Bond Bubble?

[Magox]

Bond Bubble?

 

There has been a lot of debate recently over whether or not there is a bubble in U.S. treasury bonds, and to tell you the truth there are some very compelling arguments for both sides. But before we get into some of these arguments I’d like to take a moment to review the significance of the U.S. treasury bonds market.

 

If you ever wondered how countries are able to finance their spending while accumulating debt, the answer is that it would be through government bonds, which in our case are called U.S. treasuries. Treasuries are the debt financing instruments of the United States Federal government; they allow investors an opportunity to put their money into our country, offering a yield on their investment while financing our debt; essentially a loan. These investments are regarded by many to be one of the safest on the planet; however, there are some risks to investing in government bonds. If a country continually racks up too much debt and simultaneously takes a severe hit in their ability to generate tax revenues to repay that debt, then it is quite possible that investors would begin to slack off from buying their bonds, or worse yet, sell them. Remember, the higher the demand for bonds, the lower the yields or interest rates, while the lower the demand, the higher the yields and interest rates. Higher interest rates make it more difficult for these countries to repay their debt, so this development in many cases is a very unwelcome one.

 

Unfortunately, the preceding is what we saw in Greece and Spain this year. These countries have been accumulating tremendous debt through their reckless spending binges, and when the world went through a colossal down turn, their ability to repay their debts was severely diminished. It was at this time that bond holders began to rethink whether or not it was a wise idea to keep holding on to their debt. What ensued was a mass exodus of Greek and Spanish bonds, interest rates went through the roof making it almost impossible to repay their debt, and all of a sudden within just a few weeks there were fears of default, which basically meant that they wouldn’t be able to meet their debt obligations. This sort of turn of events would have a humongous rippling effect. Greece and Spain have very small economies relative to the U.S., but the danger lies in the possible collateral damage. What most people don’t realize is that many large banks are financing these countries debts, therefore if a country were to default on their bond obligations, the banks and investors that bought these bonds would end up with a huge loss. If these banks take a huge loss then their confidence to lend would diminish, banks could freeze up again not lending even to one another, and we could very well end up with another round of systemic risk similar to what we saw in 2008 where investors sold out of their investment holdings driving down the prices of virtually every single asset class on the planet.

 

These turnings of events actually caused a positive unintended consequence for the U.S., as many of the banks, governments, and investors that were buying these Greek and Spanish bonds looked to park their money elsewhere, and by default U.S. treasury bonds became a prime destination. So consequently as a result, demand for our U.S treasuries went higher and yields went lower, allowing our country to borrow more money at a cheaper interest rate.

 

This is not the only driving force or source of demand for our U.S. treasury bonds. An area that is causing tremendous anxiety is our economy where there are fears of a double-dip recession or worse yet, a Japanese style loss of 2 decades. With these sorts of fears, they are causing many investors to move into U.S. treasuries and precious metals as opposed to other riskier assets such as stocks. The lower that interest rates move on our Treasuries, the more the bond market is signaling to the world that we are in for a very slow growth for a protracted period of time.

 

So the question that everyone is asking, is there a bubble in U.S. treasury bonds? If you look at the sort of buying that is occurring and the amount of inflows that have gone into U.S. treasuries, it would point to a bubble. However, there are many supporting arguments that would indicate that a bubble doesn’t exist in the U.S. Treasury bond markets.

 

1. Risky Southern European countries debt load is causing a rush into U.S. treasury bonds.

 

2. Slow U.S. economy is causing many investors to flee into U.S. bonds as opposed to stocks, indicating a very slow economy for the foreseeable future.

 

3. Fears of deflation and the absence of inflation (according to the Fed’s gauges) support lower U.S. treasury yields.

 

4. Savings rates are rising because people want to rebuild their finances following large losses on their homes and stocks. This means money will continue to funnel its way into investments deemed relatively safe such as U.S. treasuries and precious metals.

 

5. Bonds (and precious metals) are considered by many investors a good hedge and insurance against equity losses. In this sort of environment, it makes a lot of sense to try to protect your investment portfolio.

