Friday, July 1, 2016

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.


Walter said...

Gold and treasuries have rallied together before, in 2011. I believe falling rates are positive for both but they react in opposite directions to inflation. If that's true, then it makes sense for both to perform strongly post-Brexit as the next rate hike gets pushed out to next year or beyond.

Hubert said...

Nobody on the long end is there for yield anymore. It is all capital gains by front-running central banks.
We are already so far in Lala-Land. Any turn in the weekly or - God forbid - monthly charts would break the bond bull in a selling panic. Central banks know that.
They cannot even stop where they are. There are currently trillions in capital gains in long Fixed Income but no fixed income going forward.
So for them there is no other way than marching further into Lala-Land. Breaking -0,5 or -1,0 % short rates, then -1,5% and on and on.
In other words, there is no financial policy solution. They are in dire need for a break and a new start, a big pretext: historically this has been war. But war has changed dramatically especially if you fight it against a fully armed opponent like Russia or China. So my best guess would be some smaller battles (Ukraine, Syria, Irak etc) and then the iron curtain falling down again, this time world wide, dividing it into two blocks, trade barriers, two monetary systems, currency controls.

Hubert said...

in shorter terms: when the game can no longer be won, or credibly played at all, you cancel it and start a new one.

High Plateau Drifter said...


"If that's true, then it makes sense for both to perform strongly post-Brexit as the next rate hike gets pushed out to next year or beyond."

Actually I am not concerned about the possibility of Fed rate hikes. What I worry about, or rather anticipate with relish, is the market puking about supply in the belly of the curve - 7 to 10 yr, and driving intermediate and long rates higher, Perhaps triggered by political problems or a return of inflation in the oil-commodity-gold-silver space destroying the credibility of .gov's CPI.

Seems impossible given 34 years of steadily falling long rates.