Thursday, 24 January 2013

A Night of Reflection, Ranting and Writing - Bye Bye Bond Market

I read an article today that inspired me to write a little opinion piece in regards to the bond markets and how they interact with interest rates. Perhaps this will enlighten some of those who don't fully understand the concept of bond purchases to keep interest rates lower. What of the correlation between bond yields and interest rates? Read on to find out...

DISCLAIMER: These are my opinions and should not be interpreted as investment advice. Do your own research if you're intrigued by what you read, and make your own informed decision.

Yields on bonds rise when people flock out of bonds as an investment. To cover the yields, the Fed is forced to raise interest rates. The inverse is true to keep interest rates low - more bond buying equates to lower interest rates because the interest required to pay out the low yields is far less.

In the event of a bond market collapse, this effect is exacerbated. Yields go sky-high, and the Fed must increase interest rates in order to keep money flowing in to cover the bond yields. This rise in interest rates would lead to a hyperinflationary effect.

The reason for this is that, as interest rates rise, so, too, do the prices of assets and the overall cost of goods. In order for businesses and the average investor to cover their interest payments, they must increase their margins. As such, the macro-economic effect would be greater inflation - what is known as "hyperinflation" in economist jargon.

The reason we aren't currently seeing the hyperinflation is because it is showing up in the bond market. This is due to open market operations - more commonly referred to as "Quantitative Easing" - taken on by the Federal Reserve. They are doing large-scale asset purchases of toxic securities and bonds to the tune of $100 billion per month.

What's scary is that we are roughly 40 basis points away from a flood of toxic derivatives flooding the markets. The levees of ZIRP (Zero Interest Rate Policy) are at capacity, and they're breaking at an accelerating rate.

To put it in more simplistic terms, we are hanging on by 40 basis points - 0.4%. What this means is that if we see a decline in the value of the underlying asset base of companies and investors holding these unrealized, off-balance sheet securities (see "contingent liabilities" for a better understanding of this), the crash and credit freeze of 2008/2009 will look like a splash in the rapids that will engulf the global economy in the coming months and years.

Rising interest rates and the resulting hyperinflation would make insolvent many major "market makers", nevermind the millions of lowly investors and depositors who will be devastated along the way. This would most certainly break the 0.4% threshold as asset values would tank while seeing a simultaneous spike in the value of goods and services.

In 2008 the government stepped in to bail out the banks. That is no longer an option. Governments have no money left to bail out the system. They can't even get their own debt levels (16.4 trillion and growing) and rampant spending ($1.2 trillion deficit spending per year minimum) under control, let alone being able to inject capital into fatally-leveraged banks. JP Morgan Chase has roughly $90 trillion in liabilities - 6 times the GDP of the United States, and 642 times their $140 billion book value. I'll let that sink in...

To hold government bonds at this point seems almost masochistic. Naturally, people look towards equities as an alternative - and an alluring one at that. Markets are riding around levels seen pre-2008, just prior to the shitstorm that was Lehman Brothers and the catastrophic domino effect that rippled across the globe. Indeed, markets are pushing towards all-time highs again. The bubble has re-inflated.

The problem is that markets propped up by massive manipulation and fraud tend not to stay aloft. Sooner or later, the shadows swallow the light, the bubble pops, and everyone is left scratching their heads and scrounging for pennies. Keep in mind, I haven't even touched on unfunded pension liabilities (trillions of dollars), medicare/obamacare and medicaid (trillions more still), or the $1.3 trillion - and growing - student debt bubble.

For some perspective, the sub-prime mortgage crisis tipped over at $1.3 trillion. So, the student debt bubble alone will dwarf that - nevermind an apocalyptic bond collapse of almost biblical proportions. Certainly, it will be something the likes of which we've never seen in humankind's history.

For these reasons, among many other more positive ones, the real, intrinsic value of gold and silver are the only things I would bet my money on. Are there other options? Sure. Are they as risk-free as precious metals long-term? Absolutely not. I'll save the gold and silver spiel for another day, but I encourage you to do the research on your own. Don't take my word for it. Compile the data, weigh the odds, and choose what your gut and your heart tell you. Your brain will follow suit. It is so, after all, in the natural progression of things.

Next up I'd like to write something on why a bond market collapse spells the death of the US petro-dollar as the global reserve currency - and why China is poised to dominate with a gold backed yuan. Stay tuned for that, coming soon.

To close, I'll leave you with this these thoughts:

  • India increased its import tax on gold ores and dore bars from 2% to 5% - 2.5 times - in order to curb the pressing demand for the yellow metal
  • Russia imported 958 metric tonnes of gold in 2012. As of January 1, 2012, they had only 883 tonnes in reserves.
  • The largest silver ETF in the world added $600 million worth of silver to its assets-under-management tally - the biggest addition ever
And lastly, the kicker:

The assets of most central banks in the world are the paper currencies of other central banks (mostly US dollars). Eventually, they could simply start trading that paper for gold and other valuable commodities.

Original article that inspired this: Bond-to-Stock Shift Provokes Performance Anxiety: Credit Markets

No comments:

Post a Comment