 

6. The elephant in the room is the Federal Reserve. The Federal Reserve is printing money and buying U.S. treasuries. This action from the Federal Reserve pumps more printed money into the economy and artificially keeps rates lower in order to attempt to revitalize our flailing economy (which won’t be good for the value of the U.S. dollar in the medium to long-term).

 

 

On the other hand, when you look at our U.S. debt position, it would appear to be contradictory to sound logic that investors would want to pile into U.S. treasuries considering how much debt our country is accumulating. If investors began to reconsider owning U.S. treasury bonds just as they did with Greece and Spain, then we’d highly likely see a cascading effect on our economy; interest rates would soar, the possibility of default on U.S. debt would rise dramatically, banks would freeze, investor sentiment would be next to zero, the economy would go back into a recession and possibly a depression, and the dollar would almost certainly plummet.

 

I would say that there are very powerful forces that are driving the U.S. bonds market that would indicate that there isn’t a bubble in U.S. treasuries. Having said that, the risks of default are tremendous and the markets can suddenly change without a clear warning to many seasoned investors. In my view, the warning IS clear, and personally I don’t believe U.S. treasuries offer as much safety over the medium to long-term as what most people would believe. The risk vs. reward ratio in my opinion doesn’t warrant the demand it has been receiving specially considering the ultra-low yields. A great friend of mine once said that bubbles can grow very large for a very long time before they burst. I wouldn’t be surprised if this trend in U.S. treasury bonds continue for quite some time, but if it does begin to show cracks in its armor, which I believe it will, one of two things will occur, either we will default on our U.S. treasury bonds, or even more likely the Federal Reserve will have to switch gears on the printing presses from full throttle to hyper warp speed, which effectively will diminish the value of the U.S. dollar.

[whateverdude]

This is too intellectual for me. I need the cliff notes version to understand it.

[GG]

This is too intellectual for me. I need the cliff notes version to understand it.

 

It's paraphrasing Obama's economic speeches, "We don't suck as much as the Europeans."

 

Or to put it into Bills perspective, "You could be a Lions' fan."

[whateverdude]

It's paraphrasing Obama's economic speeches, "We don't suck as much as the Europeans."

 

Or to put it into Bills perspective, "You could be a Lions' fan."

Thanks! now I can go back to sucking my thumb

[Magox]

This is too intellectual for me.

This is what I was afraid of.....

[Jim in Anchorage]

Bond Bubble?

 

There has been a lot of debate recently over whether or not there is a bubble in U.S. treasury bonds, and to tell you the truth there are some very compelling arguments for both sides. But before we get into some of these arguments I’d like to take a moment to review the significance of the U.S. treasury bonds market.

 

If you ever wondered how countries are able to finance their spending while accumulating debt, the answer is that it would be through government bonds, which in our case are called U.S. treasuries. Treasuries are the debt financing instruments of the United States Federal government; they allow investors an opportunity to put their money into our country, offering a yield on their investment while financing our debt; essentially a loan. These investments are regarded by many to be one of the safest on the planet; however, there are some risks to investing in government bonds. If a country continually racks up too much debt and simultaneously takes a severe hit in their ability to generate tax revenues to repay that debt, then it is quite possible that investors would begin to slack off from buying their bonds, or worse yet, sell them. Remember, the higher the demand for bonds, the lower the yields or interest rates, while the lower the demand, the higher the yields and interest rates. Higher interest rates make it more difficult for these countries to repay their debt, so this development in many cases is a very unwelcome one.

 

Unfortunately, the preceding is what we saw in Greece and Spain this year. These countries have been accumulating tremendous debt through their reckless spending binges, and when the world went through a colossal down turn, their ability to repay their debts was severely diminished. It was at this time that bond holders began to rethink whether or not it was a wise idea to keep holding on to their debt. What ensued was a mass exodus of Greek and Spanish bonds, interest rates went through the roof making it almost impossible to repay their debt, and all of a sudden within just a few weeks there were fears of default, which basically meant that they would’t be able to meet their debt obligations. This sort of turn of events would have a humongous rippling effect. Greece and Spain have very small economies relative to the U.S., but the danger lies in the possible collateral damage. What most people don’t realize is that many large banks are financing these countries debts, therefore if a country were to default on their bond obligations, the banks and investors that bought these bonds would end up with a huge loss. If these banks take a huge loss then their confidence to lend would diminish, banks could freeze up again not lending even to one another, and we could very well end up with another round of systemic risk similar to what we saw in 2008 where investors sold out of their investment holdings driving down the prices of virtually every single asset class on the planet.

