Bondmageddon

In seeking to save the economy from the consequences of one economic bubble, the top political and economic leadership of the country has created another, more dangerous one—and hardly anyone is talking about it.

In fact, some of the charlatans who pose as economic commentators are assuring us that the looming disaster is actually good news. Yes, I’m talking about Paul Krugman, who recently offered this amazing assurance to his readers.

Far from fleeing U.S. debt, investors have continued to pile in, driving interest rates to historical lows…. [W]e have our own currency—and almost all of our debt, both private and public, is denominated in dollars. So our government, unlike the Greek government, literally can’t run out of money. After all, it can print the stuff.

Leave aside for the moment the blithe assurance that we can just print as much money as we like. Look instead to that assurance about interest rates being at historical lows. This in itself is a whole new crisis.

By artificially depressing interest rates to levels never seen before, the Federal Reserve has set us up for disaster when they bounce back. At some point, rates are going to rebound from a current average of about 2% to the historical average of 5%—or higher, given all of that money-printing.

And what happens then? Consider the impact on bond prices.

Here you need to know a little basic bond math, which is simple and straightforward and virtually unknown to the general public. Let’s say that you buy a $100 bond paying 5% interest, or $5 per year. Then the prevailing rate of interest goes down by half, to 2.5%. What this means is that your $5 per year in interest is equivalent to the interest paid on $200 of bonds at the going rate—which implies (all other things being equal) that you can sell your $100 bond for $200, a huge capital gain on your investment. But what will kill you is what happens when things go the other way. If you buy a $100 bond paying $2.50 per year in interest, a 2.5% rate, and then rates bounce back to 5%, who is going to want to buy your bond for $100 when they can buy a new one that pays twice as much. So you will have to compensate by selling your bond for half as much. Your $2.50 in interest will equal a 5% rate—on a price of $50.

This is basically what is about to happen to trillions of dollars of bond investments. By artificially depressing interest rates, the Fed has artificially increased the price of bonds, creating a whole new bubble that is ready to burst.

Jonathan Trugman puts some dollar figures on the potential damage.

[R]ates would not have to go through the roof to take out billions in principal for investors, most of whom are in bonds because they are nearing retirement.

“If the 10-year [bond] goes up 100 basis points, that could mean more than $35 billion is lost,” says one bond trader.

One hundred basis points is just a 1 percent increase, which would put the 10-year at about 2.6 percent. The average rate of return over the last decade is roughly 4 percent, which, if we return to that yield, could put principal losses close to $500 billion, says a bond manager.

Now consider that all of this applies, not just to retiring Baby Boomers who have been told that bonds are a safe investment, but also to the Federal Reserve itself, which is one of the world’s biggest holders of US government bonds. As Alex Pollock points out:

The combined balance sheet of the Federal Reserve has $2.9 trillion in assets and $55 billion in equity, for leverage of a heady 52 times and a capital ratio of a paltry 1.9 percent. On top of this high leverage and little capital, the Fed runs massive interest rate risk, with investments in long-term mortgage-backed securities (MBS) of over $900 billion and longer-term Treasuries of $1.65 trillion….

The Fed has announced it will be adding $40 billion a month to its $900 billion in MBS, so it’s fair to consider that in a few months it will own $1 trillion in these mortgage securities. A reasonable estimate is that a 2 percent increase in interest rates would reduce the value of long-term fixed rate MBS by about 15 percent. On $1 trillion of mortgages, this would be a hit to the Fed’s market value of about $150 billion.

The $1.65 trillion in longer-term Treasuries probably has an average maturity of at least five years. A reasonable estimate of market value loss on this position for a 2 percent increase in interest rates might be 10 percent, or $165 billion.

The total loss to the economic value of the Fed’s aggregate balance sheet would therefore be about $315 billion, compared to total capital of $55 billion. The Fed is thus vulnerable under this reasonable scenario to market value loss of over 5-1/2 times its total capital.

If this were a private bank, we would describe it as teetering on the brink of insolvency. But being a government-sponsored entity means never having to say you’re sorry, so it’s less clear that the Fed will really suffer any consequences for going broke. We’re the ones who are going to suffer the consequences.

