Monday, November 17, 2008

The Big One

A topic often discussed here is the last great bubble to burst which is the treasury bond market. (The corporate bond market has recently burst and some companies have debt selling at very attractive prices.)

So what does a bond bubble mean?

In simple terms it means interest rates are going to rise.

Imagine you own a $1,000 30 year treasury bond yielding 4%. This means you lend the government $1,000 and every year they will pay you $40 for 30 years. At the end of 30 years they will pay you your $1,000 back.

If treasury bonds become attractive to investors and more people are buying them, then the yields drop. This is because investors are willing to take a lower return on their money. This means that if you bought a $1,000 bond at 4% and now the same bond is priced at 3%, you can sell your bond in the open market for more than what you paid. This is because new bonds are now only paying $30 per year with the 3% yield. To give that same return of $30 per month to a new investor you can charge more for your bond.

The opposite is true if interest rates rise. This means the value of the bond falls. No one will buy your $1,000 bond yielding 4%, when they can just go to the government and buy a $1,000 bond yielding 5%. In order to sell your bond, you must sell it for less than the $1,000 you paid to make it attractive to a buyer.

Right now investors around the world are running toward US treasury bonds for security. This has pushed interest rates to ridiculously low levels. These yields are short term and artificial creating a massive bubble.

Foreign countries at some point will become net sellers of treasuries into the open market. This will come at a time when the government is selling treasuries to raise money to pay our enormous budget deficits and tries to stimulate our economy as it collapses.

This will raise yields on US treasuries, which remember, raises the amount the US has to pay on its new debt and its short term debt that is rolled over. (Think of an adjustable rate mortgage) It will be unable to due this which will in turn make it more dangerous to borrow from the US which in turn will raise the interest rates even higher. This will further depress the value of our currency thus making US bonds less attractive and pushing rates even higher. It will be a self reinforcing death spiral.

The last option will be for the Fed to purchase treasury bonds to try to keep the bond market from collapsing. They will do this with printed dollars which will be flooding our economy at the same time all of our dollars currently being held by foreigners are coming back to our country as they redeem their treasuries which are becoming dangerous to hold.

Investors holding dollars bonds will be killed. Of course you don't have to sell your bonds, you can keep collecting your 4% interest over the next 30 years as inflation is running between 10-20%. The only thing worse than holding dollars will be the promise to receive dollars in the future, which is what a bond represents.

Right now we are dealing with a short term financial crisis, but keep your eye on treasury bond yields as they will be the catalyst for our long term economic collapse.

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