 

These turnings of events actually caused a positive unintended consequence for the U.S., as many of the banks, governments, and investors that were buying these Greek and Spanish bonds looked to park their money elsewhere, and by default U.S. treasury bonds became a prime destination. So consequently as a result, demand for our U.S treasuries went higher and yields went lower, allowing our country to borrow more money at a cheaper interest rate.

 

This is not the only driving force or source of demand for our U.S. treasury bonds. An area that is causing tremendous anxiety is our economy where there are fears of a double-dip recession or worse yet, a Japanese style loss of 2 decades. With these sorts of fears, they are causing many investors to move into U.S. treasuries and precious metals as opposed to other riskier assets such as stocks. The lower that interest rates move on our Treasuries, the more the bond market is signaling to the world that we are in for a very slow growth for a protracted period of time.

 

So the question that everyone is asking, is there a bubble in U.S. treasury bonds? If you look at the sort of buying that is occurring and the amount of inflows that have gone into U.S. treasuries, it would point to a bubble. However, there are many supporting arguments that would indicate that a bubble doesn’t exist in the U.S. Treasury bond markets.

 

1. Risky Southern European countries debt load is causing a rush into U.S. treasury bonds.

 

2. Slow U.S. economy is causing many investors to flee into U.S. bonds as opposed to stocks, indicating a very slow economy for the foreseeable future.

 

3. Fears of deflation and the absence of inflation (according to the Fed’s gauges) support lower U.S. treasury yields.

 

4. Savings rates are rising because people want to rebuild their finances following large losses on their homes and stocks. This means money will continue to funnel its way into investments deemed relatively safe such as U.S. treasuries and precious metals.

 

5. Bonds (and precious metals) are considered by many investors a good hedge and insurance against equity losses. In this sort of environment, it makes a lot of sense to try to protect your investment portfolio.

 

6. The elephant in the room is the Federal Reserve. The Federal Reserve is printing money and buying U.S. treasuries. This action from the Federal Reserve pumps more printed money into the economy and artificially keeps rates lower in order to attempt to revitalize our flailing economy (which won’t be good for the value of the U.S. dollar in the medium to long-term).

 

 

On the other hand, when you look at our U.S. debt position, it would appear to be contradictory to sound logic that investors would want to pile into U.S. treasuries considering how much debt our country is accumulating. If investors began to reconsider owning U.S. treasury bonds just as they did with Greece and Spain, then we’d highly likely see a cascading effect on our economy; interest rates would soar, the possibility of default on U.S. debt would rise dramatically, banks would freeze, investor sentiment would be next to zero, the economy would go back into a recession and possibly a depression, and the dollar would almost certainly plummet.

 

I would say that there are very powerful forces that are driving the U.S. bonds market that would indicate that there isn’t a bubble in U.S. treasuries. Having said that, the risks of default are tremendous and the markets can suddenly change without a clear warning to many seasoned investors. In my view, the warning IS clear, and personally I don’t believe U.S. treasuries offer as much safety over the medium to long-term as what most people would believe. The risk vs. reward ratio in my opinion doesn’t warrant the demand it has been receiving specially considering the ultra-low yields. A great friend of mine once said that bubbles can grow very large for a very long time before they burst. I wouldn’t be surprised if this trend in U.S. treasury bonds continue for quite some time, but if it does begin to show cracks in its armor, which I believe it will, one of two things will occur, either we will default on our U.S. treasury bonds, or even more likely the Federal Reserve will have to switch gears on the printing presses from full throttle to hyper warp speed, which effectively will diminish the value of the U.S. dollar.

You have very good and interesting post's, but swear to me on a stack of Spanish Doubloon's you are not G Gordan Liddy and just pushing gold. Do you expect a metal that has very little practical value to keep raising in price? Or is this whole game just in buyers heads?

[/dev/null]

This is too intellectual for me. I need the cliff notes version to understand it.

See Spot.

