Cato Journal: "Was the Fed a Good Idea?" & The Eventual Sovereign Debt Crisis

Some highlights from pieces in the Summer 2014 Cato Journal issue, Was the Fed a Good Idea? The first is a piece by Kevin Dowd and Martin Hutchinson, How Should Financial Markets Be Regulated? [pdf]:

Speaking to the UK Parliament's Treasury Select Committee in June 2013, [Andy Haldane] said that the "biggest risk to global financial stability right now" is that posed by inflated government bond markets across the world. He then told astonished British MPs: "Let's be clear... We have intentionally blown the biggest government bond bubble in history."

The same could be said for the policies pursued by the Federal Reserve: the financial system wouldn't be so unstable if the Fed hadn't tried so hard to stabilize it. The Fed's response to the bubbles it has created is to blow even harder and hope for the best. The Fed has got itself into a corner and has no credible strategy to get itself out. We know that the latest bubbles must burst at some point and when they do interest rates are likely to rise sharply as bond market investors attempt to dump their holdings. When that happens the financial system will collapse, again. The temptation will then be to prop up bond prices by monetizing what could well be the entire government debt, at which point the Federal Reserve's balance sheet would explode from $4 trillion to $16 trillion or more almost overnight and inflation will be off to the races. [...]

Zero-Risk Weighting of Sovereign Bonds.
In the original Basel Accord, or Basel I, the debt of OECD governments was assigned a zero risk weight. This implies that all such debt, including Greek government debt, was assumed to be riskless. Its effect was to artificially encourage banks to hold higher levels of government debt than they otherwise would, and was a major contributor to recent EU banking problems. When the Eurozone sovereign debt crisis escalated a couple of years ago, many banks then suffered major and otherwise avoidable losses on their holdings of government debt. This rule has been repeatedly criticized, but is still on the books.

And then a piece by John A. Allison (former CEO of BB&T), Market Discipline Beats Regulatory Discipline [pdf]:

On a related point, there has been a massive failure of mathematical modeling (see Dowd et al. 2011, Dowd and Hutchinson 2013). The Fed’s models failed, and all the large financial institutions that failed were experts at mathematical models. We were told by regulators multiple times that BB&T ought to have models like Wachovia, Citigroup, and Bank of America, all of which had major problems during the correction. Mathematical modeling was forced on the banks and then the banks lulled themselves to sleep believing their models were properly assessing risk, which justified taking excessive risk. What is really ironic is that the Federal Reserve is now forcing all large financial institutions to manage by mathematical models, which will ultimately create significant risk in the financial system.

Modeling can be used as a background tool for managing risk, but overreliance on models leads to dangerous decisions. One of the major problems is that mathematical risk models always assume normal distributions, which have small tails—because if they had "fat" tails no one would pay any attention to the models. Of course, what happens is the tails (the unexpected, extraordinary events) are always bigger than predicted by a normal distribution, and tails are the only events that matter. However, the biggest issue is that mathematical models delude managers into believing they are managing risk and they become overconfident. This overconfidence creates a massive incentive to take too much risk because your models indicate you can manage the risk. Of course, in the long term, if managers take on too much risk, they eventually will pay the price. The Fed now is forcing all large financial institutions to use the same mathematical models, which means all banks are going to make the same mistakes. This same type of approach led to excessive risk taking in the subprime lending business. The concentration of risk created by regulatory mathematical modeling significantly increases the overall financial system’s risk.

As we have been observing over the two years or so, the mistake that this has led to is a consensus to be long Treasuries in the belly of the curve (5-15 year); including banks piling into these Treasury tenors to the tune of several multiples of their equity. Some recent highlights to refresh your memory:

