The bubble in US government bondsDecember 23, 2008
The President-elect has already warned the world to expect massive deficits in the coming years. For the purpose of this post, I won’t discuss whether the spending surge will be productive or inflationary, I will merely ask the question – where will the money come from? Governments can only raise money in three ways: taxation, borrowing and printing. When the purpose of your deficit is stimulus, it wouldn’t make any sense to raise funds through taxation. In fact, Barack Obama has already stated his intention to reduce taxes for 95% of the public and freeze the current level of taxation for the rest. Similarly, when you’re trying to kick-start the economy it would be counter-productive to sell bonds to the public, that removes money from circulation. They could sell bonds to foreigners, but that assumes demand will remain for these securities in the face of economic softness abroad. Foreigners are more likely to sell their existing treasuries to stimulate their domestic economies rather than buy more. The only remaining option is to print. The mechanism by which this will be accomplished has already been announced by Ben Bernanke. The Federal government will issue new treasury bonds, but instead of being sold to the public they will be sold to the Federal Reserve. Of course the Federal Reserve has no money, they will buy it with a wink and a nod by just typing some number in a government bank account. They no longer even need the paper… The way I see it, this could play out in one of three ways:
I wonder if perhaps a combination of all three is in our future. The most obvious question-mark is whether people will actually dump their treasuries in the face of tiny yields. We have seen short term bills rise dramatically despite negative yields, could that not be repeated with the long bond? My personal opinion is no, and the reason is simple – there is so much uncertainty about the next 30 years with respect to demographics, social security, medicare, the rise of China and the availability of resources, etc. that nobody has any measure of confidence a dollar returned 30 years from now with have enough value to justify the opportunity cost. Who locks in their cash for 30 years with a declining empire brimming with debt and facing hyper-inflationary monetary policy? The fundamentals that drive demand for bills are different than bonds. If the purpose of buying government debt is a rush towards safety, bonds don’t make the cut. Of course for that to be true, there must an alternative investment with at least equivalent safety and the prospect of better returns. I have suggested in other posts that gold could serve this purpose. Gold can rise in both deflationary and inflationary environments, but especially hyper-inflationary. Gold suffers only during periods of low-volatility and low-uncertainty, that’s the opposite of the next few decades.
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one short and probably irrelevant comment is that Treasury notes can be short term….as in less than a year.
As you say people are looking for places to park their money during this time of uncertainty and since at least you can get some interest, as opposed to losing, treasusries at least seem safe.
I looked into gold, just a bit, and it is not free of volatility, either. I wonder about predictions. As you have said previously economics is not a science.
Oh I agree with you 100%, take any prediction with a grain of salt. I always tell people that all outcomes are dependent on people taking actions, and there is no way for anyone to know with certainty what actions people will take, even with randomness and everything else aside. I should put that disclaimer at the bottom of all my posts.
However, I also believe the best way to make money in the long run is often to do the opposite of what everyone else is doing. That’s essentially the point of my gold awareness campaign post. The more confident people become that government debt is secure, the more likely they are to over-expose and over-extend themselves and become arrogant or almost religious in their views — that’s how bubbles are created — when the increasing prices become the justification for further increasing prices, the fundamentals be damned. Well, the fundamentals for treasury bonds are terrible yet the prices are rising nevertheless. It’s irrational and unsustainable. There will be an explosion of supply and with yields this low, a lack of demand, that will be filled by the Federal Reserve with a printing press. I mean it doesn’t take a rocket scientist to figure that one out.
Of course the price of gold moves around, but that’s really the value of dollars going up and down. But sure nothing is guaranteed, everything should be hedged.