See Armageddon.

 

Run Spot Run!!!!

 

Hope Spot had some gold to survive the Apocalypse

[Magox]

Do you expect a metal that has very little practical value to keep raising in price? Or is this whole game just in buyers heads?

1) The metal will go down for a sustained period of time at some point in the future. When? I'm not quite sure.

 

I pointed this out to JA or was it Dave? That I made a conscience and calculated decision to move into precious metals years ago because I believed that the investment environment for it would be positive. I don't see that abating any time soon for the reasons I have mentioned before.

[Peace]

You have very good and interesting post's, but swear to me on a stack of Spanish Doubloon's you are not G Gordan Liddy and just pushing gold. Do you expect a metal that has very little practical value to keep raising in price? Or is this whole game just in buyers heads?

 

Is GG G Gordon Liddy?

 

Magox pushes gold. He believes in it for the moment so he pushes it. If he was pushing stocks, he'd be writing a column about stocks he recommends. If bonds, he'd be writing about bonds. As an investment advisor, you write about the things you believe will make your clients money.

[GG]

Is GG G Gordon Liddy?

 

 

Not quite.

[Chef Jim]

Is GG G Gordon Liddy?

 

Magox pushes gold. He believes in it for the moment so he pushes it. If he was pushing stocks, he'd be writing a column about stocks he recommends. If bonds, he'd be writing about bonds. As an investment advisor, you write about the things you believe will make your clients money.

 

And what we believe in for our clients is that investing is not a short term thing so investing in one asset class is recipe for disaster. Magox says the metal will go down for a sustained period of time but has no idea when, great. When that happens, then what? Oh he or others like him find some other hot asset class to push. Maybe real estate will be hot again.

[Magox]

And what we believe in for our clients is that investing is not a short term thing so investing in one asset class is recipe for disaster. Magox says the metal will go down for a sustained period of time but has no idea when, great. When that happens, then what? Oh he or others like him find some other hot asset class to push. Maybe real estate will be hot again.

I don't advocate investing in one asset class. Never Ever.

 

I believe in diversification, as I have noted on numerous occasions. Just for the record, I didn't pile into the bandwagon of precious metals, I got in front of it way ahead of the curve, I put my own hard-earned money into opening up my own advisory and quit my (high paying) job to do so. I had the foresight to make this decision and in doing so I took a big risk.

 

That's what its all about, taking calculated risks.

 

And yes, I don't know when that drop will occur, but IT WILL HAPPEN. If I had to get my crystal ball out I would say probably 3-7 years from now.

 

I would venture to guess that U.S equities would be a great place to be.

[Peace]

And what we believe in for our clients is that investing is not a short term thing so investing in one asset class is recipe for disaster. Magox says the metal will go down for a sustained period of time but has no idea when, great. When that happens, then what? Oh he or others like him find some other hot asset class to push. Maybe real estate will be hot again.

 

Not taking a shot at Magox here but more of a general statement in my long experience in being in the market (as client), avid reader/viewer of the market. The number of investment advisers who actually add value to their client's portfolios is about the same as the number of people who come out ahead in Vegas. Lots of people crowing but someone is building those hotels.

 

Of course, every up and down always has a few people who look like geniuses. Good luck finding that tiny minority.

 

You do something with insurance am I right?

Edited September 9, 2010 by Peace

[Chef Jim]

Not taking a shot at Magox here but more of a general statement in my long experience in being in the market (as client), avid reader/viewer of the market. The number of investment advisers who actually add value to their client's portfolios is about the same as the number of people who come out ahead in Vegas. Lots of people crowing but someone is building those hotels.

 

Of course, every up and down always has a few people who look like geniuses. Good luck finding that tiny minority.

 

You do something with insurance am I right?

 

No I do comprehensive finacial consulting work (investments, taxes, estate planning). What that means is I don't have a hammer, I have a full toolbox. I don't really sell things I advise people on what they need to do and charge them a fee to do the right thing based on their situation and goals not based on what's hot. I bring a ton of value to my clients and that's why they pay me. That's why I laugh when I hear people harping on one asset class. I shook my head years ago with the whole real estate thing. It was actually quite comical and I fired many a client who wanted RE and only RE.