Sunday, May 31, 2009

The Bond Story: The Conclusion

Now that we've discussed what treasury bonds are and their future in the markets, lets look at some subplots and precession waves that occur do to this tectonic shift.

The first is China's reaction, and subsequent actions. Over the past few months, China's investment into treasury bonds has moved almost entirely into very short term bonds. Bonds that will come due in less than two years.

They are doing this because they do not want their investments at risk of currency devaluation and oncoming higher interest rates. What this means is that the United States is now financing its debt load in very short term loans at lower interest rates.

You may have heard this story before when home owners tried this tactic using short term adjustable rate mortgages. As the loans mature, the United States will have to constantly be refinancing year after year. If there are any buyers left, other than Mr. Bernanke, they will demand higher and higher interest payments as we move forward.

So the interest payments every year on that running clock to my left will go up as rates rise. How will we pay for these yearly interest payments? You guessed it, by selling more bonds. More I.O.U.'s.

The second problem arising from treasury rates moving upward is the effect on the housing market. Rates on mortgages are directly tied to rates for treasury bonds. Here's why:

Lets say you are looking at three options to invest $500,000.

30 year treasury bond. (You lend government money)
30 year mortgage. (You lend an American homeowner money)
30 year corporate bond. (You lend an American company money)

Rates on treasury bonds throughout history have been far lower than rates for mortgages, corporate loans, etc. This is because it is far less likely in investor's minds that the government will default than a homeowner or a company. They are considered a sure thing.

So lets say that 30 year treasury bonds rise from 3% to 6%. (This is very likely) Lets look at an example of where loans may be priced at if treasury bonds were 3%:

30 year treasury bond (3%)
30 year mortgage (5%)
30 year corporate bond (5%)

So what would happen if treasury bonds were to rise to 6%?

30 year treasury bonds (6%)
30 year mortgage (X?)
30 year corporate bond (X?)

Would you still lend to an American home owner at 5% when you can lend to the government at 6%? No, because the government is considered a sure return on the money, and the homeowner may not make his payments. So if you were going to lend money to a homeowner you would ask for a higher interest rate to take on the additional risk. (Maybe 8%) Otherwise you would just keep your money in treasury bonds.

Our entire economy is one huge adjustable rate mortgage. From individuals, to corporations, to the government. It is one huge ticking time bomb.

There is no way out of this situation other than disaster. We have borrowed and spent every penny that we possibly can. The great part is that we have enjoyed an incredible consumption party that has lasted over 50 years. The rest of the world has worked hard and lived below their means for decades to finance our American dream.

Now the bill is due, and all we can pay with is I.O.U.'s.