• "[T]he US has a very short maturity structure, so higher interest rates turn into higher debt service quickly. We live on the edge of a run on sovereign debt. The US has a shorter maturity structure than most other countries, and a greater problem of unresolved entitlements. Despite our 'reserve currency' status, we may actually be more vulnerable than the rest of the high-debt, large entitlement western world." [April 2017]
• Ultimately, debt implies a future transfer of purchasing power, and provides only a few choices. Either you raise adequate tax revenue, or you denominate the debt in long-term bonds and devalue them through inflation, or you default, or you violate the social contract made with those who don't hold paper claims (e.g. Social Security beneficiaries) in preference for those who do. Had the borrowing resulted in productive investment, future output would be easily available to meet those claims. Instead, what’s going on is a quiet dilution of future living standards. [December 2016]
• [Y]ou're looking at the endgame of a Ponzi scheme that ended when it caused the total fertility rate, and thus - eventually - the worker retiree ratio, to drop too much. To put in a different perspective, the total equity value of the S&P 500 companies is less than $20 trillion. Imagine the federal government exhausting that much capital in ten years. I don't know when it will happen, but I think the bond market will choke. Occasional spikes in bond yields will be the signal that no more can be borrowed. [December 2016]
• The 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 week has illustrated my point. The election of Trump led to an immediate 25 bp increase in the 10 year bond yield, which means an instant 2.3% loss in value. More than a year's worth of interest. [November 2016]
• There could be a period when stocks and bonds go down together. For example, instead of stock declines -> people wanting the security of bonds, people might decide that stock declines lead to bailouts which are really stealth currency devaluations, and decide they want no part of the long end of the yield curve. It is very, very nonlinear, because once bonds lose momentum, who will want to own them? Professional asset management and retail investor sentiment are both all about momentum. And every credit - government or corporate - looks much worse with rising interest expense. I think we will come to realize that a lot of stuff in the economy (junk bonds, private equity) was part of a virtuous interest rate cycle. If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. [May 2016]
• We can see with Trump's tax plan (implausible tax cuts and no specific expenditure cuts) that the personalities no longer really matter to the ultimate outcome: sovereign debt crisis, inability to debt finance expenditure, followed by loss of legitimacy of government. [September 2015]
• Having $3 trillion of assets under management puts you in the top handful of asset management firms. Owning $1 trillion of treasury debt (like China or Japan) makes you one of the largest holders. Who, then, is going to be buying the $3 trillion a year that federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls? [June 2015]
• For the counterargument that the Fed will just buy bonds to "keep rates low", you have to face the fact that QE invariably caused rates to rise, and you could (and we did) make money buying bonds every time the Fed stopped buying them. As I kept trying to explain, the QE bond purchases may have been respectably large in relation to the flow of debt issuance, but they were puny in relation to the stock of $60T of dollar denominated debt. It freaked creditors out about inflation more than it helped. [May 2015]
• The legitimate purpose of public debt is to borrow money to build infrastructure improvements that have a positive net present value. However, a vast portion of federal expenditure now leaves nothing tangible, leaves no collateral. A treasury bond is a certificate that money has successfully been expended on section 8 housing, or on make-work military "jobs". The lack of collateral makes these treasuries creatures of social mood. In a way, they are as valuable as tulip bulbs or south sea shares. What is a treasury going to yield when mood darkens, and a distressed investor who looks over the enterprise for scrap value is the marginal buyer? [February 2015]

This blog was bullish on Treasuries as far back as 2010, when the "marketable" federal government debt (consisting of securities that traded and excluding intragovernmental holdings) was $8.1 trillion. In March 2017 it is now $14 trillion. Yet the 10 year yield has fallen from 3.3% to 2.3% even as debt/GDP has grown from 53% to 74%.

As the fundamentals of owning government debt have gotten worse, the prospective gain (yield) from owning has fallen! We can see that the federal government deficit is on the order of a trillion dollars per year, since there has been a $6.7 trillion increase in the marketable debt in just under seven years.

Someday when the economy experiences another recession, the debt to GDP ratio will climb faster than it has during this expansion, since three factors will be working to accelerate it: GDP will fall during a recession, lowering the denominator; and debt will increase because tax revenue will fall while at the same time transfer payments will increase.

Meanwhile, despite the booming economy the government debt keeps growing because the federal government runs an enormous deficit. It is politically imperative for whatever party is in power to borrow at low interest rates and maintain spending rather than try to balance the budget. Otherwise that party would be displaced by a different coalition willing to borrow on behalf of its voters. Trump has consistently said that he would grow the national debt, and his ideal budget consists of tax cuts, substantially more spending on defense and infrastructure, and no cuts to entitlement programs. The big drivers of the federal government deficit and therefore the increasing federal debt are the entitlement programs: Social Security, Medicare, and Medicaid. Defense spending is of course enormous but unlike the entitlement spending it does not scale with the growing aged population.

The Congressional Budget Office just predicted that the federal debt will grow by another $10 trillion dollars over the next decade (optimistically projecting the same rate of increase of one trillion dollars per year) to reach $25 trillion by the end of 2027. When George W. Bush took office, the debt was only $3.4 trillion and now the government needs to borrow that much money every two to three years.

It is easy to lose sight of how much wealth these sums represent. There are only about 100 million federal income tax payers in the United States. The current marketable debt is $140,000 per taxpayer and is projected by the CBO to be $250,000 per taxpayer in 10 years. The total equity value of the S&P 500 companies combined is just over $20 trillion. By the CBO's projections, the federal government will need to borrow that much additional capital in under twenty years.

The biggest asset managers like Vanguard and Fidelity each have a few trillion dollars under management. The biggest foreign buyers of treasuries like China or Japan each own about one trillion dollars of U.S. government debt, giving them a certain amount of political leverage. The assets of all the commercial banks in the United States total only $16 trillion dollars. So who is big enough to step up and buy all this government debt year in and year out?

The alternative to borrowing is to get expenses back below revenues. Some think that there are hard limits, like the Laffer curve, to the percentage of GDP that a government can collect, although quite possibly it could collect more than it does now. If so, taxes will be higher, not lower, and disposable incomes and corporate profits will decline. Significant cuts to expenses seem politically infeasible since the largest expenses are these entitlement programs, not discretionary expenses. However, it does not seem as though any serious effort to balance the budget will be made unless and until the bond market, through higher interest rates, forces the issue.

