Thursday, August 22, 2013

Bond Market Misconceptions, Facts, and Fallacies; Bond Market About to Collapse?

The number of truths, half-truths, and blatantly false perceptions regarding US treasuries all strewn together is quite typical in mainstream media analysis, and also non-mainstream media analysis.

For example, please consider Will the Last Person to Leave the Treasury Market Please Turn Out the Lights? by Michael Pento as presented on Yahoo!Finance.

Here are some statements Pento presents with my comments.

Pento: In truth, [treasury] yields currently do not at all reflect the credit, currency or inflation risks associated with owning Treasuries. If the Fed were not buying $45 billion each month of our government bonds, investors both foreign and domestic would require a much higher rate of return.

Mish: Correct, depending on the definition of "much".

Pento: Investors have to be concerned about the record $17 trillion government debt (107% of GDP), which is growing $750 billion this year alone.

Mish: Correct

Pento: Foreign investors have to factor into their calculation the potential wealth-destroying effects of owning debt backed by a weakening U.S. dollar.

Mish: Somewhat correct but also misleading as well as incomplete. Foreign "investors" do have to factor in a weakening dollar but primarily vs. their own currency. The US alone is not printing like mad. Currency risks are everywhere you look. More importantly, foreign central banks do not have to factor in weakening dollar calculations (and indeed they don't for mathematical reasons explained below).

Pento:  Due to its foolish embracement of Abenomics, Japan will also have to fear a collapse of its debt market from rising inflation in the near future, just as we do in here.

Mish: Correct but Backwards. On the current Abenomics path, Japan faces a far bigger risk of currency collapse than the US. Japan is the big story and faces a bigger as well as quicker collapse than the US.

Pento: If the free market were allowed to set interest rates and not held down by the promise of endless Fed manipulation, borrowing costs would be close to 7% on the Ten Year Note.

Mish: Pure speculation and likely drastically overstated. Pento does not know where rates would be, nor do I, but I suggest Pento simply does not understand the debt-deflation drag that would force yields lower. 4-5% is a much more reasonable expectation in my opinion, and even that might be high. If governments reined in debt on account of a less-accommodating Fed, long-term rates would likely collapse with short-term rates rising.   

Pento: Long term rates have been pushed lower by four iterations of QE. The latest version is record setting, open-ended and massive in nature. Since QE is mostly about lowering long-term rates, it shouldn’t be hard to understand that its tapering would send rates soaring on the long end.

Mish: Correct depending on the definition of "soaring", but also assuming governments did not rein in debt and also depending on actions of other central banks. If 4% constitutes soaring, then assuming not much else changes, I am inclined to agree (but that is a lot of IFs).

Pento: When the Fed stops buying Treasuries, foreign and domestic investors will do so as well. This means for a period of time there won’t be any one left to buy Treasuries unless prices first plunge.

Mish: A very common misconception, and widely spread fallacy. It's important to distinguish between foreign investors and foreign central banks. Central banks buy US treasuries as a function of math, no more - no less. If the US runs a trade deficit, it is a 100% mathematical certainty that countries with a current account surplus vs. the US will have dollars to "invest". Where do they put them? The answer is US treasuries. In theory, foreign central banks could invest in any US$ denominated asset, but not wanting equity risk, and in preparation of eventual capital flight, the only market big enough to meet the needs is the US treasury market. Therefore, in practice, foreign central banks in current account surplus countries are net buyers of treasuries regardless of price.

Nonetheless, people propose all kinds of silly things such as "China and Japan should buy oil or other commodities with their dollars". 

The problem with such ideas is two-fold. First, Commodity-buying is pro-cyclical. China is slowing, it has less demand for raw materials. What would China do with a stockpile of coal or copper with prices collapsing and infrastructure needs sinking at the same time? Second, assuming China or Japan bought oil (ignoring storage costs) what would Saudi Arabia or Iran do with the dollars?

Once again, it is a mathematical fact that someone has to hold US trade deficit dollars or dollar-denominated assets. It is also a fact that foreign central banks are not concerned about theoretical losses on treasury holdings.

Here's why: If China and Japan did somehow permanently stop buying US treasuries, it would place upward pressure on the Yen and the Yuan. Does either Japan or China want significant upward pressure on their currencies? I think not.

The US has been begging China to strengthen the yuan. China has resisted, and Japan is doing everything it can to sink the Yen. 

Bond Market About to Collapse?

Pento is Author of the book “The Coming Bond Market Collapse”.

Depending on the definition as well as the suggested timeline, I might even agree with the idea of a "bond collapse". However, Pento clearly missed some significant factors and seems far too US-centric focused as well.

From my point of view, a bond market collapse in Japan, India, Indonesia, Argentina, the UK, and the Eurozone is far more likely.

For further discussion, please see Mish Video: Troubled Currencies (And There are Lots of Them), Gold, Bernanke, Carry Trades, Bubbles).

Also consider Official Denials Run Rampant in India; "No Question" of Economic Crisis; Rupee Plunges to Record Low; Gold Coin Imports Banned.

Please think about a definition of "collapse" and your timeline. Depending on your definition, a collapse may be a lot further away than most think.

Mike "Mish" Shedlock

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