Bonds: The Next Big Short?

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Summary

People seem increasingly convinced bond prices will stay permanently high.

In fact, some economists are now suggesting there is a "shortage" of government bonds.

This sort of thinking often happens when an asset class is near its peak.

A bold economic theory out of the St. Louis Fed is gaining currency; if implemented, it would crush the bond market.

I ran across an interesting quote from the Credit Bubble Stocks blog:

[T]he next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest extraordinary popular delusion.

This is an excellent point worthy of further discussion. It is true, many people are blaming the plunge in interest rates on the fact that there aren't enough "risk-free" assets around. Particularly with changes in Basel banking standards that reward banks for holding government debt and penalize them for just about anything else, there's been a historic surge into government debt.

However, does government debt remain "risk-free" if too much of it is issued? Historical precedent, while admittedly contrary to recent experience, would suggest excessive debt loads are almost always liquidated either be default, devaluation or printing press - rather than repayment at face value.

The point the author makes at the end is quite interesting indeed; the US is taking on more debt, but it's not using this to construct infrastructure or other things that would grow the economy and boost future tax revenues. To the extent the government is spending money merely to create make-work jobs and fund subsidy payments, it is borrowing without creating any collateral - no future value to offset the added debt load.

In Dying of Money, written about the American experience in the 1960s-70s, Jens Parsson described this phenomenon quite well:

A spurious job was one that the system could quite well have eliminated altogether, paying its holder the same large amounts for not doing anything at all, and no one would have noticed the difference.

The author went on to complain of how, during the stagflation era, the government subsidized a lot of these spurious jobs by heavily promoting higher education, the law profession and the financial industry, all at the expense of the real economy. Quite the eerie parallel to today, I would add.

This is all interesting, since the US government (and various foreign ones) appears to be using the current extreme interest rates as a justification for yet more deficit spending. Look at this bold claim stated by former FOMC member Narayana Kocherlakota:

Are government-imposed restrictions holding back the U.S. economy? In a way, yes: The federal government is causing great harm by failing to issue enough debt [...]

The price [of debt] is near record highs, suggesting that the U.S. government's supply of such safe investments is falling far short of demand. In other words, we're starving the world of desperately needed financial safety.

To some, the idea that the U.S. government isn't issuing enough debt may seem counterintuitive -- after all, federal debt outstanding has more than doubled over the past 10 years. But scarcity is not about supply alone [...] Market prices tell us that the government needs to produce more safety in order to meet this increased demand.

This is absolute crazy-talk of the most dangerous sort. Government debt traditionally was used during wartime or a crisis to keep the nation's essential services operating. In recent years, it has transformed into a tool to allow moderate overconsumption in the present, to be paid for by future taxpayers.

The idea that debt is issued to meet supply for "safe assets" is novel and worrying. The government has no duty or obligation to create a balanced market in treasuries - in fact, much of the normal economic cycle revolves on interest rates rising and falling, thus providing pricing information to the economy. This is, in fact, a basic element of the capitalist price-setting mechanism.

Kocherlakota, incredibly enough, goes on to blame the lack of sufficient debt for saddling retirees with insufficient yields. This is a brazen attempt to say the government should forcibly (to an even greater extent) make the young and still unborn pay for the current generation's entitlement expenses by taking on an infinite amount of debt - whatever is necessary - to keep interest rates stable.

The idea that the government needs to indebt itself further to maintain minimum interest rates for retirees is amazing. It takes the idea of US social security as Ponzi scheme to a whole new extreme.

The other problem (if there weren't enough already) is that if you balance "supply and demand" for government bonds at a very high level of debt outstanding and then "demand" drops, then what happens? You can't easily cut supply of outstanding treasury bonds - you're talking about trillions of dollars of real financial obligations, not just variables in an academic economic model. How would the government come up with trillions of dollars on a whim to snuff out a now excessive debt supply?

Of course, there are no immediate issues as long as interest rates keep falling. The government can keep increasing the supply of debt to meet supposed "demand" until one day market preferences switch and the bond market goes into a bear.

Then momentum goes the other way, people panic and start dumping bonds and interest rates spike, causing a large budget deficit and necessitating massive tax hikes, spending cuts or use of the printing press. As Dying Of Money reminds us, the benefits of cheap money are always offset by costs that eventually come home to roost.

With that in mind, it should come in mind that Kocherlakota is very much opposed to a new proposal out of the St. Louis Fed to hike interest rates in order to try to raise inflation. Kocherlakota's supply/demand based model of debt issuance would utterly collapse if the St. Louis Fed proposal is adopted. To the extent financial markets have been a one-way trade based on perpetually lower interest rates, there's a great deal of potential risk to the current financial market structure.

Raise Interest Rates To Boost Inflation?