The bond market is often the smartest market and can anticipate an individual company or macroeconomy's fate earlier than equity market investors can.

Note that the 10 year and 30 year bonds have never come close to recovering from the election of Trump.

Perhaps the election of Trump will be end up being totally inconsequential as a historical event, except to inaugurate a new bear market in bonds?

The Coming Bond Bear Market: Will "Inflating our troubles away?" Work?

At The Grumpy Economist:

I think our most immediate danger is a rise in interest rates. If the real rates r charged to our government rise, say, to 5%, then the service on a 100% debt/GDP ratio rises to 5% of GDP, or $1 Trillion dollars. Now, debt service really does matter, and our outstanding stock of debt really does pose a surplus problem.

There are two mechanisms that might raise interest rates. "Not so bad" interest rate rises come as a natural consequence of growth. Higher per capita growth times the intertemporal substitution elasticity equals higher interest rate. If the elasticity is one, the interest rate rise "just" offsets the benefits of higher growth.

Conversely, low real interest rates can buffer the impact of lower growth. γ above one and r thus falling more than g may be a reason why our current slow growth comes with rising values of government debt.

"Really bad" interest rate rises come without growth, from a rising credit spread -- the Greek scenario. If markets decide that the entitlements are not going to be reformed, cannot be taxed away or grown out of, they will start to charge higher rates. Higher rates explode debt service, make market more nervous, and so forth until the inevitable inflation or default hits. In present value terms, higher r can quickly make the present values on the right implode. This sort of roll-over risk, interest rate risk, or run has been the subject of at least half the papers in this conference.

Here, I find the most important implication of this paper's calculations. The paper shows that the US has a very short maturity structure, so higher interest rates turn into higher debt service quickly. The paper shows that a large slow inflation results in a small change in the present value of surpluses. It follows, inexorably, that if a small change in the in the present value of surpluses has to be met by inflationary devaluation, that inflation must be large, and sharp. If x is small, 1/x is large.

We live on the edge of a run on sovereign debt. The US has a shorter maturity structure than most other countries, and a greater problem of unresolved entitlements. Despite our "reserve currency" status, we may actually be more vulnerable than the rest of the high-debt, large entitlement western world. That, I think, is the big takeaway from this paper -- and this conference.

Hussman on the Government Debt Bubble

This week's essay:

Sure, you can devalue those claims through inflation, but only if the debt is in the form of long-maturity bonds (which is why the recent discussion of issuing 50-100 year Treasury bonds seems understandable but also a bit nefarious). At shorter maturities, inflation just raises the interest rate that the government has to pay when the shorter-term debt is rolled over. Though the weighted-average maturity of Treasury debt is currently longer than normal, the average is still only 5.8 years, and half of the debt will have to be rolled over by 2019, at whatever interest rates emerge in the interim. Ultimately, debt implies a future transfer of purchasing power, and provides only a few choices. Either you raise adequate tax revenue, or you denominate the debt in long-term bonds and devalue them through inflation, or you default, or you violate the social contract made with those who don't hold paper claims (e.g. Social Security beneficiaries) in preference for those who do.

Had the borrowing resulted in productive investment, future output would be easily available to meet those claims. Instead, what’s going on is a quiet dilution of future living standards. That’s only going to be reversed by thoughtful policies, focused more on long-term productivity than near-term gains. Even massive debt-financed spending will not help unless the projects are intentionally designed to durably enhance the long-term productivity of the U.S. economy, to avoid duplicative capacity, and to relieve constraints that threaten to become binding in the future (personally, I remain convinced that renewable energy should be central to that list).

I've written that "a treasury bond is a certificate that money has successfully been expended on section 8 housing, or on make-work military 'jobs'."

Also, Hussman understands that another piece of the problem was the falling worker/retiree ratio.

"Granola Shotgun" and the Eventual U.S. Sovereign Debt Crisis

Some highlights from "Granola Shotgun", I think the entire blog is worth reading.

• As I went through life I watched as another boom and bust cycle played out with the crash of October 1997 and then again in the crash of September 2008. The interesting thing to me is the way different generations interpreted these events. The older folks never adjusted their penny pinching when times were good. They reflexively saved against lean times regardless of the current abundance. Boomers never learned to restrain their enthusiasm no matter how often they screwed up. They held firm to their buy-now-pay-later ethos decade after decade. A dog doesn’t change its spots. -"The Lost World of the Solvent American"
• The solution is always the same – work harder, earn more money, wait longer, take on more debt, buy something that someone else built, and feed the existing system regardless of how inefficient or pointless it might all be. - "Building Codes and the Self Built Mortgage Free Home"

He has a number of examples of how crushing regulatory burdens - at the county level - make it very difficult to build small, efficient commercial or residential properties. [See: 1, 2, 3, 4, 5 for examples.]

