Tuesday, July 13, 2010

Bond Yields, Inflation, Risk and You

The connection between bond yields (interest rates) and inflation is at best correlation, not causation. The difference could impact our own individual finances.

Of all common financial assumptions, there may be no more universally accepted truism than "inflation causes interest rates and bond yields to rise." Too bad it's wrong.

To the degree that bond yields are set by the market (as they supposedly are) as opposed to being set by cloaked government intervention (i.e. the Fed giving proxies free money to buy Treasuries at absurdly low yields), then the key dynamic-- as in any open, transparent market--is supply and demand.

Bond yields rise when the demand for bonds paying low yields falls below supply. Inflation is not the cause--the perception that inflation might be a risk going forward is one factor which would cause bond buyers to refuse to lock up their cash for long periods of time at absurdly low yields.

But inflation isn't the only risk which can cause yields to rise, as Greece has illustrated. Default is also a risk which must be priced into the yield of a bond, and thus yields can skyrocket even in zero inflation.

It is not inflation which drives up interest rates and bond yields, it is the perception of risk and an insufficient supply of willing capital to meet supply.As the supply of bonds flooding the market rises, then cash must be pulled away from other investments and assets into bonds.

What few observers seem to grasp is the sellers of bonds--nations, banks, et al.--have no Plan B. They have to sell the bonds to raise cash to fund various Elites, cartels, fiefdoms and "bread and circus" benefits to the marginalized citizenry.

They cannot go to the capital markets and float an IPO, and short-term borrowing by banks to keep afloat has only exacerbated the problem: in addition to central governments coming to the market to sell trillions in new debt, banks must sell $5 trillion in new debt as all their short-term obligations come due.

Crisis Awaits World’s Banks as Trillions Come Due:

Their concern is that banks hungry for refinancing will compete with governments — which also must roll over huge sums — for the bond market’s favor. As a result, credit for business and consumers could become more costly and scarce, with unpleasant consequences for economic growth.

Banks worldwide owe nearly $5 trillion to bondholders and other creditors that will come due through 2012, according to estimates by the Bank for International Settlements. About $2.6 trillion of the liabilities are in Europe. U.S. banks must refinance about $1.3 trillion through 2011.

Bottom line: banks need $5 trillion, governments need $5 trillion (or more) and globally, private enterprises need trillions more to finance new capital projects.That's a lot of supply of new bonds (debt) and even if the capital/cash is available, the owners of those cash assets might be wary of the risks and thus they might (or should) demand much higher yields as compensation.

One party's debt is another party's asset. The American public is finally awakening from its credit-drunk decade to recognize that Debt is not the wonderful, generous friend who gives you the money to fulfill your heart's desires without the horrible bother of sacrificing consumption to scrimp and save, but a remorseless, pitiless oppressor who demands obediance to the iron laws of financial obligation and risk and return.

If risk is perceived, yields (return) must rise. It's supply and demand and risk and return, Baby, all the way--inflation is only one possible risk of many.

The consequences of this dynamic--risk and return, supply and demand--are far-reaching. Yes, we can get much higher interest rates and bond yields even if inflation is near-zero. We can also get a global "bidding war" as various banks and nations, desperate to keep afloat, keep raising the yields on their new debt issues.

The "solution" which is generally accepted as inevitable is that Central Banks will "monetize" the debt via printing trillions in new money. It seems highly likely that the EU's central bank and the Federal Reserve in the U.S. are already funneling "free money" to proxies who have marching orders to buy risk-laden debt just to make everything look under control.

The central banks will of course cover any losses, or discreetly buy the bonds from the proxies at full coupon value, absorbing the losses that way.

Can this mechanism cover the $10 trillion which must be floated in the next year, and another $10 trillion in the year after? That is an open question. Here's another: who benefits from the rise in yields? Those asset holders who are currently earning very little on their cash and other liquid investments.

An astute reader asked why the Financial Power Elites I described in The Con of the Decade Part I and The Con of the Decade Part II would encourage rates to rise, as any increase in yield would decrease the market value of the bonds they already hold. Excellent question, and I reckon the answer is that the Power Elites (and perhaps China as well) are selling longer-term Treasuries and other bonds and buying only short-term debt. Since you can hold a six-month T-Bill to maturity, then increases in yields will have little adverse effect on one's capital.

Only those foolish enough to see no risk going forward--those who hold 5-year or longer bonds--will suffer huge losses in the value of their bonds as rates rise.

Once rates have risen--I would guess to the 7-8% yield on short-term bonds and much higher on long-term--then the financial Elites will move their trillions into the long end. Once that move is complete, then rates can be allowed to fall.

Nothing is guaranteed in life, but holding firm to cui bono (who benefits?), risk and return and supply and demand will serve us better than distractions about inflation/deflation.

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