending power of the currency it pays off in is down fifty percent, you just lost your ass.

You don't need me to tell you that.

[boneyard bill]

While I don't disagree with most of what you have said here, I think it mostly misses my point. The law of supply and demand says that if you increase supply, the price goes down. So an increase in the supply of money could push interest rates down as the initial reaction. But that would likely give way very soon to inflationary expectations.

I said the Fed could become "technically" insolvent although it is no danger of it collapsing. However, even if the Fed holds bonds to maturity, it could lose money on them if it bought them at a premium. And I would assume that it carries them on its books at its purchase price, not its redemption value.

With operation twist, the Fed is buying long-term securities which helps to keep the price high. That is why I said that the current low yields are due to deliberate Fed policy. If market forces had driven them down, we wouldn't be in a bubble. The decline in interest rates since the 80s due to the decline in the rate of inflation did not create a bubble. It is the forced decline below any reasonable market rate due to more recent Fed intervention that has produced the bubble.

Greenspan sought to rescue from a recession caused by the dot.com bubble by creating a real estate bubble. Of course, that just led to a bigger bust. Now Bernanke is trying to rescue us from the bursting of the real estate bubble by creating a treasury bond bubble. Somehow, these guys just never learn.

I realize that the Fed doesn't normally purchase treasuries directly from the Treasury, what I'm suggesting is that they might try it as an act of desperation if we have another bank meltdown. They know it's inflationary, but when everything is falling apart you become desperate and the Fed is a one-trick pony. They can do nothing, or they can inflate.