Bear Traps in the Bond Market

Fat guys can surprise you. They don’t move very fast. But they can be very agile intellectually.

That was how G.K. Chesterton was. Laurence Lindsay, former assistant to George W. Bush for economic policy, seems to be the same way. Slow on his feet, perhaps. But quick in his mind.

Writing in The Wall Street Journal, Lindsey delivers thoughts that might have come from The Daily Reckoning. First, he notes that the budget problems faced by Washington are larger than generally reported. Growth rates have been overestimated, he says, while interest costs and deficits have been grossly underestimated. When more realistic assumptions are plugged in to the numbers it adds more than $4 trillion in ‘budget costs’ over the next four years. He concludes:

Underestimating the long-term budget situation is an old game in Washington. But never have the numbers been this large.

There is no way to raise taxes enough to cover these problems. The tax-the-rich proposals of the Obama administration raise about $700 billion, less than a fifth of the budgetary consequences of the excess economic growth projected in their forecast. The whole $700 billion collected over 10 years would not even cover the difference in interest costs in any one year at the end of the decade between current rates and the average cost of Treasury borrowing over the last 20 years.

Only serious long-term spending reduction in the entitlement area can begin to address the nation’s deficit and debt problems. It should no longer be credible for our elected officials to hide the need for entitlement reforms behind rosy economic and budgetary assumptions. And while we should all hope for a deal that cuts spending and raises the debt ceiling to avoid a possible default, bondholders should be under no illusions.

Under current government policies and economic projections, they should be far more concerned about a return of their principal in 10 years than about any short-term delay in a coupon payment in August.

Yesterday, stocks rose. The Dow was up 145 points. Oil increased a little too. Gold stayed at $1,500.

Still no clear direction.

But the direction of the bond market for the last few months has been up. This appears to contradict Mr. Lindsey. QE2 is ending. Everybody knows it. The Fed was the world’s biggest customer for US debt – in some months buying two times as much debt as the US government issued. Now that the Fed’s buying program is coming to an end, shouldn’t bonds go down?

If the economy sinks the way we expect, Lindsey will appear to be a fool – for a while. That is, the Great Correction will intensify rather than go away. Bond yields will fall, not rise. Lenders will make money as bond prices go up, while stocks, employment, commodities, houses and almost all other assets go down.

People will say:

“See, everybody wants the US dollar. Everybody wants to buy US Treasury debt. It’s the only thing you can trust. Debt is not the problem. The problem is growth. That’s why we need QE3.”

This is probably the trap Mr. Market is setting. The Great Correction will prove to be more bad news for investors – except for those who have put their money in ‘safe’ US dollars…and US treasury debt. Gradually, investors will move more and more of their money out of ‘risky’ assets and into bonds. Then, Mr. Market can spring his trap. As Lindsey warns, that is when they will stop worrying about debt ceilings and Congressional budget talks. That is when they will realize that it is too late. That is when bond yields shoot up and bond prices fall. That is when investors regret having lent money to Washington.

How far ahead will that be? We wish we knew. But Bill Gross, who famously sold US bonds, could turn out to be years early.

Then, Mr. Market – the joker – will have such a laugh. All those people who tried to get away from risk…by moving to the dollar and US Treasury bonds…will get whacked.

Bill Bonner
for The Daily Reckoning

The Daily Reckoning