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Are U.S. Treasuries A Bubble Ready To Pop?

Interest-Rates / US Bonds Sep 30, 2009 - 04:55 PM GMT

By: Andrew_Butter


Diamond Rated - Best Financial Markets Analysis ArticleThe standard theory is that the price/cost of risk-free long-term debt is a function of (a) the cost of short-term debt plus (b) some function of the market's anticipation of the likely course of inflation or deflation over the term of the debt.

Governments (the Fed) can control short-term rate but they are at the mercy of markets to fix long-term rates. And of course markets are "efficient", unless of course there is a "bubble", when...Err...they are not.

But then US Treasuries cannot be a bubble - who ever heard of such an idea!

What is a bubble?

A bubble, by definition happens when markets or market participants seriously misprice some class or category of asset, and they have this uncanny ability to pop up and bite you in the backside when you least expect it.

Examples from the past include the South Sea Bubble (which Sir Isaac Newton invested in (on a margin), and he was financially wiped out), the 1929 stock market bubble which Sir Winton Churchill invested in (on a margin) and was financially wiped out, more recently there was the S&L and the bubble, and if course the house price bubble in which many Americans invested in (on a margin) and they, and many banks and bond-holders that provided the margins, were financially wiped out.

It's not just greedy lunatics that get fooled by bubbles, some very smart and otherwise perfectly decent and sane people have got fooled in the past, and every time they tell themselves, "it's different this time".

A bubble in Treasuries?

Of course there has never been a bubble in long-term Treasuries, so there is nothing to worry about. I talked to a knowledgeable person who is in "bonds" and got told "there is a good appetite now, and of course in the medium term we might see some pull back...but nothing to worry your pretty little head about old chap!"

And yet I can't stop remembering being "honored" to be able to have a moment with the senior analyst of a major-major international real estate company in about September 2008, talking about Dubai, those were the exact words he used.

Six months later prices had halved.

So I said to Mr. Bond, "Well I'm talking about something else...bubbles. And I know about them, that's how on 26th February I could say that the S&P would turn as soon as it pierced 675 and would go up to 1,000 without a major reversal"

To which he said, "well if you got that close then you must have been lucky".

Can't win.

So what's the chance of third-time-"lucky"?

Bubbles are ultimately unstable which is why they pop. Often the "pop" is catastrophic, and fast (

The key reasons bubbles are created (no they are not accidents) are:

  • Market participants lose sight of the fundamental value of the assets in question, quite often that's because of a "new" situation, or because they get confused and don't have access to the right information to make rational investment decisions.
  • Often this is facilitated or caused by actions of government.
  • Often credit plays an important part, typically when it is available at a cost less than the inflation in a particular class of asset.

Fundamental value

Now, I'm going to have to think! Can I think of any instance in the recent past when "market participants" (by that I mean the "professionals") lost sight of the fundamental value? 

That's a tough one, hang on I remember a conversation wasn't there something to do with housing? But then of course that wasn't anything major, after all the Chairman Greenspan The Great said that was all just a bit of froth.

It's coming back...I remember I had a conversation in 2005 about house prices in USA and UK, and someone told me "there is a good appetite now, of course in the medium term we might see some pull back...but nothing to worry your pretty little head about old chap!"

What was new then was securitized debt.

This time what's "new" is that the financial system had a "near miss". That's new, unless you buy the idea this is a carbon copy of the Great Depression and that by understanding what went wrong then you got a road map to dig out of that hole.

Which sounds a bit like the theory that learning the lessons of the first Great War could help you fight the second one, which was the logic behind the Maginot line.

Another thing that's "new", is that there is a huge debate going on amongst the gurus and the market participants about whether to expect inflation or deflation in the near, medium or long term.

In the old days, that conversation was conducted POLITELY in oak paneled rooms over sherry as the great economists of the time mused of such imponderables as "inflation targeting", and "M" and "V" and "T" and "ABCD".  Now the debate is starting to look a bit like a catfight.

There are many "schools" all with conflicting positions. Close your eyes and you might be fooled that the "war of words" was one of those debates between high priests in the Middle Ages about how many angels could stand on the tip of a needle.

The only contribution that I would like to make to that debate is to remark that (A) there is clearly not a consensus, so it is possible that at least half of the market is going in the wrong direction (whatever that ultimately turns out to be).

That sounds "confused" to me, and economists even hinting that they might be confused, is new.

(B): What if instead of inflation/deflation affecting the bond price, the bond price affects inflation/deflation, like "is the dog wagging the tail or is the tail wagging the dog?

The “Government” has the idea that it is “in control”, but is it?

