Down to the Sea Again...
Every line in the financial world has a hook on it. And at the end, sooner or later, is a banker with the wit of a tuna.
Back in the early ’00s, the Fed cast out a line, urging member bankers to lend more money. Dallas Fed chief Robert McTeer had bad advice for consumers too: “Buy a Hummer,” he said, before the price of oil went over $100. A few years later, Alan Greenspan caught the entire financial sector in a net. Financial derivatives, he said, helped spread the risk and helped make the system more stable.
Last week, the Bernanke Fed, along with the Federal Deposit Insurance Corporation, told bankers to maintain larger stocks of “unencumbered highly liquid assets…readily available…during the time of most need.” What exactly did they have in mind? US Treasury securities.
The timing couldn’t be better. Last week, the US Treasury market began to crack. And this Wednesday, the feds’ $1.25 trillion program of buying mortgage-backed securities came to an end. On the 25th of March, the 10-year T-note reached a yield of 3.91%. Long bonds – 30 year Treasury bonds – traded at a yield of 4.75%, up from what now seems to be the bottom in November 2008 at 2.5%. Technical analysts think they see a big head-and-shoulders formation, marking the end of a major trend. Fundamental analysts wonder why it took so long.
Here at the Daily Reckoning, we’ve called the top in the bond market on at least three occasions in the last 7 years. Our feelings wouldn’t be hurt if this one turned out to be another Elvis sighting too. But now that the feds have banks on the line, rising bond yields must be almost a sure thing.
Long bond yields hit a high of 15% back in 1981. Since then they have been going down. That they would eventually find a bottom would surprise no one. But that the bottom would be found in March 2010 would inconvenience practically everyone. Never before have so many borrowers counted on such low rates. And ‘never again,’ lenders might soon tell one another, will they be willing to fund such huge deficits for so little nominal return.
In 1981, consumer price inflation was running at about 9%, leaving a net, real return of about 6%. But that was also when Paul Volcker was tightening the screws on the whole financial system, toughening up credit rules to bring inflation under control. It was also at a time when the US balance of trade was still positive…when the US was still a net creditor to the rest of the world…when the national debt was only 33% of GDP (it is close to 80% today) and when the deficit was only $57 billion (today, it is 25 times that amount). No one at Moody’s was studying the balance sheet of the US government back then. There was no need to. Its triple-A credit rating was not in doubt.
Much has happened between then and now. But of all the many changes since the Reagan Era we can’t think of a single one that actually improves the credit quality of the US government. Thirty years ago, not only were US finances much more solid than they are today, so were its demographics, and its politics. In 1980, the baby boomers were just reaching their prime earning and spending years; now they’re beginning to shuffle and stoop. The stated mission of the Reagan administration was to reduce government’s role in the economy. “Government is the problem, not the solution,” said the Reaganites. “Government is the solution,” says Obama’s team.
The US administration just pushed through a $1 trillion health care overhaul. This was on top of $1 trillion deficits as far as the eye can see. This year alone, the federal government will sell some $2.4 trillion in securities.
Judging from these facts alone, you would wonder who would be dumb enough to buy US bonds now? The bankers, of course. They give their money to the feds for less than a third of the interest yield they demanded 29 years ago. What mutation happened in the human gene pool accounts for it? None at all, is our contention. They were fools then…and fools still. A generation of rising bond prices simply changed what they were foolish about.
But this time it is different. This time the feds have put the harpoon into the whole economy. First, they exchanged the toxic, mortgage-backed assets of the financial industry for US Treasury bonds. Then, they set up a carry trade to make it easy to finance their deficits: the banks borrow from the Fed. But with such low interest rates the banks don’t lend the money to the private sector; they lend it back to the US Treasury. The public sector is flush but the private economy remains locked in irons.
This was very similar to what happened in Japan 20 years ago. The banks began to go under, dragged down by their own mistakes. The government tossed them a line. They were saved…but at a price – two “lost decades” in the Japanese economy. Instead of lending to business, banks were urged to buy government bonds to finance runaway fiscal stimulus programs. This kept the GDP above the waterline, but the ‘growth’ was nothing but a fata morgana – a vision of the damned, financed with debt. Now, the banks own so much government debt that a downturn in the bond market (such as caused by real growth) would undermine their reserves and sink them all.
US banks, led by the Fed, follow them down to the sea.