The Bond Bubble

The Bond Bubble
Profile photo of Caleb McMillan

blowing-bubbles-300x255Central banks have artificially lowered interest rates, making bonds attractive. And since bonds are historically safe havens, it’s hard to even comprehend a bond bubble.

But as interest rates start to rise, the concern over bonds rises too. Adding some gasoline to the fire is the fact that the largest buyers of government bonds have been governments themselves. When they stop this buying spree, there will be more bonds than buyers.

This will likely to lead to a default or something equally painful.

Simply, US Treasuries are in a bubble.

Of course, many are confident that the US central bank, the Federal Reserve, won’t continue hiking rates much longer. That higher short-term interest rates are a short-term strategy that will be abandoned soon.

Bond markets aren’t expecting interest rates to return to normal levels. Why?

For one, the US economy is addicted to cheap credit and this has only gotten worse since the last financial crisis.

Therefore, with higher interest rates, people go bankrupt. And not just mortgage borrowers, but consumers and corporations face dire consequences if interest rates go higher.

Since the price of stocks, bonds, and real estate are all inflated to the nth degree, higher interest rates will likely correct these prices and send them downward.

Since expected future cash flows would be discounted at a higher interest rate, present values (and thus market prices) would deflate. Deflation of assets won’t change the amount of debt, but it will wipe out equity capital.

Meanwhile, the yield curve has become “flatter” recently, suggesting banks’ profit opportunities from lending are diminishing, which in turn decreases the inflow of new credit into the system.

Further declines in yield spread essentially mean a severe economic recession and most certainly a stock-market crash.

And since “real” interest rates are negative, the problem with raising borrowing costs is that it bursts the bond bubble the Fed has created through its inflation-friendly monetary policies.

Raising the costs of borrowing, that is, trying to wean the economy off cheap money, can’t be done without bursting the artificial boom the Fed has created.

How this plays out remains to be seen. One scenario involves, not the central bank, but the commercial banks, who, looking at indebted borrowers, decide to stop extending credit. The central bank will then have to increase the money supply to keep the boom going, inflating prices to the degree that people start dumping their cash. With the demand for money collapsing, the bubble pops.

The next crash will make 2008-2009 look like a walk in the park.

Profile photo of Caleb McMillan

Caleb McMillan is a writer that lives in Vancouver, British Columbia.

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