The Government as a facilitator of anarchy and chaos
Some commentators have argued that the history of Monetarism is about the government lending, or creating conditions for lending money cheaper than the inflation in assets, thereby creating a frenzy of "economic" activity, which creates bubbles, which then burst, bringing you back to Square One.

The fact that gets you to back to square one (or worse) is because of the pesky Second Law of Thermodynamics which says that you can't create something from nothing, not that some people don't get very rich in a bubble (and some get very poor), but it's just a re-distribution of wealth, and the sum of all the parts is zero, or less (due to efficiency losses, which in the case of the housing bubble was the "commission" Wall Street creamed off the top).

The current US administration believes that a "bit of froth" is a good thing from time to time, so long as you can control it. Some people think that's crazy, and the passion surrounding that debate is as intense as the passion surrounding the inflation/deflation debate.

By the way, I had a friend called David. He was great; you couldn't meet a nicer guy, kind, considerate, funny!
He used to take heroin from time to time, "not much mind"; just he felt that now and then it was a "good thing", and he told me, "don't worry your pretty little head about it, I can control it".

He's dead now.

Sometimes you can have too much of a good thing.


What's happening at the moment is that the US Government (as a whole) is borrowing money at about 2% lending that to bankers at less than 1% then the bankers are buying 30-Year-Treasuries at 4%.

In the old days they had the 3-6-3 rule (borrow at 3, lend at 6 and be on the golf course at 3), the US Government is evidently going with the 2-1-4 rule; that reminds me of Milo & Milo in Catch 22 (he who bought eggs for $2 and sold them for $1 and made a profit).

By the way the logic there is the bankers can "earn" their way out of trouble. I can't understand why they don't just give them money; I suppose that's politics, or perhaps they think that by doing that they can create money out of nothing?

Easy money bidding up asset values to "earn on the turn", is a classic cause of bubbles ("plenty of demand out there old chap"), perhaps that's the "bit of froth" that the government is creating, which of course is a "good thing"....from time to time.

Big picture:

A lot of people are in debt, all over the world, they would like to get out of debt, but they can't sell the assets they hold at a decent price, and even if they did, they might still not be able to pay their debts.

So what choice do they have?

Well they need to roll over debt but no one wants to lend to them, so what should that be doing for the 30-Year Treasury? Pushing up the yield (i.e. the interest people pay), and pushing down the price.

But it's not; could that be a bubble?

But don't worry! People much smarter than you have got everything under control!
Of course the way to get out of debt is to take on more debt, just like the way to cure a heroin addition is to take more heroin. That's why the US Administration (taken as a whole), is piling on more debt, lots of it.

So how much debt we talking about?

Some people are getting all hot and bothered about the debt that the American Government (as a whole) is taking on.
I hate to be a killjoy, but that's not the half of it, if you think that's a problem, well consider this, the debt that the WHOLE of America has taken on and that is owed to foreigners is a bigger problem, and whether that debt is increased by individuals borrowing or the state borrowing is just detail.

This is a chart of how much tradable debt (i.e. bonds) was issued in USA since 2000:

It's not exactly apples for apples, "Private Label" comes from the chart presented by Mark Zandi to the Financial Stability Committee in July which was prepared by Thompson Reuters, and is the total value at face of bonds issued and does not include any roll-overs, the Treasuries is the change in the National Debt and is therefore net:

The first point that I would like to make is that the total "Private Label" generated from 2000 to 2008 was much more (about $17 trillion) than the total Treasuries ($4.2 trillion), i.e. the amount of debt the private sector was piling on was up to five times what the government was piling on, but of course that wasn't enough to make a little bell go "ding" in someone's head.

I have not found reliable data on how much of that was sold to foreigners, but the consensus appears to be about 50%. So that's about $10.6 trillion "exported".

A problem right now seems to be that USA can't get enough debt to keep its shaky bicycle on the road because the "shadow banks" aren't making it any more. And most of the debt is being found is being used to pay back or somehow conceal old debts.

And the only way America can get debt now appears to be to sell 2-Year Notes, not 30-Year Notes (which would be a more realistic timeframe for paying them back). Perhaps a reason the 2-Year is in such favor is that the Treasury doesn't think it can sell 30-Year in any quantity, and has thus devised a circuitous route that will keep up "demand" for 30 Year stuff?

I wonder what's next?  Can we expect to see auctions of 1-Year Notes, then 6-Months, then 30-Days? Is this the desperation of an addict in search of one last fix?

And of course, something to look forward to, at some point in the not to distant future Americans are going to find $10.6 trillion of Yen, and Yuan, and Euros and Pounds to pay back that debt, or the proportion of it that they did not renege on.