I've been looking quite a bit at the projected budget deficits over the coming two decades that will be caused by Social Security, Medicare, Medicaid and state pension obligations. State pensions are massively underfunded - to the tune of several trillions of dollars. Social security and Medicare represent liabilities of tens of trillions.

The federal budget deficit is now over a trillion dollars per year. Using accounting tricks, the government claims it's less than that, but look at the amount that the public debt grows every year. The increase in debt = expenses less revenue = true deficit. Simple check: the federal debt grew by $10 trillion in Obama's eight years. I think we can count on $1 trillion as the baseline going forward.

Using the government's own projections, Medicare will cause the deficit to increase by another $500 billion annually by 2026, Social Security will have the deficit increasing by a bit less but still several hundred billion, and Medicaid an extra couple hundred billion. (This assumes, of course, other federal expenditures and revenues held constant.) The total increase is a trillion dollars per year, which means eventually $2 trillion annual deficits for the federal government.

The current plan is just to borrow this. But these are enormous amounts of money. To put it in an individual perspective, there are fewer than 100 million federal income tax payers in the U.S. The current public debt of $19 trillion is $190,000 per taxpayer. Outspending revenue by $2 trillion annually is $20,000 per taxpayer.

If this sounds crazy, it is because you're looking at the endgame of a Ponzi scheme that ended when it caused the total fertility rate, and thus - eventually - the worker retiree ratio, to drop too much.

To put in a different perspective, the total equity value of the S&P 500 companies is less than $20 trillion. Imagine the federal government exhausting that much capital in ten years. I don't know when it will happen, but I think the bond market will choke. Occasional spikes in bond yields will be the signal that no more can be borrowed. (Ask James Carville.)

The alternative to borrowing is to get expenses back below revenues. There seem to be hard limits to the percentage of GDP that a government can collect (Laffer curve), although I'm sure it could collect more than it does now. If so, corporate taxes will be higher, not lower, and corporate profits will decline. Disposable income will fall significantly when income taxes rise. (Think: luxury cars, Starbucks, Amazon, Apple, cable TV bills, restaurants and breweries.)

In terms of cutting expenses, the federal government's largest expenses are these retirement Ponzi schemes. (And why would any baby boomer continue to support the federal government if these promises are not paid?) The only other expense that comes close is the military.

Interestingly, only a third of the military budget is for personnel. You could save maybe $200 billion a year if you stopped all materiel purchases and brought them back to bases in the U.S. to do pushups all day. If you want to get really clever, retrain them to do infrastructure repair of roads, bridges, water, sewer - another multi-trillion dollar can that has been kicked down the road and I am not even going to talk about in this post.

These cuts and tax increases are going to be very painful. I would imagine they will be the only political topic under discussion. No more neocon wars, no more gay marriage disputes. I would not bet on selling a new jet fighter or a 1,000 ship Navy. The Ponzi scheme disputes will have a racial identity politics dynamic because the older Ponzi participants are much whiter than the working age population.

Thus, my overall impression is that the U.S. is less rich than people currently believe or people's behavior currently implies. Stocks aren't worth their current multiple of earnings at peak profit margins; bonds shouldn't be yielding so little given that there is a recipe for a sovereign debt crisis. People's thinking right now is clearly delusional: Uber apparently subsidizes rides to the tune of 60% of the fare, so logically it is not worth the ~$100 billion that people think.

And in a period of rising property taxes, income taxes, and interest rates, people are going to find out that residential housing is not an investment. Depending on state law, it may be possible for retired municipal employees to expropriate significant amounts of home equity to maintain their pensions.

What do people say to this? I find that the rebuttal is that the Fed will print money and buy the government bonds to fund the deficit. That is what is going to look really delusional in the history books!

I realize that people have been talking about this for decades. I guess the mistake then was thinking that this would matter as long as interest rates were still falling. But I think it will be a mistake to assume it will never matter.

Finally, note the scary conclusion from the Granola Shotgun blog is that, at least at first, people are not going to be allowed (allow each other, really) to do a lot of the belt-tightening that will be needed to cope with the loss of illusory wealth. Can't build a little accessory dwelling in the backyard for your parents to live in.

Repost: "Not Bullish On Bonds"

Key points from bearish bonds post in May 2016:

• Trump essentially says that he would grow the national debt - he's a developer and he loves low interest rates!
• It is very, very nonlinear, because once bonds lose momentum, who will want to own them? Professional asset management and retail investor sentiment are both all about momentum. 
• Every credit - government or corporate - looks much worse with rising interest expense.
• We will come to realize that a lot of stuff in the economy (junk bonds, private equity) was part of a virtuous interest rate cycle.
• QE invariably caused rates to rise, and you could (and we did) make money buying bonds every time the Fed stopped buying them. The QE bond purchases may have been respectably large in relation to the flow of debt issuance, but they were puny in relation to the stock of $60T of dollar denominated debt. It freaked creditors out about inflation.
• The 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 week has illustrated my point. The election of Trump led to an immediate 25 bp increase in the 10 year bond yield, which means an instant 2.3% loss in value. More than a year's worth of interest.

