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The Myth of the Great Bond

Bubble
by atthedome (2010-08-20 14:17:59)

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There is increasing chatter of the great “bond bubble” as U.S. Treasury bonds
surge ever higher and deflation fears rise. This is just one more myth that has
persisted in recent years (decades really) due to mass misconception of the way
the bond market actually operates and this propensity to label everything as a
“bubble”.

Before we dive into the real meat of the argument it’s important that we define
what a market “bubble” is. A “bubble” occurs when market forces combine to
generate a highly unstable position. This results in the system entering an extreme
disequilibrium and ultimately failure. The causes of this “bubble” (or extreme
disequilibrium) can be many – though primarily psychological any number of
exogenous factors can contribute to the instability of the system (government
policy for example). The psychological aspect of a bubble is well explained by
analysts at BNP Paribas:

“When interacting agents are playing in a hierarchical network structure very

specific emerging patterns arise. Let us clarify this with an example. After a
concert the audience expresses its appreciation with applause. In the beginning,
everybody is handclapping according to their own rhythm. The sound is like
random noise. There is no imminence of collective behavior. This can be
compared to financial markets operating in a steady-state where prices follow a
random walk. All of a sudden something curious happens. All randomness
disappears; the audience organizes itself in a synchronized regular beat, each pair
of hands is clapping in unison. There is no master of ceremony at play. This
collective behaviour emanates endogenously. It is a pattern arising from the
underlying interactions. This can be compared to a crash. There is a steady
build-up of tension in the system (like with an earthquake or a sand pile) and
without any exogenous trigger a massive failure of the system occurs. There is no
need for big news events for a crash to happen.

Financial markets can be classified as open, non-linear and complex systems.

They also exhibit emanating patterns as a result of which the “invisible hand” can
be very shaky. More then 40 years ago Benoit Mandelbrot described the fractal
structure of cotton prices and the emanating properties of fat tails and volatility
clustering and Hyman Minsky proposed a theory for endogenous speculative
bubble formation. More recently Robert Shiller and Alan Greenspan made the
irrational exuberance paradigm fashionable. These all fit in the framework of

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Complexity Economics, which describes the properties that emerge from

interacting agents. It has become clear that herding behaviour in financial
markets results in positive or negative feedback mechanisms causing price
accelerations or decelerations and (anti)-bubble formation, where asset prices
become detached from the underlying fundamentals.”

So, we can conclude that a bubble (as it pertains to markets) is an irrational

psychological market environment resulting in extreme disequilibrium and
ultimately some form of systemic collapse. The keys here are extreme
disequilibrium and systemic collapse. In order to have a bubble both aspects must
occur. I will revisit this later.

There is ever increasing chatter of a bubble in the U.S. bond market. This idea of
a bubble has become pervasive due to the myth that the U.S. government bond
market can and will collapse under mounting fiscal burdens and the idea that
bonds are “expensive” when compared to other assets.

Over the years investors have become increasingly concerned about the risk of
sovereign default in the United States. China officially “hates” us. Alan
Greenspan is frightened that the bond vigilantes are merely sleeping. Jeff
Gundlach is worried that the United States is already insolvent. But are these
concerns justified?

This brings us to a key question. What exactly is the U.S. government bond
market? In a country with monetary sovereignty in a floating exchange rate
system (USA & Japan, for instance) the bond market is really nothing more than
a mechanism through which the central bank controls the money supply. It
doesn’t actually fund anything as it does in Europe or under a gold standard. This
is best understood by studying the bond auction data in the USA. Despite
constant shrieking of a potential lack of buyers in government bonds over the
years we continue to see incredibly high demand for US debt. The auctions are
always oversubscribed. They never fail. Why is this? Why do the buyers keep
coming back for more? The simple answer is because the government puts the
buyers there. The auctions are designed not to fail. How is this you ask?

The government bond market is merely a monetary tool that the central bank
utilizes to control the cost (or supply) of money by controlling the level of
reserves in the system. So, when the government auctions bonds they are merely
targeting reserves in the system. This action is mandated by Congress as an
accounting tool and so is seen as a source of funding, however, in reality the
Central Bank is merely draining reserves that the Treasury already spent into
existence – reserves that were deposited at various banks (read this process in
greater detail here). Therefore, it’s incorrect to argue that there won’t be buyers
of U.S. bonds – with the banks earning 0.25% on their reserves and the
government offering anything above that (depending on duration) the trade is a
no-brainer for the banks who hold these reserves. The government is basically
offering them free money and the Central Bank keeps control of the money
supply in exchange (at least in theory). What is not occurring is some sort of
funding mechanism. The Fed could care less if the auctions are 2X, 3X or 4X
oversubscribed. They don’t get extra money when this occurs. They don’t get a
gold coin that can then be spent. So long as they meet the 1:1 bid to cover the
auction is a huge success because they drained their targeted reserves and
convinced Congress that we aren’t going bankrupt.

