“The Federal Reserve bank buys government bonds without one penny.” John C. Danforth
Good morning and welcome back to Bygone Relics. I’m C Thomas Printer and I want to apologize to you, the viewer, the listener, and the reader. I realize I have created the most boring program in America by talking about bonds and bond yields. If I did this at the bar, no girl would ask me to dance much less want to go home with me. But damn it, this is craziness in the bond market and we are going to talk about it even if no one else is going to. People bonds are boring, they don’t move around, they are sloths, snails, if they were a vegetable they would be a legume. Do you remember in the movie The Big Short when they talked abut the birth of MBS products and how all these bowling all star look-alikes became filthy rich and somehow became cool? This is today’s bond market. The swings in the bond market are huge, the action is exciting and as always, I will ask you again, who is going to buy the bonds, and at what price?
That’s right bond yields have exploded higher, and like we have been saying for a year now, when the Fed is buying half the bonds and you remove the Fed who will buy? If they do buy, how good of a price or yield will a seller have to offer. The 2 yr is over 5% and the 10 year is over 4.34% which took out last fall’s high. To the moon, these yields are going. I don’t know actually, but I know that the move index is over 130 again. That is the volatility index for bonds and it is again flashing dangerous levels of volatility. This isn’t normal which is why I am writing about it. No one and I repeat no one thinks that the US could be in danger, but I think if any other countries had bond yields rise this fast it would be a problem.
Is Japan responsible for this? Many people think they might be. They could be selling US bonds and buying Japanese bonds instead to reduce the currency risk as we have talked about. Could it be the US Treasury selling lots of bonds like we have asked? More supply requires cheaper prices on those bonds and since bond prices and yields move in opposite directions yields have went up. Is the bond market starting to believe Jerome Powell that he is going to keep rates higher for longer. These are three of the most popular theories out there, but let’s think outside the box.
One reason I think interest rates are going higher is that money supply is contracting. In April, banks were failing like Silicon Valley Bank and First Republic Bank. We saw that many banks, not just the ones that failed, were buying bonds with their excess reserves on the asset side of their balance sheet to offset the deposits of customers on the liability side. Wake up people! Sorry, I assumed you were falling asleep while I talked accounting. It’s true banks were buying bonds, but with customer taking their deposits out of banks and to money markets or even high yield savings account like we discussed here, there is less bank buying of treasuries. Banks weren’t lending and creating new money when they were buying bonds and they are continuing that practice now, and if banks don’t lend money into existence there is just less money to buy stuff out there and there is a lot of competition for money right now. There are vacations, stocks and the FOMO of not being in the stock market, Real estate has been hot for the last 5 years and has pulled back in the last year or so just slightly. Are people wanting to buy more real estate?
Zero days to expiry options are another huge liquidity drain right now. Up to 40-50% of options activity right now is in these short-term options. That is money that is not going somewhere else. It is a substitution effect. Why would you want to buy a boring old station wagon bond when a sleek new corvette option is an alternative. 4% yield over 30 years is no match for a 1000% return by happy hour. Much like Bitcoin took money away from gold in the sound money group, 0 DTE options are a major alternative for retail money. They could buy bonds, but they aren’t.
What if, and this is a big one, what if the risk free rate isn’t risk free anymore? We talked about this a couple weeks ago, but Fitch downgraded the US credit rating for a reason and rates have gone up since. The media rolled out the usual suspects to say loudly that it didn’t matter, but a purchase decision isn’t propaganda. That is where the rubber meets the road. Do you buy something that you know you are going to lose on? It doesn’t matter that the US might default, I am a good American and I will buy bonds anyway. No, of course not. It is easy to say, but no one does this. The debt clock is now over $32.7 trillion dollars. The federal government is spending money like Montgomery Brewster following the wishes of Rupert Horn. That was $30 million in a month and we are overspending by more than $100 billion every month.
There is a world out there of people, clueless people with more interesting lives than listening to bond talk on a Wednesday, that have no idea how this will affect them. They are happily spending their pensions which are loaded with bonds, bonds yields are the underlying input into the discount rate of how to value stocks and the higher the rate the lower the stock valuation, not that valuations matter right now to investors, but they will. These people own homes that have no market. There are no buyers for their homes at these prices because the mortgage costs are too high which are driven by you guessed it, the interest rate behind that mortgage. These are nice people that you know, you chatted up at a barbecue, you see at work, and there is an anvil hanging over their portfolios. They have equity in their homes, and maybe a second home, an RV, or maybe just a large 401k or pension. Every thing they believe is comfortable, that they think is safe, is at risk. Their entire life they have followed what our government has told them to do. Invest, be diversified, and vote for us. They have and they have been rewarded, but what happens when they realize that it was the government manipulation that allowed the growth to excess to happen? Bailouts in 2008, low interest rates, and lots and lots of easy credit has allowed them to become far richer than they deserve to be. Easy come and easy go. No one can foresee how the US treasury could be at risk, it is on no one’s bingo card and that is often what can rattle markets. What do you think can never happen? Last year, bonds sold off in the worst way since the Civil War, it couldn’t happen again, but we are back at those levels again in the 10 year bond. What about their enablers, the governments themselves? What is to stop the governments from just changing the tax laws and taxing that wealth. There is no easier way to balance the budget than to increase government tax revenues to offset spending. C Thomas raising taxes is unthinkable in today’s day and age, no cutting Social security and Medicare benefits is still unthinkable in today’s society, but they too will have their day. Taxing rich people with two homes and an RV isn’t unthinkable but the near term future, but today let’s focus on bonds.
One reason people say that bonds can’t go higher is that is unthinkable. That’s right not able to think. We like to try thinking once in a while and it doesn’t mean we are right or timely, but we want to consider what could happen. Why don’t we think this could happen? Let me tell you a little story about a country that thought interest rates could never go up. They had interest rates really low and people said that rates could never quadruple or go up just 5x. They were right, rates went up 10x in one year and the people were shocked that it didn’t break the financial system. That little country was us just last year. No analyst had 5.50% interest rates prognostications last year. We said that we were going to 5% here at CTPC, but that was only after we had gotten to 3.5% or 4%. I didn’t even think this would happen, and I am a pocketful of cloudiness most days. So what is to say that we don’t go to 7 or 8%? Charts don’t say it, because a long-term bond chart looks like we are about to explode like Violet Beauregard. Unions are negotiating higher wages, UPS drivers are making over $100k, a few might make the advertised $170k but the United Auto Workers are about to strike over their wages, and they are going to take their executives to task and demand higher wages, lots higher. This is inflationary and if you think Powell can lower rates while inflation goes up, then you don’t know our Jedi Jerome Powell. If forced to choose inflation which affects everyone or taxing rich folks to balance a budget Powell would suggest raising taxes. He is adamant that inflation will be back to 2%. Avoiding social unrest is more important than taxing the rich. This is the single oldest mandate of the Fed and he will provide it. Yes, he will wreck the economy to do so. That isn’t unthinkable, that is what he is doing.
Sincerely Yours,
C Thomas Printer
On this date in history… 718 years ago to be exact, William Wallace was executed for demanding freedom from heavy taxation at the hands of the English.
Today’s thought experiment is simple- what would you do if interest rates go to 8%? Would you be the one to buy the bonds?
Also born on this date- Kobe Bryant, Renaissance man.