Bond crash to continue in 2002

The following is an extract from commentary that was originally posted at www.speculative-investor.com on 3rd January 2002, but it is certainly just as relevant today. As bond yields rise during the course of this year a lot of explanations will be put forward to explain the rise, many of which will be off-the-mark. For example, both the perennially-bullish contingent and those who are married to a deflationary view of the future will no doubt concoct spurious reasons for the upward trend in long-term interest rates in order to avoid having to acknowledge the real cause. 

Alan Greenspan made the following comments during a speech in January 1997. We've referenced these comments in the past because, whether this was Greenspan's intention or not, they neatly sum-up both the nature of our fiat currency system and the immense power wielded by central banks.

"Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank. That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency."

At this time we'd like to focus on the underlined section of the above quote: a government cannot become insolvent with respect to obligations in its own currency. To put this more bluntly, the US Government will never run short of US Dollars. Over the past several years the private-sector demand for US Government debt has remained reasonably strong, but if there should ever come a time when private-sector demand dries-up then the Fed will provide the US Government with whatever amount of money it needs to continue functioning. The money will be provided in exchange for IOUs (US Treasuries) which will never be repaid. In other words, the US Government has unlimited access to US Dollars. Unfortunately for the Argentines, their government does not.

The implication of the above is that there is zero risk of default on US Government debt. Actually, to be more accurate we should say that there is zero risk of direct default on US Government debt. The US Government will never be unable to repay its debts, but repayment will likely be made in dollars that are worth less than they were at the time of the original loan. As has always been the case, a long-term lender to the US Government (anyone who buys a US Government bond) takes the risk that inflation will reduce the value of the Dollar during the course of the loan by more than the inflation premium that was originally built into the interest rate on the loan. 

In some important respects the way things are in the financial markets today is the opposite of the way things were 70 years ago. During the crisis of the early-1930s the US$ was convertible into gold at a fixed rate. This meant that US Dollars could not be arbitrarily created by the Fed in unlimited amounts to satisfy the financing needs of the Government which, in turn, meant that there was a genuine risk of direct default on US Government debt. US Government bond prices plunged during the early-1930s as this risk of default was discounted by the market. The risk that the bond market must discount today is not that the US Government will directly default on its obligations, but that it will surreptitiously default via inflation.

US Government bond prices have tumbled over the past 2 months, thus driving long-term interest rates sharply higher. This development fits our inflation thesis - the inflation has already occurred (the inflation is the past year's huge increase in the money supply) and the next 2 years will see the effects of this inflation ripple through the financial markets and the economy. One of the last places that the effects of the inflation will become evident is the Consumer Price Index, whereas one of the first places that it will become evident is the bond market.

Although bonds have broken below their short and medium-term up-trends since peaking in early-November, it is still possible that we are simply seeing a severe correction in an on-going bond bull market. However, we think it is more than that. In our view, the era of falling interest rates has come to an end. 

Bearish sentiment towards bonds is approaching a level that is usually associated with at least a temporary bottom, so the near-term downside potential appears limited. However, we expect bonds to fall far enough in 2002 to push yields well over 6%. In fact, a rise in the bond yield to challenge the Jan-2000 peak of 6.75% is likely before this year is over.

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