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Over the years the classic hyperinflationist or defaultista argument has been that
China will stop buying our debt or that Japan will stop buying our debt. But the
problem with this argument is that China is not our banker. Japan is not our
banker. What do we care if they buy our bonds? They desire to net save with the
U.S. and we happily send them pieces of paper with old dead white men on them
to satisfy this desire. In recent months Chinese net holdings of U.S. debt declined:

“China’s ownership of US government debt has dropped to the lowest level in at

least a year, Treasury data showed Monday, in a sign Beijing is increasingly keen
to diversify out of US bonds.

The cash-rich Chinese government reduced its US Treasury bond holdings to

843.7 billion dollars in June, the lowest level since at least the same month last
year, the Treasury said in a report on international capital flows.

The June data was lower than the 867.7 billion dollars in Treasury bonds held by
the Chinese in May and 900.2 billion dollars in April.”

But U.S. treasury yields continue to plunge. The demand for this paper is
enormous even though the largest holder of these bonds appears to be getting
scared off. The demand is well beyond what the Fed even requires (as previously
explained). While the Chinese fret about U.S. insolvency we’ll gladly keep
sending them pieces of paper in exchange for real goods and services. If they
desire to save less (which actually benefits their citizenry) then the United States
will save more domestically (not all bad if you ask me). But ultimately, what they
decide to do with those pieces of paper is their business and is not going to sink
the U.S. economy.

Many of the arguments in favor of a bond bubble can be debunked by reviewing

the hyperinflationist argument over time. For instance, in January of 2009 The
Telegraph had a provocative piece titled “The bond bubble is an accident waiting
to happen“. The author, Ambrose Evans-Pritchard, said the bond vigilantes were
asleep and that China and Japan would soon stop funding the US need for debt:

“The bond vigilantes slumber. As the greatest sovereign bond bubble of all time
rolls into 2009, investors are clinging to an implausible assumption that China and
Japan will provide enough capital to keep the happy game going for ever.

It is lazy to think that China, Japan, the petro-powers and the surplus states of
emerging Asia will continue to amass foreign reserves, recycling their treasure
into the US and European bond markets.”

The only thing that appears lazy in this whole argument (aside from the argument
itself) is the bond vigilantes, who, 18 months after this piece was penned, just
refuse to wake up! Unfortunately for Mr. Evans-Pritchard China has already
begun reducing their holdings of treasuries and the bond yields have continued to
tick lower. He went on to describe how Mr. Bernanke was about to be the cause
of horrid inflation and how we weren’t at all similar to Japan:

“Investors have drawn a false parallel with Japan’s Lost Decade, when bond
yields kept falling, forgetting that Tokyo waited seven years before resorting to
the printing press. Mr Bernanke has no such inhibitions. He has hit the nuclear
button in advance.”

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Unfortunately, that nuclear option did not prove inflationary at all and we are
looking more and more Japanese by the day. Although the Fed’s actions changed
the composition of bank balance sheets and helped trigger a mean reverting move
in some asset prices it has not caused even one iota of inflation. In fact, recent
data shows that the private sector appears to be at serious risk of retrenching and
could take prices down with it. In a de-leveraging cycle, the Fed has far less
control over the money supply than many presume. Bernanke’s great monetarist
gaffe was based on this idea that saving the banks would save the economy which
would save the private sector. But that has been proven entirely false as
Bernanke’s focus on saving the banks has actually translated into very little
private sector good. Without a steep acceleration in borrowing I would argue that
Mr. Bernanke has failed entirely. Hence, his frustrating battle with disinflation
(and risk of deflation).

Some market participants have gone so far as to compare the U.S. bond market to
the Nasdaq bubble. This is simply not a fair comparison. The Nasdaq declined
90% from peak to trough. If you buy a 10 year government bond and hold it to
maturity you will receive your principle back in full in addition to the coupon
payments. If inflation jumps from the currently low levels to 5% you will be
sacrificing 2.5% per year in real terms. Certainly not a winning pick, but nowhere
near what the apocalyptic results of the Nasdaq bubble were. To reinforce this
point I would highly recommend reading this paper from Vanguard which nicely
summarizes the risks of the current low rate environment:

“When evaluating the potential risks in the bond market, it is critical to remember
exactly why bonds are an integral part of a well-thought-out asset allocation
plan—to diversify the risk inherent in the equity markets. Simply put, while the
fear of rising interest rates may be legitimate, a potential bear market in bonds is
dramatically different from a bear market in stocks (or other risky assets). In fact,
unlike stocks, where the common definition of a bear market is a 20% decline in
prices, to most investors a bear market in bonds is simply a period of negative
returns. And to date, the broad U.S. bond market has never experienced a –20%
return. Indeed, it’s the magnitude of returns that is the key differentiator between
bad periods for bonds versus stocks. For example, the worst 12-month return for
U.S. bonds since 1926 was –9.2%, while the worst 12-month return for U.S.
stocks was –67.6% (12 months ended
June 1932).

