Friday, October 29, 2010

Bond Bubble Redux - the "Quality Bubble"

Two years ago, we watched a credit bubble burst. The bubble centered around low quality borrowers, primarily in the sub-prime mortgage area. Now, we have a different kind of bubble: a quality bubble.

Ask yourself, what happens when the government issues, say, a ten-year note? Investors buy it and collect interest for ten years and then get their principal back. Simple enough. 

But where does the government get the money to pay investors back? Well, if the government starts to run surpluses between now and then, it can use cash to pay investors back.

What’s that, Sparky? You’re laughing, so I can’t quite understand you…oh, you think I was joking about the surpluses? Okay, gotta agree with you there. Seems we’re careening in the other direction, actually.

Option two is we get more investors to invest in new debt in order to pay the old investors back. That should be easy, right? It’s never been a problem before.

A what? A Ponzi, you say? Well, that sounds extreme, Sparky. New investors will simply be lured in to pay off the early investors before everyone figures out that…hey wait, that sounds just like…okay, you got me again. In fact, now that I think of it, the government will have to borrow money not just to pay off bondholders, but also to finance all the new deficit spending between now and then…eventually, we run out of “greater fools.”

But wait, there’s still one more option! The government can always print money to pay people back. The Fed can just buy our debt from us! Good to know that’s always an option of last resort. Wouldn’t want the U.S. to drop to junk bond status.

The Fed is already doing that, you say? C’mon, be serious. You are? $1.5 trillion worth in 2009 alone? Holy Quantitative Easing, Batman!

Gosh, no wonder government bond rates are so low. The Fed is eating its own cooking. Plus, banks have been incentivized to be heavy buyers to repair their balance sheets. So 10-year rates are down around 2.6%. 2-year rates are – get this – at 0.38%. Just curious, Sparky, who do suppose finds this an acceptable return over two years? Give a hundred bucks and get back $100 plus 76 cents. Nice!

Actually, this is basically happening all around the world. Here are some sample 10-year bond rates.

UK             3.14%
France        2.96
Germany    2.56
Italy           3.92
Japan         0.90

Japanese debt is almost 200% of GDP, exceeding all countries of the world other than Zimbabwe, and yet people loan them money at close to zero. They, and others, will run out of greater fools soon.

Which leads me back to the notion of the quality bubble. There are systemic reasons – the government and bank buying I mentioned – why the yields on debt of highly profligate nations (including our own, alas), are being driven to record lows. These systemic forces are completely at odds with the fundamentals. Which do you think prevails? 

Sparky asks if this is a trick question. No, Sparky.

The trigger will be inflation. 

Hey, that reminds me, where the heck is it, anyway? It’s there, hiding in the weeds, waiting. Inflation hasn’t come back because there’s no “velocity” of money, which is to say the trillions of dollars of cash out there is hiding in our nation’s mattresses, both personal and corporate. It starts moving again when there’s loan demand, and that doesn’t happen until employment comes back. There is a tight correlation between employment and money velocity:
The correlation here is 0.75, which is really high for anything in economics land.

When people start getting jobs, inflation comes back. This time it will be nasty.

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