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Bond Market, The Most Dangerous Bubble of All

Interest-Rates / International Bond Market Feb 07, 2011 - 08:57 AM GMT

By: Martin_D_Weiss

If you agree that the tech bubble of the 1990s and the housing bubble of the 2000s were extreme, then you must not ignore a bubble that could be the most dangerous of all — grossly overvalued bonds.

That’s precisely the bubble we have right now! And in just a moment, I’ll tell you why it’s going to bust. But first, consider …

The Swift and Certain Impacts Of ALL Bond Market Busts …

Let’s say I pay $10,000 for a $10,000 face value bond paying 5 percent. I earn $500 in interest each year. No more, no less.

Now let’s say the price of that bond plunges to $5,000. If you buy it at that price, you still get $500 in yearly interest.

But all you’ll have to invest is $5,000. So your interest yield is not 5 percent. It’s 10 percent! The price of the bond falls in half; the yield doubles!

In fact, the price and the yield of a bond are really two ways of measuring the same thing — much like a cup 3/4 full is the same as a cup 1/4 empty.

So when the bond market bubble busts, the inevitable and immediate consequence is that interest rates surge — not only on bonds, but also on mortgages, auto loans, business loans, and almost every kind of financing imaginable.

If you hold fixed-income investments locked in at today’s low interest rates, you will almost definitely get hurt, regardless of what kind you own — Treasury bonds, Ginnie Maes, municipal bonds, mortgage bonds, corporate bonds, long-term bank CDs, plus many kinds of life insurance policies and annuities.

Either …

• You’ll get stuck with miserable, below-market yields for years to come, or …
• You’ll have to pay a tremendous price — losses in principal and/or stiff penalties — to switch to higher yielding investments.

Not a pretty picture!

On the flip side, though, you will also have the potential for large profits with a relatively high level of certainty.

How?

Well, years ago, it would have been very difficult or very risky. You’d have to be a government security dealer trading tens of millions of dollars. Or you’d have to get involved in futures contracts.

Today, fortunately, you can profit from rising interest rates with simple exchange-traded funds (ETFs) that any investor can buy in any standard brokerage account, online or offline. The more bond prices go down — and rates go up — the more you stand to make.

This is why Safe Money editor Mike Larson has been recommending these ETFs continually, and they’re starting to pay off.

Take TBT, for example.

For most of last year, this ETF didn’t do well — it fell in value because long-term Treasury bond yields were still going down.

But since September 2010, when those yields began to rise virtually nonstop, TBT has been going up in tandem — also virtually nonstop.

Moreover, it’s designed to rise at TWICE the pace of the move in the bond market:

If Treasury bond prices fall by 10 percent, this ETF is designed to rise by 20 percent. And that’s precisely what it has done — or better — in the past few months!

Why the Bond Market Is Undeniably a Bubble

The most obvious, telltale sign of a bubble is when asset prices are artificially driven higher by misguided government supports, subsidies, bailouts, or sheer greed and stupidity.

That was certainly the case of the housing bubble.

It was also true for some of the greatest bubbles in history — the Dutch Tulip Mania in the 17th century, the South Sea Bubble of the 18th century, the stock market bubble of the 1920s, plus many others.

And it’s definitely the case here — not only in recent years, but going back for over a decade.

In fact, since the year 2000, one of the most frequently used — and abused — policy tools of the Federal Reserve has been to cut rates and artificially bubble up bond prices.

• The Fed cut interest rates and supported bond prices to fight the technology bust, the 9/11 aftermath, the housing bust, the mortgage meltdown, the credit crunch, and the debt crisis.
• The Fed did it again to help avert deflation, debt defaults, and other disasters. And …
• The Fed is still trying to do it AGAIN now, but with a big difference: Its bond-market buying binge is finally starting to backfire.