What is clear is that the Fed’s policy of trying to stimulate the economy by driving down interest rates as close to zero as possible has put the entire economy into new and uncharted territory of interest-rate risk. It is the usual pattern of government intervention: in trying to push off the consequences of one crisis, they create another crisis. And then everyone wonders why we go five years—or ten—of constant turmoil and anemic growth.

 

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5 Responses to Bondmageddon

  1. Edward Komito December 2, 2012 at 7:20 PM #

    The author points out some very interesting and potentially worrisome problems that may lay ahead for the economy. But I think the article would be more thorough were there to be some potential solutions to the problem. That is to say, ways individuals might hedge their position in MBS. For example, does Mr. Tracinski believe buying the PST (etf) at this juncture would be an efficient way to protect against the potential rise in rates? What other ideas does he have? In general I’m concerned with articles that tend to point out potentially hazardous situations without a possible solution. Perhaps this can be addressed in a future article.

    • Robert Tracinski December 4, 2012 at 10:57 AM #

      Well, I’m not an investment adviser, which is why I don’t like to get into recommending specific vehicles for investment. It all depends too much on your wider context and your needs. And while I can be pretty confident that the bubble will burst, I have no idea when, or what other interventions the Fed will launch to try to keep that from happening.

      Here’s an example of why I don’t give that kind of advice. In my case, I would say just to avoid bonds altogether and look to other asset classes. In fact, the asset class I like best right now is real estate, because it is the only thing that has gotten the hell beat out of it for five years straight. (Gold, by contrast, has already at least quadrupled, so you have to bet that there’s still more upside.) On the other hand, my biggest investment right now is my house, and my wife is an architect–which means that my family has a lot of exposure to housing and real-estate as it is, so putting even more into real estate is not exactly good for diversifying the portfolio, is it? So you see how these things get complicated by individual circumstances.

      Besides, my focus is on the political and philosophical implications: the destructive actions of the Fed, and generally the illusion that government force can somehow overturn the laws of economics.

      • Michael December 18, 2012 at 5:13 AM #

        Robert is exactly correct about investing in real estate. Real estate should definitely be a part of the portfolio but certainly not a large part. Why not?

        1. Real estate is not liquid. You can’t sell a part of your house.
        2. Its fixed. You can’t pick up your house and move elsewhere. You’re tied to a location.
        3. Its dependent on the neighborhood. You can have the best house in your neighborhood but if the surrounding owners change and they start letting their properties deteriorate, there isn’t much you can do to prop up the value of your home.
        4. Its a lot more prone to local regulation and thus politics. It would take only a few crazy members on the local city council to create havoc for you.
        5. It takes a very large outlay of initial capital (down payment) and regular money toward maintenance. So, you have to build up your financial position to that point.
        6. Rental real-estate is particularly tricky because people’s behavior changes very quickly when times become hard. Your renters may not care for your property, may default on rent etc. and your property may be subject to rent control.

        I’m not an investment adviser either. I say all of the above from my experience as a landlord. Do I have alternate recommendations? No, not really. A bit can be done by following sound investment principles of someone like Warren Buffet (know the business you invest into, invest only for the long term, invest in companies that employ smart and efficient managers, invest in companies that may have franchises, try to avoid industries that may be subject to heavy government regulation etc)..

        That’s about what occurs to me!

  2. Barry Tilles December 10, 2012 at 11:54 AM #

    Just stumbled over here. This is GOOD STUFF. Perhaps you discussed this elsewhere, but wouldn’t another great crisis of the return of borrowing costs to or above their historical averages be the increase in the debt-servicing part of the federal budget, as expiring short notes are rolled over and new bonds to cover deficit spending are issued? ( rom gorilla to Godzilla or 7% of fed budget to 30%?) Or perhaps it works the other way – as your $$$ are worth less after an inflationary period – that is equivalent to a forgiveness of part of the debt? Or would rising rates strengthen the dollar?
    Thank you.

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