How to Tell the Top in Bonds Is Getting Close!

When you see articles like this: "The Looming Shortage in Government Bonds".

That is toppy thinking. In fact, anytime you hear "shortage" you should beware of a price reversal coming. Shortage of natural gas, shortage of oil.

In the U.S. we have an debtor that has borrowed close to 100% of GDP already and planning to borrow a lot more to cover ponzi retirement and healthcare promises. The federal government is like an insolvent insurance company and if it didn't have nuclear weapons it would be in receivership alreadu.

Believe me, there isn't going to be a "shortage" of government empty promises.

Which Option Sounds Better?

• Silver puts. Marginal cost and all-in cost are around $10 plus or minus a couple bucks, and the spot price is back to almost $20 with speculators record long futures and commercials very short. A 2018 $13 put can be had for under 50 cents, make 5x if the price goes back to $10.
• 30-year treasury puts. Fiat debt from banana republics is garbage, not a "magic sword of necessity" - the yield was twice as high as recently as the end of 2014. That would be $95 on TLT, a decline in value of about a third. The Jan 2018 $100 put for TLT is about 80 cents.

High Plateau Drifter on the Government Bond Bubble

CP and I often discuss the problem of timing the top in the bond market. The bond market is the big kahuna. It is the one market that is so huge that governments will not be able to control it once it starts heading south. At the moment, and as long as the government can issue bonds and have the Fed purchase them, it will have ample funds to keep the S&P 500 elevated and counteract the steady selling by individual investors:

"According to Lipper data, U.S.-based stock mutual funds, which are held by retail mom-and-pop investors, posted cash withdrawals of $2.8 billion over the weekly period ended Wednesday; this was the 16th consecutive week of outflows.

All stock funds, including ETFs, posted an even wider $6.8 billion outflow last week to mark their biggest withdrawals since early May, while taxable bond funds posted $2.6 billion in outflows after raking in $2.5 billion the prior week. The perpetual question of who is buying remains especially after BofA reported earlier this week that its "smart money" clients sold US stocks for the third consecutive week and in 21 of the past 22 weeks, led by institutional clients' sales."

Baby boomers, who own directly and indirectly about 75-80% of the U.S. stock market have begun selling and will continue to sell to maintain their life styles. Fed governors and employees are academics. They are not multi millionaires. They and everyone they know in their social circles have university sponsored TIAA and CREF accounts and pensions funded by future stock market gains. So naturally, the primary real policy of the Fed is to keep the stock market elevated. Their worst nightmare is a clear inevitability - that at some point the boomers are going to panic and sell everything attempting to get out before the rush.

The big question then is what happens to bonds?

Right now the Fed is creating new money to buy treasury debt which finances the ongoing fiscal deficit. At the same time, corporations are issuing record amounts of new debt to finance share buy backs. In the Euro zone Draghi is buying corporate debt as well as European sovereign debt, most of which has no coupon and much that is in NIRP. Of course to the extent that the Fed purchases government debt with a positive coupon, the remittance of the coupon amounts back to treasury eliminates the interest cost on Treasury debt parked at the Fed. The positive coupon is the cheese that lures pension funds and insurers to take down slices of this thus far appreciating debt.

The reason I write this now is that the gold and silver markets are screaming that the end is near for bonds. The question is, how near?

I think everyone in the markets understands that the debt "purchased" with newly created money and held by central banks will never be sold into public markets and purchased by private investors. It is a translucent fig leaf to cover naked money printing. Printing that must continue for as long as governments continue deficit spending. After all, halting central bank purchases and offering all this sovereign debt to private purchasers would produce a dramatic hike in interest rates.

We can see that gold and silver now "get it." How long before pension funds, insurers and other balanced portfolios begin to listen to the gold and silver markets and begin to demand higher yields to compensate for the risks of higher inflation.

I don't have the answer, but I am watching for clues. I would be interested to know what you readers think.

Watching Bond Yields

The 10 year and 30 year are close to retesting their all time low yields.

Not Bullish On Bonds

Last summer I noticed that the possible bond bear market was three years old. Now we might be four years into it!





Not saying that it's going to happen, but it's going to upset a lot of people's plans if SPX starts falling and bond yields start rising.

People are used to an overall falling interest rate trend (since Sept 1981!), which has been a tailwind for asset values, but they are also used to a shorter term inverse correlation where people flee equities for the safety of bonds.

That's the principle that 60/40 asset allocation is based on - if you own stocks and bonds, at least one will always be "working".

But remember Charles Dow Looks at the Long Wave: that pattern that asset allocation is based on has existed because we've been in the long period in between the peak in interest rates and the peak in stock prices, as Charles Kirkpatrick explained:

"The period after interest rates peak is when stock prices rise as an alternative investment. During that period declining interest rates force yield-conscious investors into alternative investments of lesser quality in order to maintain yield. Since stocks are the most risky and least quality investments, they become the final alternative, especially when their price continues to appreciate as a result of increasing cash flow into the stock market. [positive feedback loop] The recent conversion of government-guaranteed CD deposits into stock mutual funds is typical during this period. Unfortunately, it eventually leads to the declining long wave in stock prices."

