SUMMARY: Bonds have seen a three decade bull market which will collapse if the interest rates start rising. Signs are emerging that the six years of unprecedented low interest rate regime will end now. And when that happens, Bond prices may collapse. Current yield on 10 year US Treasury was 2.5% that is 2.5% above the Fed rate of 0%. When the Fed moves rates higher in 2016 to its target 2.25%, it puts the 10 year Treasury yield at near 4.75% - and it will lead to an approximate loss of 16% in Bond values. A long term Fed target rate of 4% puts the yield near 6.5% and loss near 29%. Losses can be higher for longer duration bonds.
For bond markets which have an average historical return of 5.2% p.a., losses of more than 20% are disastrous.
US looses both ways – if inflation (and interest rates) does not rise, it faces risk of deflation that can lead to depression. If inflation (and interest rates) rises, it leads to asset bubbles – and eventual burst.
For years now, experts have been saying that there is a bubble – this article explains the issue in factual and logical sequence.
- Is Inflation Rising?
- What will trigger rise of inflation – personal spending, bank lending, or Fed buying even more debt?
- How big is the bubble?
- What happens when bubble bursts?
- When can it burst?
Is Inflation Rising?
Though there has been concern that the stimulus would lead to a surge in inflation but core personal inflation has averaged only 1.4 per cent since the recession ended in June 2009.
Recently the inflation as measured by the Federal Reserve's preferred price index surged in the second quarter to the highest annual rate in three years, potentially making the central's bank effort at managing the U.S. recovery more difficult. The PCE index rose at a 2.3% annual rate in the April-to-June period, compared to 1.4% in the first quarter. That's the fastest pace since the second quarter of 2011. And the core PCE that excludes food and energy climbed at a 2% clip, up from 1.2%.
The PCE index rose 1.6 percent on monthly basis in June from a year earlier. “Core” inflation, which excludes volatile food and energy prices, was 1.5 percent.
What will trigger rise of inflation?
a. Personal spending will trigger rise in inflation?
Real disposable personal income has been rising though not very strongly, and may be the reason for rise in personal consumption expenditure and inflation. An alternative to spend more is to reduce savings, and the chart below shows that recently, the personal savings figure has been falling.
Apart from a weak rise in per capita income and falling savings, the main driver of economy – employment growth, has not been showing any significant turnaround. In absolute term the employment has reached near the pre 2008 levels but as a ratio of Employment to Population, it is nowhere near its pre recession levels (see the graph below).
Even the economic confidence level in country as indicated by Gallup’s Economic Confidence Index shows a serious drop in confidence (see the chart below).
In summary, economic growth, employment, and incomes do not seem to have strength to trigger a strong rise in inflation.
b. Bank lending will trigger rise in inflation?
This issue was discussed in previous post also (
Global Money – Bubbles in Stocks, Bonds, and Real Estate) which showed that as of now the commercial lending is not rising substantially. Banks are skeptical of repaying capacity of businesses. But banks are sitting on trillions of Dollars, part of which is lying with Fed as excess reserves which is earning them a meager 0.25%. Excess reserves are dollars that banks now hold that are in excess of what they need to have on hand to satisfy reserve requirements.
Excess reserves have now reached $2.6 trillion. When the banks start using this money for lending, it is unimaginable what will be the effect of this epic amount of liquidity on inflation!
c. Fed debt buying will trigger rise in inflation?
Fed is tapering its bond buying program (QE) which is expected to end in October this year, and according to Fed, it will keep the rates low for a considerable period of time after QE ends. How long would be that time?
In May this year, the current Fed Chair Ben Bernanke mentioned his intent to begin to taper, that is, reduce the amount of QE. The stock and bond markets on Wall Street threw a tantrum. The Fed panicked and executed a fast retreat. Is the Fed trapped in this dodgy venture?
The Fed seems to be cornered. It has to wind down QE3 and has to raise interest rates. As soon as it will announce that, markets will panic. Under pressure it may again resort to more bond buying – QE4. This will further inflate the bubble. Many believe the economy will suffer the mother of all bond market selloffs as these steps unfold.
How big is this bubble?
The US bond market has roughly doubled from year 2000 to $39 trillion. This is more than twice the size of US economy.
What happens when bubble bursts?
Bond owners face huge default risk, huge interest rate risk, and huge inflation risk. When the bond bubble ends this means that bonds will decline rapidly in price pushing interest rates markedly higher – think Spain or Itally.
- Bond prices will fall (as mentioned in beginning)
- The QE is an attempt to push interest lowers to support the economy. Low rates were supposed to boost economy. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.
- The Fed is now world’s largest hedge fund with over $4 Trillion in assets. LTCM (Long Term Capital Management) which managed only $100 billion at the time nearly brought the economy to its knees when rising interest rates caused it to collapse. The Fed is 30x the size and growing.
- Housing market will collapse when rates rise. People have to make higher payments when rates rise.
- Higher interest rates are negative for industrial growth. They take fewer loans at higher rates.
- When rates are low, people borrow and invest in stocks, bonds, and real estate. When rates rise they will sell the assets, causing a panic crash in prices of all assets.
- The massive derivatives market will collapse as interest rate spread derivatives go bust.
- As rates increase consumers will have to pay more on their variable rate loans. Stagnant wages and increased taxes will lead to a rapid contraction in income and rising defaults.
- Rising defaults will dent banks’ profitability and even sustainability.
- Commodity prices may plunge as the global economy weakens
- Rising rates will mean Fed has to pay more on its debt and may default
- Fed’s action to survive will lead to currency wars
When can this bubble burst?
The trend in economy has been different from that of in markets for quite some time now. And it may continue for some time.
But when do we expect the bubble to burst?
Next…