Stephen Williamson of the St. Louis Fed is out with an article promoting a provocative idea deemed Neo-Fisherism. I'll let him explain:

The key Neo-Fisherian principle is that central banks can increase inflation by increasing their nominal interest rate targets-an idea that may seem radical at first blush, as central bankers typically believe that cutting interest rates increases inflation.

Williamson argues that since the 1960s, central banks have become preoccupied with controlling inflation. Initially they had success with monetarist ideas taken from Milton Friedman, grow the money supply at a stable rate and you get a stable inflation rate. This worked for a time, but has had less success in recent years. The feedback loop between money supply and inflation is slow - often beyond the patience of central bankers or elected politicians to endure.

Central banks have also taken to adjusting the overnight rate as a key factor in controlling inflation. They hike when the economy seems strong to put a damper on economic growth and they conversely cut to give the economy a boost.

However this mechanism also appears broken. In the wake of the 2008 crisis, interest rates hit zero and then nothing happened. The Keynesians argued that this would cause a massive deflationary bust. This didn't occur. The monetarists and Austrians said this could provoke a hyperinflation and dollar collapse. This also didn't happen.

In fact, basically nothing happened; inflation and interest rates have both been notably quiet since the policy rate hit zero and stayed there for almost a decade. However, according to traditional models, chaos should have ensued.

If you accept that both Friedman's ideas and neo-Keynesian ideas haven't worked so well in regulating inflation lately, then perhaps a different paradigm is needed. Enter Neo-Fisherism, which uses economist Irving Fisher's long-known observation that nominal interest rates and inflation are closely connected. Williamson provides the key graphic showing this correlation:

And this makes intuitive sense. At the end of the day, the real cost of money is the interest rate after inflation, not the sticker rate. If you increase interest rates, it is likely you'll also increase inflation, all else held equal.

Immediately following an interest rate hike, savers will earn a higher real rate of return (increase of purchasing power) and debtors will pay a higher real cost (decrease of purchasing power). The market is likely to find a new equilibrium that prices out some of that change by raising inflation, and thus restoring the pre-existing balance between saver and debtor.

Modern economic theory suggests this effect is outweighed by the stimulative "pump" of a rate cut or slowdown provoked by a tightening. However, many folks recognize this is a temporary effect - once the stimulative or repressive effect is gone, you still have your altered interest rate.

Williamson argues that central bankers have become deluded thanks to the Taylor rule, suggested in 1993, which effectively posits that large changes in policy interest rates should be used to target inflation. Since the natural tendency of lower nominal interest rates is also lower inflation/real rates, Taylor followers will almost always end up at the zero percent interest rate bound sooner or later.

And in fact, since 1993, that's increasingly what has happened around the world. Williamson suggests it is time for a change, discarding a theory that hasn't worked, and try raising rates as a way of getting inflation back to its normal 2-3% range.

He concludes by arguing that further cuts - such as pushing interest rates below zero - will only drive inflation even lower. And, I would note, this appears to be the case in Europe, where interest rates have gone negative without doing anything for inflation. This failure damages central bank credibility and leaves them without policy tools if an actual recession hits. Williamson writes that a:

"permazero" [inflation rate] damages the hard-won credibility of central banks if they claim to be able to produce 2 percent inflation consistently, yet fail to do so. As well, a central bank stuck in a low-inflation policy trap with a zero nominal interest rate has no tools to use, other than unconventional ones, if a recession unfolds. In such circumstances, a central bank that is concerned with stabilization-in the case of the Fed, concerned with fulfilling its "maximum employment" mandate-cannot cut interest rates.

With St. Louis Fed chair Bullard increasingly on board with interest rate hikes as a way of normalizing the economy and potentially even getting inflation back to the target, we have to start to speculate whether the Fed will end ZIRP and reverse the unceasing chase into yield.

Bonds: Maybe Not The Big Short Yet, But It's Coming

There's been an increasing consensus lately that US long-duration bonds (NYSEARCA:TLT) have entered a permanent new state of high valuations.

Interest rates will never be allowed to rise again, it is argued, for various reasons. Governments couldn't afford higher rates, souring demographics discourage higher rates, and that changing banking regulations have created a permanent bid under the bond market since they are the main "risk-free" asset in bank risk models, among others.

As Credit Bubble Stocks astutely noted, often the biggest financial blow-ups occur in "risk-free" assets. When something is literally deemed too safe to concern yourself with, there's a good chance things could go wrong.

And there's no doubt how developed countries intend to fund their entitlement gaps in coming decades. They're going to serve up a massive amount of new debt to a shrinking pool of working age people as the buyers. According to currently popular economic theories, this is great, since the supply of government debt is insufficient to meet demand.

I'd suggest those economists, whose theories have generally worked poorly since 2008 in either diagnosing the economic malaise or resolving it, may be proven wrong again.

When you start seeing headlines like "shortage of government bonds" you have to start considering that a top could be getting close. Remember how well the "peak oil" shortage trade worked out for believers subsequently to 2008?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.