There could be a period when stocks and bonds go down together. For example, instead of stock declines -> people wanting the security of bonds, people might decide that stock declines lead to bailouts which are really stealth currency devaluations, and decide they want no part of the long end of the yield curve.

Remember, all of the federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls. They think it will be no big deal thanks to low interest rates. In the most recent Fortune, Trump essentially says that he would grow the national debt - he's a developer and he loves low interest rates!

I've said that the federal public debt was only $6 trillion when Bush left office, and there's easy ballpark math that says that within a decade, the public sector will need to borrow that much every year.

The other scary thing for bonds is the effect that interest rate increases have on this system, because it contains so many feedback loops. The pension assets become worth a lot less, the interest expenditures rise (and they are borrowing to pay the interest since there is no debt service), so the credit quality (such as it is) deteriorates.

Also, corporate pensions have the same problem and an interesting feedback loop of their own. To the extent that their pension funds lose money, earnings will take a hit. As we know from Grantham, when earnings fall multiples fall too.

It is very, very nonlinear, because once bonds lose momentum, who will want to own them? Professional asset management and retail investor sentiment are both all about momentum. And every credit - government or corporate - looks much worse with rising interest expense. I think we will come to realize that a lot of stuff in the economy (junk bonds, private equity) was part of a virtuous interest rate cycle.

For the counterargument that the Fed will just buy bonds to "keep rates low", you have to face the fact that QE invariably caused rates to rise, and you could (and we did) make money buying bonds every time the Fed stopped buying them. As I kept trying to explain, the QE bond purchases may have been respectably large in relation to the flow of debt issuance, but they were puny in relation to the stock of $60T of dollar denominated debt. It freaked creditors out about inflation more than it helped.

The legitimate purpose of public debt is to borrow money to build infrastructure improvements that have a positive net present value. However, a vast portion of federal expenditure now leaves nothing tangible, leaves no collateral. A treasury bond is a certificate that money has successfully been expended on section 8 housing, or on make-work military "jobs".

The lack of collateral makes these treasuries creatures of social mood. They are no more valuable than tulip bulbs or south sea shares. That makes them vulnerable to going down with stocks when social mood becomes more pessimistic.

If you synthesize the best parts of Falkenstein and Redleaf, you predict that the 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.

Krugman has spent years poking at the "invisible" bond bear. The problem is that years of success at borrowing for consumption (not investment) without any noticeable effect on interest rates made the Keynesians in government complacent and cocky.

P.S. For Buffett fans: he didn't become a billionaire until 1986, five years after rates peaked. 99% of his net worth was made during the declining interest rate trend.

Don't Forget the Donativum

From Wikipedia - remember that Pertinax was Roman Emperor for three months in AD 193, after the assassination of Commodus at age 31.

Ancient writers detail how the Praetorian Guard expected a generous donativum on his ascension, and when they were disappointed, agitated until he produced the money, selling off Commodus' property, including the concubines and youths Commodus kept for his sexual pleasures. He reformed the Roman currency dramatically, increasing the silver purity of the denarius from 74% to 87% — the actual silver weight increasing from 2.22 grams to 2.75 grams. This currency reform did not survive his death.

Pertinax attempted to impose stricter military discipline upon the pampered Praetorians. In early March he narrowly averted one conspiracy by a group to replace him with the consul Quintus Sosius Falco while he was in Ostia inspecting the arrangements for grain shipments. The plot was betrayed; Falco himself was pardoned but several of the officers behind the coup were executed.

On 28 March 193, Pertinax was at his palace when, according to the Historia Augusta, a contingent of some three hundred soldiers of the Praetorian Guard rushed the gates (two hundred according to Cassius Dio). Ancient sources suggest that they had received only half their promised pay. Neither the guards on duty nor the palace officials chose to resist them...

There is not going to be a sovereign debt crisis here tomorrow, but you can see how it is going to happen (Thinking About the Unthinkable Bond Bear Market):

All of the federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls. They think it will be no big deal thanks to low interest rates.

After all, who cares about promising to pay $X next year if what that really means is that you are going to amortize $X over the next thirty years.

Instead of just one constituency that can't be disappointed, this country has many, many. Can a donativum be denied the Pentagon, defense contractors, public sector workers, public sector retirees, social security and medicare recipients?

We can see with Trump's tax plan (implausible tax cuts and no specific expenditure cuts) that the personalities no longer really matter to the ultimate outcome: sovereign debt crisis, inability to debt finance expenditure, followed by loss of legitimacy of government.

Thinking About the Unthinkable Bond Bear Market

All of the federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls. They think it will be no big deal thanks to low interest rates.

