So, who wants to talk about bonds? No? C'mon, bonds are the cornerstone of the global economy, 10 times bigger than the S&P 500. Bonds literally make it all work.
And those thousand-point drops we just saw for the Dow Industrials were in part a reaction to bond yields going higher.
Still nobody? It'll be fun, I promise. I've even got a bond joke for you...
Well, last week, a major Asian economic power was dumping U.S. Treasuries. Nope, not China. It was Japan. And they dumped $8 billion worth.
Apparently, the Japanese government is now losing money on some of its Treasury holdings due to a wicked combination of falling bond prices (rising yields) and the weak U.S. dollar. It's weird, because with Japanese bonds posting negative yields, I thought the Japanese liked losing money on bonds!
Ha! See? Told you I had a bond joke. I didn't say it would be funny...
Is this thing on?
Anyway. So, when Japan buys U.S. Treasuries, it has to convert yen to dollars. Conversely, when it sells, it's dollars to yen. And in one of the most shocking developments of the last 20 years, the yen has actually been rallying vs. the USD. So much so that Japan is losing virtually all of its yield, down to 0.6%. That's a yield Bernanke would have been delighted with! (Holy crap, another bond joke, ladies and gentlemen!)
But seriously, folks. If Treasury prices fall much further — as that 10-year yield marches toward 3% — other countries might discover that they, too, are actually losing money on the world's safest investment: U.S. Treasury bonds.
It's not supposed to work like that...Buy High, Sell Low
Foreign central banks don't really buy Treasury bonds for the profit potential. Treasuries are more like a bank account where you can stash billions, get a percent or two in interest, and cash out easily whenever you want. The only significant difference is that the Treasury doesn't keep a bowl of lollipops out for customers.
But that cozy little arrangement changes when you can no longer get more than percent or two and, in fact, start paying to keep your money in the Treasury bank. And it's changing at a very unfortunate time. To see why, let's have a look at what may be the MOST IMPORTANT CHART IN THE WORLD:
That's a chart of the 10-year Treasury bond yield over the last two years. The yield has basically doubled in the last 18 months. And when bond yields rise, it means the price is falling.
There are a few reasons U.S. Treasuries have been losing value pretty steadily.
One, the Fed has been hiking rates. Bond yields have been kept artificially low for years now. Former Fed Chief Ben Bernanke used a constant bond-purchasing strategy (quantitative easing) to keep yields low in the hope that it would spur lending (cheap money) and investment (low return from bonds).
Two, inflation is picking up, in part because the labor market is getting tight. Former Fed Chief Janet Yellen started hiking rates based on a tried and true formula: tight labor markets mean rising wages and rising prices. You may recall Yellen saying it was a little odd that inflation hadn't picked up given the low unemployment rate, but that she still expected inflation to crop up at some point. Well, she was right. It's not runaway inflation, but the market now expects 2018 CPI to run about 2.14%.
And three, notice the big jump that yields took in November of 2016... Hmmm, was there some big event that really took the markets by surprise in November 2016?Spend, Spend, Spend
Trump won the election in part because of his campaign promises to spend money. He said he would spend more on the military, build a big wall, cut taxes, and dump a trillion into infrastructure.
If you believe that lower taxes will create so much growth that new tax receipts will offset the cuts — the Laffer Curve — well, I've got a wall in Texas to sell you. There is exactly zero evidence to support this. And the bond market knows it... ( Editor note:This is an opinion that has support as to it working)
That's why bond yields took off after the election. The bond market fully understands that Trump's policies mean more spending. More deficit spending. And that means the U.S. Treasury will be selling bonds in record amounts.
Right on cue, the Treasury is selling $258 billion in short-term notes this week. Yeah, that's not a typo. $258 billion in a week.
Now, John Maynard Keynes gets a bad rap. Critics like to say Keynesian economics promotes deficit spending all the time. That's not accurate. Yes, when an economy is struggling, Keynes said the government should take on debt to give a boost. But Keynes also said deficits should be paid down when an economy is cooking. The U.S. is now doing the opposite of that...
We are gonna be running record deficits for the next few years. And all the supposed fiscal hawks in Congress who have complained for years that the budget is out of control and that your so-called entitlements should be cut to close the gap are spending money like drunken sailors. The government is acting like the credit cards it just got in the mail are free money.
Yeah, I'm talking to YOU, Speaker Paul Ryan.
All this spending will create growth, no doubt. It's also going to push inflation higher, require more bond sales, and also make it more expensive for the U.S. government to service its debt. All this at a time when central banks are raising rates, in effect sopping up extra liquidity.
So, basically, the U.S. government is trying to borrow more money when there's less money available.
If you ask me, this is the scenario that's going to end this magnificent bull market. Not tomorrow, mind you. We will probably see a surge in stocks and GDP while all this cash hits. But these bills will come due. And the bond market knows it.
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