Bonds: Black Storm on America’s Horizon
Like a category 5 hurricane slamming the gulf coast, all hell will break loose when the bond market comes unglued. We are in the calm before the storm. The tempest, though, is very near our shores.
No, European sovereign debt isn’t the dark cloud hovering over our horizon. Its something else… something far more sinister. Its a tiny number that will violently shake this country’s economy to its core.
That innocuous little number is the yield on U.S. Treasury bonds.
The Safest Investment
Right now United States Treasury bonds are considered the safest investment in the world.
As of yesterday the yield on U.S. Treasury bonds is 1.96% over 10 years and falling. (In investor-speak that’s 196 basis points. A basis point is 1/100th of a percent)
If you purchase a 10-year Treasury bond today you will earn 1.96% interest. For $10,000 that is a $196 return on investment over 10 years.
That’s not very much. Wall Street stock brokers scoff at a pittance like that. Real men trade stocks! That is where the big bucks are made.
But when markets turn to manure brokers fly to the safe haven of bonds like bees to pollen.
On the seller side, however, $196 dollars is a bargain price to pay to borrow $10,000 for 10 years. As a seller, the U.S. government is sitting pretty right now.
In the topsy-turvey world of bonds there is an inverse relationship between yield and a risk-free investment. The safer the investment, the lower the yield. Investors only buy bonds as safe investments to tide them through when times are bad.
It helps that the U.S. dollar is the world trade currency. The Euro is weak and under siege. China’s Yuan is not strong enough yet.
That is why, at 1.96%, U.S. Treasury bonds are considered the safest large investment in the world today.
Financing Federal Government Debt
The federal government finances its debt by selling Treasury bonds.
At only 1.96% over 10 years that is a bargain basement sale price for selling debt.
With debt problems in Europe and world stock markets in turmoil the large scale investors, like China, with money to spend are buying U.S. Treasury bonds like hotcakes.
Things should be hunky-dory, right? Wrong!
The Safety of Bonds
To understand the danger we are in we need to understand bonds.
Bonds, traditionally, are a safe haven for investment. They are the bedrock of economic stability and growth in a strong economy.
We usually think of bonds as things sold by countries, states, municipalities, utilities and school districts to fund large scale building and infrastructure projects. Examples would be the interstate freeway system, or sewer systems, or new municipal power plants or new schools.
Bonds are normally risk-free and have guaranteed, albeit small, returns on investment. Though yields are small the infrastructure they fund creates jobs and drives an economy forward.
When the stock market is volatile like it is now, investors flock to bonds to ride out the storm until stocks recover. Then they leap back into stocks again when the danger is past.
Bonds Have Changed
Two fundamental changes have altered bond markets:
- The bond market has grown precipitously
- Nations used bonds to pay for ordinary services
There are a lot more bonds out there then there used to be. From mighty nations to lowly school districts, they compete with each other. That raises the overall cost of borrowing for everyone.
These days bonds are used to pay for all types of government debts, not just economy building infrastructure projects anymore.
The down side is that if bonds are used to pay ordinary day to day expenses then their cost doesn’t generate a tangible economy building product like infrastructure does. The money is just gone but still has to be paid back with interest.
The more bonds are used to pay ordinary expenses the more weakened a country becomes and the less faith investors have in a government’s ability to repay.
That drives yields up, too. A country must then pay a higher interest rate to attract investors. That can turn into a downward economic spiral.
That is what has happened in Europe. High bond yields are behind Europe’s sovereign debt contagion affecting Greece, Ireland, Portugal and now Italy.
Greece and several other countries sought EU bailouts when government bond yields rose above 7%. Italy’s bond yields briefly topped 7% and they may be next to seek a bailout.
Us Up… Greece Down!
Because of stock market uncertainty and the European debt crisis, U.S. Treasury bonds became the de facto haven of last resort for large investors world wide to protect their money. They might prefer to invest elsewhere but there is literally no where else to go.
We are living off the fat of the land. It keeps our bond yields low.
That will not last forever. China, Asian and other emerging country bond and stock markets will become more attractive to investors as they continue to grow and prosper. China is projected to replace the U.S. as the world’s #1 economic power in late 2016.
The United States is committing the same fiscal sins as Europe. We are selling government bonds to pay for ordinary expenses just like many of them are.
Thirty nine cents of every dollar the federal governments spends is borrowed money paid for by selling U. S. Treasury bonds. Clearly, we cannot keep spending like that indefinitely. The more we spend the less confident investors become.
Now the spotlight will shift to the United States’ huge and growing debt. Our national debt leaped above $15 trillion dollars this week. Our deficits are over 10% of GDP.
U.S. Treasury bonds will become less attractive and bond yields will inevitably rise.
Greece had 15 years of strong GDP growth until 2009. On paper it was the strongest economy in the eurozone.
Then the bottom dropped out in just two short years when bond yields rose.
Greece sold more and more bonds to finance its everyday expenses and to pay off its bonds as they came due. Their bond yields shot over 7% and the European debt crisis was off and running.
The United States is doing the same thing as Greece did. Our details will be different but the outcome will be the same.
The big difference for the United States is that there is no one to bail us out when our bond yields inevitably rise above 7%.
Its basic math. Massive spending cuts will have to be made because we will no longer be able to afford the interest rates on bonds we sell.
Funding for social programs, defense and all the other services provided by government will come crashing down in a giant thunderclap of overbearing debt.
And all because of one simple little number – the yield on U.S. Treasury bonds.