How the Fed will Crash the Bond Market


Slide1

When you or I buy bonds, we pay a certain amount of money to buy someone elses debt. In return, they pay us a certain amount of interest for a fixed period of time. The Federal Reserve can influence prices of debt by offering a certain risk-free interest rate. In this article, this risk-free rate is pictured as the Fed-O-Matic, a money-printing machine sitting on the desk of Lord Bankingstone, respresenting big finance. You put money in, it dumps more money into the bucket according to the rate of interest.

Slide2

While the Fed-O-Matic pays good rates of interest, Mr. Rumplypump’s bonds aren’t worth so much. At the same time, anyone wishing to issue bonds is going to have to beat the Fed-O-Matic rate pretty handsomely, seeing as how the machine has absolutely zero risk.

Slide3

When the Fed-O-Matic pays crappy rates of interest, Mr. Rumplypump can command high prices for his high-paying bonds. At the same time, anyone issuing bonds doesn’t have to pay very much interest to beat the Fed-O-Matic.

 

Slide4

People saving for retirement, especially using 401(k)s, are routinely told to buy stocks early in their careers, and then as retirement gets closer, transition to safe, low-yielding bonds to guarantee income and avoid the possibility of a stock market crash. Assuming stable interest rates, this is a good strategy. However, wildly fluctuating interest rates resulting from an activist central bank can play havoc on the bond market.

Slide5

Mr. Roflpants gets burned when he buys bonds during a zero-interest-rate policy (ZIRP), and then has to sell his bonds during a period of more typical interest rates. If prevailing interest rates double, the same bond is worth half as much. The recent news that the Fed is reconsidering its money-printing extravaganza bodes ill for the bond markets for several reasons.

  • Clearly, the value of existing bonds will crash. As the bond market crashes, the stock market won’t look as attractive. The low prices on existing debt and good rates of return on new debt will move money out of stocks and into bonds.

 

  • Imagine what will happen when Treasury bond rates are 6% instead of 1%. The United States would be forced to pay roughly a trillion dollars a year in interest on its $17 trillion debt. This would increase the deficit by roughly a trillion dollars, likely reducing trust in US debt. The US government, looking for buyers of yet more debt, without the Fed as its biggest customer, will be forced to raise interest rates further. Higher rates lead to bigger deficit. Bigger deficit leads to higher rates.

 

  • Higher interest rates will also cause mortgage rates to increase, meaning the mortgage payment for a given size of home loan will increase. Seeing as how the mortgage payment size is what decides whether someone can buy a house, home prices will necessarily have to come down, other things being equal.

At first, the end of the Fed’s money printing experiment will be read by investors as a sign of recovery, and commodity assets like gold and silver will probably suffer. Then, as interest rates rise and the Treasury bond market bubble deflates, those stores of value won’t look so bad and will likely rebound. Should things unfold in this way, there will be a good buying opportunity for gold and silver between the announcement that QE3 is ending and the inevitable increase of interest rates that will follow.

 

Published in: on February 24, 2013 at 8:24 pm  Comments (14)  

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14 CommentsLeave a comment

  1. Eventually the FE-O-MATIC will own so many bonds they will be in a catch 22 situation. Those bonds may very well have to be held to maturity. Meaning that all the FE-O-MATIC money from haven that was used to purchase Trillions in Bonds will never be sterilized. It will be Inflationary followed by money debasement and will push rates up increasing the consequences of the catch 22.

    Bonds rates can only be manipulated and not reflect valuation and risk if the currency they are issued in is not convertible but this can only be done as long as the curency they are issued in does not start to devaluate. That’s when the catch 22 realy kicks in and and rates are pushed up like or not.

    Wen this occurs there will be two choices devaluation or high rates. Either way all of the FED’s deferal of reality will come back as a very bad recession or very strong inflaton. You can’t push rates down below there natural level with ou expecting “cause and consequence”. It will be proportional so look at the FED 3 triion balance sheet and it’s buying 85 billions per month and calculate what percentage of the Bond market they will own by the end of this year. Kind of scary

  2. Eventually the FE-O-MATIC will own so many bonds they will be in a catch 22 situation. Those bonds may very well have to be held to maturity. Meaning that all the FE-O-MATIC money from haven that was used to purchase Trillions in Bonds will never be sterilized. It will be Inflationary followed by money debasement and will push rates up increasing the consequences of the catch 22.
    Bonds rates can only be manipulated and not reflect valuation and risk if the currency they are issued in is not convertible but this can only be done as long as the currency they are issued in does not start to d evaluate. That’s when the catch 22 really kicks in and and rates are pushed up like or not.
    Wen this occurs there will be two choices devaluation or high rates. Either way all of the FED’s deferral of reality will come back as a very bad recession or very strong inflation. You can’t push rates down below there natural level with our expecting “cause and consequence”. It will be proportional so look at the FED 3 trillion balance sheet and it’s buying 85 billions per month and calculate what percentage of the Bond market they will own by the end of this year. Kind of scary

    • I think I will do that calculation on percentage of bond market owned by the Fed.

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