The facts supporting this thesis are undeniable and speak for themselves:

• In the early 2000s (starting January 3, 2001), the Federal Reserve lowered short-term interest rates 13 times, to 1 percent, and then sat on them at that level for 12 months.
• In the late 2000s, when the financial crisis struck the world, the Fed did it again, lowering short-term rates nine times to virtually zero.
• And starting more recently, when the Fed ran out of room to lower short-term rates, it targeted long-term interest rates — by running the printing presses and buying up even more bonds.

The consequence is also undeniable: The biggest bond market bubble of all time. The only remaining question is …

What Will Trigger a Bond Market Bust?

Take your pick (one or more) …

Trigger #1. Inflation and Inflation Fears. Inflation has been so low for so long, that the complacency on Wall Street and Washington is bordering on the pathological.

Here we are — with massive surges in the price of gold, silver, agricultural commodities, and now, energy to boot — but STILL most bond investors, including the “smartest” banks and insurance companies, don’t seem to bat an eyelash.

Here we are — with money supply and inflation surging in China and other emerging markets — and again, virtually no one seems to care.

These price surges are bound to pop up in the U.S. producer and consumer price indexes, which investors DO pay attention to. And when they do, an instant bond market bust is a likely outcome.

Trigger #2. Deficit Inaction. When the Congressional Budget Office recently announced that THIS year’s deficit would hit nearly $1.5 trillion, bond prices fell and interest rates rose.

Bond investors knew that the Treasury would have to issue huge new supplies of bonds to finance the deficit. And they knew that big new supplies equal even bigger price declines.

What happens if the deficit balloons to $2 trillion? Another big decline in bond prices!

And what if Obama and Congress continue do little or nothing to make good on their promises of deficit reduction? Still MORE steep price declines!

Trigger #3. Dollar Collapse. Three out of every five dollars financing the U.S. federal deficit now come from foreign investors. Only two out of five come from domestic investors (other than the U.S. government itself).

Heck, the last time America was so dependent on foreign money, Benjamin Franklin was sailing to Paris to beg the French to help finance the Revolutionary War!

What happens next? As long as those foreign investors believe they’ll be paid back in dollars that are worth something, they may hang on.

But as soon as they see the value of their dollars collapsing, the only rational response is to dump their holdings — driving bond prices down and interest rates skyward.

What if the economy sinks? Will that save the bond market?

Before he passed away, my father, J. Irving Weiss, who lived through — and even predicted — the Great Depression, answered a similar question in a very unique way. Here are key excerpts from his manuscript of the subject …

The Bond Market Bust of the Early 1930s by J. Irving Weiss (1908 – 1997)

In the early 1930s, I had one of the greatest income opportunities in history.

I could have gotten high, juicy, double-digit yields on the best bonds of the strongest companies in America. And I could have locked in those high returns for 20 or 30 years with virtually no inflation.

The yields on guaranteed government bonds were not as high, of course. But even there, the income opportunity was unusual.

Unfortunately, I missed it entirely. I made the mistake of believing the textbook theory on interest rates.

That theory was based almost entirely on the economy and inflation. When we had more growth and inflation, interest rates were supposed to go up. When we had less growth and inflation, rates were supposed to go down.

Nobody looked at interest rates as separate and apart from growth or inflation, and neither did I.

Boy, was I in for a big surprise! In fact, just as I began to watch rates more carefully, every single thing I had read about them went by the wayside.

Here’s what happened: After the Crash of 1929, interest rates fell sharply, which was to be expected, because of deflation.

But then, something absolutely astounding took place: Although we were still in a deflationary era, although the economy was still sinking, interest rates began to surge dramatically.

The immediate reason: Bond markets collapsed.

However, in the early 1930s, when I saw rates surging, I didn’t understand the cause. It didn’t make sense because we had deflation. And with deflation, the textbooks said interest rates were supposed to go down.