In another example, the worst calendar year for the broad bond market was 1994,
when due to an unexpected upward shift in interest rates, the bond market
returned –2.9% (in 1995, the bond market returned 18.5%). Contrast this to the
experience of stock investors in 2008, when the Standard & Poor’s 500 Index lost
more than –2.9% in 27 individual trading days.”

When it comes to this whole debate the most important factor is the mere reality
of our economic plight. As we all know by now, we are currently confronted with
the threat of deflation, 9.5% unemployment, 74.8% capacity utilization, falling
home prices, durable goods orders that are more than 20% from their peak levels,
rising unemployment claims, equity prices that are 30% from their peak and high
historical private sector debt levels. When your options are 0% cash, unstable real
estate and equity in what appears like a weak economy that 2.6% government
bond doesn’t sound so bad. Perhaps not the best bet in the world, but irrational?
Certainly not. As Vanguard says, when compared to the long-term growth
potential of equities bonds currently look like a fairly good hedge.

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So, you can see that it is not accurate to describe the U.S. government bond
market as even remotely comparable to the “bubble” occurrences we have seen
in other asset classes throughout history. Even at its worst “valuations” the U.S.
government bond market has performed relatively well when compared to the
well known “bubbles” of history.

In summary let us remember that a bubble (as it pertains to markets) is an

irrational psychological market environment resulting in extreme disequilibrium
and ultimately some form of systemic collapse. These characteristics are not
currently attributable to the U.S government bond market. Given the economic
environment (and potential outlook for equities) it is not irrational for investors to
seek a very safe interest bearing asset in a time of high uncertainty and 0%
interest rates. In addition, as shown in the examples above, it is highly improbable
that the US government bond market will collapse as the market itself is designed
solely as a monetary tool. Lastly, while bond investors might be susceptible to
losses history shows that it is not accurate to imply that they are susceptible to a
“collapse”. While a 10 year U.S. treasury at 2.6% might not be the world’s
greatest bargain it’s entirely incorrect to argue that there is a “bubble” in
government bonds. In fact, I would argue that the term is not even applicable.

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by atthedome (2010-08-20 14:23:11) Delete | Edit | Return to Board | Ignore Poster |
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There’s great concern over the sustainability of US deficits. Most of the fear
mongering, hyperventilating, flat earth economists believe foreigners will at some
point stop “funding” our spending. The hyperinflationist crowd likes to keep a
very close eye on US government bond auctions hoping foreign demand for debt

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will dry up, auctions will begin to fail and interest rates (and inflationary
pressures) will surge as the United States effectively defaults (which is
technically impossible) and dies the death that so many of these people wish
upon it.

Unfortunately, 99% of the inflationistas have a very poor understanding of

reserve accounting so their arguments have not only been wrong for a very long
time, but they never really carried any weight to begin with (as one reader
eloquently put it – “at some point being right has to count for something” – the
inflationistas have been horribly wrong throughout this downturn). So what is
really happening when the government auctions off bonds? Let’s take a look.

First of all, we must remember that the US government bond market “funds”
nothing. As a sovereign issuer of currency in a non-convertible floating exchange
rate system the US government never really has nor doesn’t have money. For
simplicity, the US government is much like an alchemist who simply presses a
button (the government literally presses a button) and abracadabra, they have
money! Inflationistas call this “money printing”, but in reality the government
issues money that primarily offsets the dollars they debit from the private sector
via taxation (in addition to a few other factors such as population growth, etc).

Second, we must remember that private sector net savings is public sector deficit
(to be more precise: net household financial income = current account surplus +
government deficit + ∆business non-financial assets). This is simply an
accounting identity. To grasp this relatively simple yet unaccepted concept,
imagine if the US government imposed a one time 100% asset tax on it citizens.
What would happen? The public sector would have all the assets! The private
sector would have nothing. So it’s important to remember that taxation debits the
private sector and deficit spending credits the private sector. But what happens
to that money when the private sector “gets” it? They deposit it at a bank or it is
electronically deposited. What does this do? This creates excess reserves at the
banks. So government deficit results in excess reserves. By definition.

