Sunday, October 22, 2017

The Coming Bond Market Collapse

Savvy investors have been crying wolf for so long that one is tempted to ignore their warnings. Whereas Robert Rubin once told Bill Clinton that he could not just do as he pleased, because he had to answer to the bond market, today’s politicians do not seem to have the same worry. 

Apparently, central bankers have taken charge of the bond market… which means that the market is effectively being rigged… in order to keep interest rates low, to keep mortgage rates low, to keep real estate prices high and to flood the system with money that moves the stock market higher and higher. The bond market has, in its terms, mispriced risk.

Of course, it does not make a great deal of sense to speak of an advanced free market economy when the biggest market of them all, the bond market, is rigged.

As you know, I am not even close to being able to explain it all. William Cohan offers some seemingly sage advice in Vanity Fair. I pass it along for your edification.

He begins by emphasizing the importance of the bond market.

The stock markets get most of the attention from the media, but the bond market, four times the size of the stock market, helps set the price of money. The bond market determines how much you pay to borrow money to buy a home, a car, or when you use your credit cards.

What does a rigged market look like? Cohan explains:

… the yield on European “junk” bonds is about the same—between 2 percent and 3 percent—as the yield on U.S. Treasuries, even though the risk profile of the two could not be more different. He correctly pointed out that this phenomenon has been caused by “manipulated behavior”—his code for the European Central Bank’s version of the so-called “quantitative easing” program that Ben Bernanke, the former chairman of the Federal Reserve, initiated in 2008 and that Mario Draghi, the head of the E.C.B., has taken to heart.

Bernanke’s idea was to have the Federal Reserve buy up trillions of dollars of bonds, increasing their price and lowering their yields. He figured lower interest rates would help jump-start an economy in recession. Whereas Janet Yellen, Bernanke’s successor, ended the Fed’s Q.E. program in 2014, Draghi’s version of it is still going, which has led to the “manipulation” that so concerns Gundlach. European interest rates “should be much higher than they are today,” he said, “. . . [and] once Draghi realizes this, the order of the financial system will be turned upside down and it won’t be a good thing. It will mean the liquidity that has been pumping up the markets will be drying up in 2018 . . . Things go down. We’ve been in an artificially inflated market for stocks and bonds largely around the world.”

The Gundlach in question is first named Jeffrey. He manages so much money invested bonds that people around Wall Street call him the Bond King.

Cohan ends on a sober note. Forewarned is forearmed:

But the major propellants of the stock market these days are the economy Trump inherited, the tax cuts that may turn out to be a chimera, and an overinflated bond market that misprices risk every day. When it all comes crashing down, will Trump take credit for that too?

To which we are tempted to ask whether Barack Obama really deserves credit for an economic recovery that was engineered by the Federal Reserve. Unless, of course, you want to credit him for having set up policies that made that recovery the most anemic in recent history. As I often noted during the Obama administration, he looked to me like an "apres moi le deluge" president.


Ares Olympus said...

Stuart: To which we are tempted to ask whether Barack Obama really deserves credit for an economic recovery that was engineered by the Federal Reserve.

Agreed, at least whatever credit we give to the Obama recovery should consider the national debt that increased from $10.5 trillion when he took office to nearly $20 trillion when he left office, or over $1 trillion deficit average per year. And all this new debt has been financed by record low interest rates, but treasury notes that sell debt will eventually mature, and the government will have to raise interest rates sufficiently to encourage people to stay invested, which risks blowing up the budget where we'll no longer be able to afford government services and interest payments. So that's all in our future.

OTOH, Trump recently took credit for $5 trillion in stock market rises since he took office, and apparently we can continue 20% private annual returns going by letting the rich keep more of their money so they;ll invest more back into the markets and raise asset values even more. And when we return to $1 trillion+ deficits as the new normal, its no matter, since assets keep going up.

At least that argument seemed true for the Bush years as people kept paying off their credit cards by borrowing more money from their appreciating house values. But we know how that ended. The problem with debt is it doesn't disappear along with your falling asset values, it just puts you underwater and forces you to sell when everyone else is selling.

My little school district has a vote in November for a $16 million referendum for school infrastructure improvements, and the loudest voices so far are saying no, and there are fewer families now with kids than in the past, so there's a good chance it'll fail. Part of the argument for doing this now is interest rates are still low, and I understand that argument. 30-year bonds at 2.8% seem hard to pass up, for borrowers at least, while its still hard to imagine inflation will stay low enough for investors to be happy.

Everyone predicts inflation, but I suppose we have to remember its like bankruptcy coming slowly, and then all at once. In the meanwhile, there are tax cuts for the rich to be had, and circuses for the people.

sestamibi said...

Ares gets part of it right. The full inconvenient truth is that Obama's pipe dreams ramped up the national debt to over $20 trillion, so it is in the government's interest to keep interest rates at rock-bottom levels. Remember that at 5%, the interest on that debt would be $1 trillion a year, and if it is not paid on time, then it is added to the debt and the following year's interest even greater.

Needless to say, this is unsustainable. As it is said, something that can't go on forever, won't, promises that can't be kept won't be, and debt that can't be repaid won't be either.

Sam L. said...

"Apres moi, le deluge"; Obama got out just in time, did he not?

Illuninati said...

Interesting article, but the main concern seems to be European bonds since the USA has already reversed course.

If the Feds really did have the ability to influence the stock market as much as the article claims, Trump should be facing a headwind as the Fed unwinds its positions. Also the article fails to note that Trump has greatly improved the business climate by lessening the regulations which have held back businesses. The tax reform depends on Congress and may well fizzle out and that would greatly hurt the market.