So I asked myself: Was inflation coming back? Did I read the textbooks upside down? The answer to both questions was a flat “no.” Yields were surging because bond prices were crashing, just like stocks. And that’s when I began to look at interest rates as a powerful fundamental force in their own right, separate from the economy or inflation.

The yields on low-grade corporate bonds were the first to surge as their prices plunged. It was like an aftershock from the stock market crash.

This made sense because these were bad bonds and they traded almost like common stocks. They were issued by companies that were expected to default on their payments; and a lot of the companies did just that. So it was natural that their bonds should fall in value or even become worthless.

As always, the lower the prices, the higher the yields. And wow! Did those yields surge! They went to 15 percent, 20 percent, 30 percent, even 45 percent. But what good was it if you lost your principal?

Then high-grade corporate bonds also got hit hard. Investors feared that any company — regardless of rating — could go belly-up, and they were right!

At some companies, finances deteriorated so quickly that, by the time the analysts got around to downgrading them, they were already in the bankruptcy courts. As the price of these high-grade corporate bonds crashed, their yields surged.

And amazingly, they surged beyond their 1929 highs. Someone was obviously selling the heck out of them. But who?

You’d think that at least government-guaranteed Treasury bonds would be spared from this selling panic. They weren’t. Investors sold them aggressively, driving their prices to new lows, following in the path of corporate bonds. Yields surged.

Where was all the selling coming from? One source was the U.S. Treasury itself. In the sinking economy, the government’s tax revenues plummeted. So it needed to borrow more to replace the missing revenues. And that meant it had to issue more Treasury bonds — more bond supplies, lower prices, and higher yields.

But that still wasn’t enough to explain it. It still didn’t tell us what drove interest rates up when every textbook in existence said they should be going down.

It wasn’t until later that my brother Al and I figured it out. To understand what was going on, we had to forget about inflation, deflation, money supply, the Federal Reserve, and all the theories economists swore by.

Instead, we looked at bonds like any other kind of investment — no different from stocks or commodities. When investors sold them, they went down in price. When investors bought them, they went up.

These investors didn’t give a hoot about textbooks. All they cared about was the fact that they needed cash.

The banks needed cash to meet huge demands by savers withdrawing their money. Businesses needed cash to pay bills. Insurance companies needed cash to pay claims.

So the execs went to their financial VPs to dig up something they could sell off for cash.

“What’s this stuff?” they asked.

“They’re bonds, sir,” came the answer. “They’re solid investments — not like stocks.”

“Can you sell ‘em?”

“Sure we can. But bonds are good for bad times. You shouldn’t be selling them now because …”

“I don’t give a damn if they’re good, bad, or in between. Sell ‘em! Raise cash!”

Thus, tremendous amounts of bonds were dumped on the market. High-grade bonds. Low-grade bonds. Muni bonds. Treasury bonds. It didn’t matter what color or denomination. Everywhere, individuals, financial institutions, and businesses were getting rid of their bonds.

If they were low grade or on the verge of default, they got no more than pennies on the dollar. And even with higher grade bonds, many investors were simply throwing the baby out with the bath water, driving prices to new lows.

Looking back, I wish I could have had the foresight to convert my winnings from the stock market crash into the highest grade bonds. On top of the high yields, the purchasing power of the dollar improved. And throughout the entire Depression, bonds outperformed virtually every other investment in the world, with far less risk.

But by the time we had figured it out, the opportunity was gone. As the Depression progressed, rates fell back down again, and only those who had locked them in during that unusual period were able to enjoy the higher incomes. — J. Irving Weiss

The Key Lesson to Be Learned From Dad’s Experience: Wait till you can get juicy, double-digit yields on some of the highest quality bonds in the world. Then, start buying! But whatever you do, don’t get stuck in bonds when their yields have been driven down to the lowest levels in history.

Good luck and God bless!

Martin

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Comments

John 13 Feb 11, 20:24

when So Martin when do you think this all going to happen. You have been talking about this for a while and nohting yet !!