After all, who cares about promising to pay $X next year if what that really means is that you are going to amortize $X over the next thirty years.

The steady state federal budget deficit is probably a good $1T now (wait untill a bear market takes away capital gains), but social security should at least double that in the next few years [pdf].

Then, state and local governments have been averaging $300 billion a year in borrowing, but that could easily grow to be about a trillion every year, given that they will need to borrow for the pension benefits.

I could easily see $3T a year of sustained new government debt issuance. Plus, the Obama-era federal debt is almost all (~75%) notes, which is about $8.3T and about 1/8th being rolled every year makes ~$1T. There's also $1.4 trillion in bills which will of course need to be rolled every year [pdf].

This adds up to like six trillion a year and the thing is it would be more in bad years when government deficits are worse AND pension assets do not return what they were assumed to, so the plans have to borrow more. [And it does not even count roll over of existing state and local debt, which totals $3 trillion, until I figure out the maturity profile of that debt.]

The point is, the total federal debt held by the public was only $6T as recently as when Bush left office, and now the governments are going to need to borrow/roll that much every year.

I could never really figure out what would cause the bond bull market to end, but this is enough to do it in my mind.

The other scary thing for bonds is the effect that interest rate increases have on this system, because it contains so many feedback loops. The pension assets become worth a lot less, the interest expenditures rise (and they are borrowing to pay the interest since there is no debt service), so the credit quality (such as it is) deteriorates.

Also, corporate pensions have the same problem and an interesting feedback loop of their own. To the extent that their pension funds lose money, earnings will take a hit. As we know from Grantham, when earnings fall multiples fall too.

It is very, very nonlinear, because once bonds lose momentum, who will want to own them? Professional asset management and retail investor sentiment are both all about momentum. And every credit - government or corporate - looks much worse with rising interest expense. I think we will come to realize that a lot of stuff in the economy (junk bonds, private equity) was part of a virtuous interest rate cycle.

Maybe this is why the low on the 10 year yield is almost three years in the rear view mirror now.

For the counterargument that the Fed will just buy bonds to "keep rates low", you have to face the fact that QE invariably caused rates to rise, and you could (and we did) make money buying bonds every time the Fed stopped buying them. As I kept trying to explain, the QE bond purchases may have been respectably large in relation to the flow of debt issuance, but they were puny in relation to the stock of $60T of dollar denominated debt. It freaked creditors out about inflation more than it helped.

No Longer Bullish On Bonds, But Was July 2012 the Top?

Prechter's latest Elliott Wave Theorist issue (February 2015) repeats his call that the July 2012 low in the 10-year bond yield (1.46%) is a major, multi-decade low.

Although recently we have thought of bonds as the flight to safety asset (moving inversely with stocks), he correctly points out that bonds and stocks have been going in the same direction since the mid-1960s. Both have been in a huge bull market.

I had thought that bond yields cannot rise until after the stock market has crashed, because the government could just refuse to bail out the stock market and thereby "chase" people back into bonds. But I had not considered that people need to view bonds as perfectly safe in order for that to work. And treasuries clearly are not perfectly safe.

That makes them vulnerable to going down with stocks when social mood becomes more pessimistic. The only thing that would rise would be the dollar - which of course has had a massive breakout.

And you see that there have been a series of higher lows in the ten year yield after the July 2012 low of 1.46%. First, April 2013 was 1.66% and then January 2015 was 1.68%.

I am officially open to the possibility that bonds have topped.

George Gilder On the Welfare State, and the Implications For Treasuries

New Republic:

George Gilder, a pro-family conservative who was the person most often quoted by President Ronald Reagan, believes that welfare “usurps the male role as chief provider and undermines the foundation of families. His provider role is absolutely central to the family; if the state replaces the male provider, you don’t have families. The welfare state cuckolds the man.” In other words, if the state provides women a source of income that doesn’t require marriage, Gilder surmises, women simply won’t marry. Worse yet, in Gilder’s parlance, welfare constitutes state cuckoldry, as though food stamps steal sexual access men are rightfully entitled to. Thus, in the words of once and likely future Republican presidential contender Mike Huckabee, Uncle Sam becomes “Uncle Sugar.”

The original Gilder interview:

Religion is primary. Unless a culture is aspiring toward the good, the true, and the beautiful, and wants the good and the true, really worships God, it readily worships Satan. If we turn away from God, our culture becomes dominated by “Real Crime Stories” and rap music and other spew. This is the most fundamental point. When the culture becomes corrupt, then the businesses that serve the culture also become corrupt.

The legitimate purpose of public debt is to borrow money to build infrastructure improvements that have a positive net present value. However, a vast portion of federal expenditure now leaves nothing tangible, leaves no collateral. A treasury bond is a certificate that money has successfully been expended on section 8 housing, or on make-work military "jobs".

The lack of collateral makes these treasuries creatures of social mood. In a way, they are as valuable as tulip bulbs or south sea shares.