What happens next is where the fear mongering flat earth economists get it all
wrong. They think the Fed issues bonds to fund spending, but the US government
is never revenue constrained. The government doesn’t get a gold coin when they
auction bonds just like they don’t care whether you pay your taxes in cash. In
fact, if you did pay your taxes in cash the IRS would send the pile of money up
to the Treasury and guess what they would do? They would shred it, or, if it was
pretty and new they would send it back out for circulation. What they wouldn’t
do is turn around and say “Well Mr. Obama, Joe Schmo just paid his taxes so it
looks like you can spend some more”. No, the US government as a monopoly
supplier of currency just presses a button regardless of whether or not you pay
your taxes. This doesn’t mean deficit spending can be reckless or doesn’t matter,
but that is not today’s topic of discussion….

So what happens when we auction bonds? Well, the NY Fed has accounts all
over the country. The Treasury keeps very close tabs on excess reserves so as to
avoid overdraft at the Fed. So the Treasury hops on the phone with the Fed and
they target some level of bond issuance necessary to soak up these reserves.
Why do they do this? Because excess reserves drive down the overnight lending
rate so if the Fed is going to maintain the Fed Funds target rate they drain the
excess reserves. Some people view this as auctioning off bonds that “fund” our
spending, but in reality (because private sector net savings is public sector deficit

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– TO THE PENNY) it is just a monetary tool that helps the Fed hit their almighty
and supposedly omnipotent target rate.

In today’s world where reserves pay interest the banks have already driven the
overnight rate down. The excess reserves that banks currently carry are not due
to deficit spending, but rather the expansion of the Fed’s balance sheet. For more
on why banks are still holding excess reserves in today’s unique environment I
would highly recommend reading this paper from the NY Fed which describes
why excess reserves are not inflationary and also currently being caused by the
Fed’s balance sheet expansion.

Getting back on topic though – much to the chagrin of the fear mongering
inflationistas the auctions never seem to fail. The success rate of these auctions is
unbelievably high – like shooting fish in a barrel. In fact, they are almost always
oversubscribed. Many bond market “experts” highlight the bid to cover ratio at
these auctions as if disaster is imminent. The bid to cover ratio is just the dollar
volume auctioned off versus the actual receipts. These auctions generally come
in well oversubscribed. For instance, the Treasury had three auctions yesterday.
In their 13 week treasury bill auction they issued the following results:

auction1 WHEN WILL THE BOND AUCTIONS BEGIN TO FAIL?

The Bid-to-Cover Ratio: $105,589,158,600/$27,000,182,600 = 3.91 which is

WELL over their targeted levels. Any bid to cover over 1 is sufficient to “cover”
our “borrowing” costs though the fear mongerers tend to tell you that any bid to
cover below 2 is worrisome (which is entirely false). The levels are never below
1, however, because the Fed and Treasury coordinate the auctions to target the
excess reserves the Treasury has already “spent”. For emphasis, the auctions are
designed to succeed because they are coordinated to soak up the reserves the
Treasury effectively “spent” – the same reserves they KNOW are in the banking
sector and the same reserves they know they can offer a higher rate of interest on
via bond issuance.

Where do these bond buyers come from? They come from many places (in
addition to the banks holding reserves – which is why they are always
oversubscribed), but most important is the fact that there are excess reserves at
the banks earning 0.25% and they have the option to trade these reserves in
favor of higher earning assets with a marginally different risk structure. It’s
practically a no brainer trade for the banks. Why would they not turn in their
excess reserves? The important fact here is that the money the Treasury has
spent has ended up in the banking sector as excess reserves and the Fed is simply
issuing bonds to soak up those reserves and maintain their overnight rate. It’s that
simple. The auctions never fail because there is always excess reserves if there is
deficit spending.

This doesn’t mean that auctions can’t fail. The Fed could fall asleep at the wheel
and stop contacting the Treasury. The bankers could be out playing golf all day
and forget that they can earn a few extra bps on their reserves if they so choose.
But in reality, auctions should never fail. The savvy market readers will note that
a UK bond auction technically “failed” in March of 2009. But what happened
after this failed auction? Absolutely nothing. In fact, almost every single risk
asset on the planet was not only bottoming but was on an upward trajectory.
Credit markets were in the beginning stages of one of the greatest recoveries in
the history of markets. The next few UK auctions were oversubscribed and their

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government was able to continue soaking up reserves after the banks foolishly
failed to trade in their excesses at that particular auction.

So next time you hear someone hyperventilating over a US bond auction failure
(please bear in mind that the Euro currency system is different and that bond
auction failures very much matter there) give them a paper bag. Tell them to
breathe into it for 10 minutes and then tell them that everything is going to be
okay. Bond auctions have no operational reason to fail. In fact, the only reason
for them to fail in the USA is due to excessive golf playing – but considering the
banks have traded in their 3-6-3 model in favor of the Enron banking system I
think there’s no need to worry about that.

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