What is a treasury going to yield when mood darkens, and a distressed investor who looks over the enterprise for scrap value is the marginal buyer?

Longer Term Bearish View On Treasuries

In order to amortize the current public debt of $13 trillion over 30 years, the federal government would first have to permanently stop incurring budget deficits, and then the principal repayments would be about $433 billion a year.

Just balancing the budget is pretty unlikely, and to reduce spending by that much (taxing more will be self-defeating) and begin amortizing seems practically impossible.

Many people have observed this already, of course, but they were too early. Even Japanese government bonds are still increasing in value! I believe that the key insight is the astonishing demand for "safe" stores of value created by aging populations. Highly deflationary.

Realistically, this demand is going to grow, and they will borrow more at lower rates, digging the hole deeper.

We will watch for a chance to trade our "safe" treasuries for "risky" precious metals and oil, and lower rates and higher prices, respectively.

Trouble With The Curve?

Hardly. This was a good year to be long the long bond.

But this week was time to rotate out of long duration and into something that looks more attractive.

I think the value is in the 5y note. You get 1.65% yield vs 2.77% on the 30 year.

See what other countries' five year paper is yielding:

• France, 21 bps
• Germany, 4 bps
• Italy, 1%
• Portugal, 1.4% (!)
• Japan, 3 bps

All lower! So, the U.S. 5y looks like a value to me relative to other countries, to the fed funds rate (much higher) and to the 30 year yield (only 112 bps lower).

If you agree that the USD is the best currency to own right now, then it's doubly strange for U.S. rates to be higher than these other countries'.

Some Great Posts From Stagflationary Mark and Young Money

Stagflationary Mark is the only one of the 2015 predictions participants to exhaustively document his rationale for his predictions.

• "Full year exports of goods to China will not increase from 2014 to 2015. I am now 80% confident and no longer feel that this prediction is my weakest link. Can exports go higher? Sure. As a conservative guess, I'd say there's a 20% chance."
• "I predict that the 30-year treasury yield will be below 3% for all of 2015. In order for my prediction to come true the yield needs to say below the blue line for just a very small moment in time (that last little interval on this long-term chart that spans from 2015 to 2016). I was tempted to go with an average for the year, but this should keep the game more interesting."
• Last three: "For the past 5 years, predictions about the Fed's ability to raise rates have continuously been way too optimistic. Now that oil has fallen, I'm going to stick with what works."
• "As for department store sales, they've been in a downtrend since 2000. I just need a dollar! One dollar less. That's all I'm asking. Jeff Bezos, you got my back?"
• "And lastly, ShadowStats is my ringer. If they raise their subscription price from $175.00 to $175.01 then all hope is lost for me. These predictions could all go very, very wrong!"

Making fun of ShadowStats for not raising its subscription price during a period of 90% probability hyperinflation is delicious.

Amazingly, Stagflationary Mark links to a report that "91% [of institutional investors] are bearish on Treasury bonds, and 95% see 10-year yields over 2.5% by the end of 2015 compared to 2.1% today." That means we are going to have to hold onto our treasuries for longer, even after the massive rally this year.

Young Money also has a new post up today. Highlights:

• "Glenn Chan argues that investment managers' ability to identify scams is a good measure of their skill. [...] I don't follow Watsa closely, but his largest stock investments over the past decade are an all-star list of value traps: Abitibi, Canwest, Dell, Exco, Frontier Communications, Research in Motion, Sandridge, and Torstar."
• "Taking the $77.979 billion that Canadian farmers owed in 2013 and dividing it by $53.890 billion (the total cash receipts which Statistic Canada reported Canadian farmers received that year) we get a ratio of 144.7 per cent... the U.S. ratio of farm debt to total farm receipts is much lower at 69.4 per cent."
• "In Barron's, Anne Stevenson-Yang claims that 'Chinese corporations have taken on $1.5 trillion in foreign debt in the past year or so, where previously they had none. A lot of it is short term.' I haven't been able to verify the number, but it's ominous if true."

That much foreign ownership of China debt will have serious (like 2008) style consequences when the China ponzi unravels.

Yet Again, Long Stocks And Short Bonds - "How Are Investors Positioned Heading Into 2015"

How Are Investors Positioned Heading Into 2015:

"[I]nvestors, both large and small, are positioned for and expecting equities to be the big winner and bonds to be the big loser in 2015."

I can't believe it, after the incredibly good year that bonds have had in 2014.

Stagflationary Mark On Bond Yields

Latest:

"[O]ur economy cannot tolerate higher interest rates. It only seems to thrive on exponential/parabolic credit expansion and falling interest rates from what I see. The interest rate part of this ride is just about over. We seem destined to hit the floor just like Japan did and get stuck there. That's why I have been so willing to lock in long-term interest rates any time I could. In fact, I'd do so right now if I had more money to deploy."

"Treasuries are always right. They are saying something is coming."

Sounds promising:

"Treasuries are always right. They are saying something is coming. This monthly 30YR chart shows they are going much higher, at least for 2015."