AAA Quality: Made in America With Pride

That $10.6 trillion of debt was not counted as an "export" (because it was supposed to come back), but it generated foreign exchange all the same, which more than covered the current account deficit in goods and services that was accumulated over that time ($5.2 trillion).

So effectively what was happening was that Americans were mortgaging their houses, and via the kind intermediaries on Wall Street, selling the mortgages to foreigners who paid in Euros, Yuan, Yen, Pounds etc, and then they were using the foreign exchange to buy oil so that they could drive Hummers and also to buy nice toys and gizmos from China.

And they bought lots of stuff, little of which had the capacity for generating revenue in the future with which the ($10.6 trillion) debt could be paid back, any more than what's left after you sniffed some of that nice "good thing" from Columbia up your nose, i.e. zero.

That's a new category of borrowing; in the old days (1) you borrowed to finance CAPEX or working capital (which if you got your sums right had some chance of generating revenue to pay the debt back).

Then: (2) you borrowed to finance current expenditure, which you told yourself "might" have some chance of generating income (as if that was some sort of working capital).

Then: ((3)-the new category) "what the heck", you borrowed so you could sniff stuff up your nose to tide you over the withdrawal symptoms.

That's the bottom of the greasy pole.

Is that where USA is right now?

Looking at that another way:

Setting aside the "Inflationist/Deflationist" arguments for a moment, and also setting aside the notion that the yield on the 30-Year Treasury is somehow an efficient market that magically and mysteriously takes into account all future inflation/deflation, even when market participants (or at least their economists), can't agree these days on the semantics or the definitions.

Perhaps there is something else that affects the yield on a 30-Year which depends, not on the infinite wisdom of the market in guiding the decision about how many angels are going to fit on the needle, but on something that happens, in reality, in the real world, right now?

Perhaps #1:

Perhaps there is a link between (A) the amount of foreign currency that get changed into dollars every year, compared to (B) the amount of dollars that get changed into foreign currency, and (C) the 30-Year Treasury yield?

I'm sure there are a multitude of complicated economic and financial theories to explain that, which are easily as complicated as Einstein's General Theory of Relativity.

The only difference is those theories have never been subjected to rigorous scientific examination, well two things actually, that; and he fact that they have been used to cause more damage to the world than Einstein's Theories ever did.

And I'm sure the Fed has all sorts of complex data, but frankly (a) I can't make head or tail of them and (b) given past experience I think I prefer to deal with figures that I trust and that have been audited.

Perhaps #2:

Perhaps the big story in any case is just those three numbers, if A>B then there would be spare dollars floating around so yields would go down, and if B > A then it would be the opposite?  Just a hypothesis, that's what I want to test.

So how much were A and B over the past few years?

Well the net of exports less imports is pretty uncontroversial, even the economists don't argue about whether those are reported correctly or not.

OK so let's add to those numbers 50% of the tradable debt "manufactured" every year to get what I call the "Virtual Current Account Balance" (and just in case there are any "real" economists left in the audience I will give that the acronym VCAB because economists just love acronyms).

VCAB is a simple non-controversial number, three well-known numbers added together with only two assumption (50% of the debt was sold abroad), and net-net that was the main part of the current account balance.

How about a plot of that against the average 30-Year Treasury rate since 2000?

Now look at that!

What a pretty-pretty "S" curve, actually I'm not sure if it's an "S" curve or a line, but the point is when VCAB goes up the rate appears to go down, within the range of data being looked at.

OK the "proof of the pudding" is only three points, I suppose I should go back a few years, but big-picture they then hadn't invented the really toxic stuff that everyone loved, and in any case I don't have any clue on how much debt was sold abroad since then.

So on that chart, where is USA right now?

Err...see that red dot?

That's where it is, and a reason for that is in part because those shadow bank boys seem to have lost the knack of selling "AAA Made In America With Pride" Toxic Debt to dumb foreigners, like so many oil tankers full of melanin tainted milk (if they could that red dot would be over to the right).

That says something is keeping the 30-Year Treasury yield unnaturally low right now, it could of course be a bit of this it and could be a bit of that and it could be an angel with a sore toe standing on the tip of a needle. Trying to find exactly how that works is like trying to get a drug addict to tell you the truth about their habit, don't even bother.

But my guess is it's a lot to do with Milo & Milo or do they call them Goldman Sacks these days?

Whatever it is, it's unstable.

If this analysis is valid, at some point something has to give, perhaps quite soon no one is going to want to buy a 30-Year Treasury at 4% or something yield, they are going to say "No Thanks" I'll give you 7.5%.

Then I wonder what the value of the 30-Years that the Zombies bought at 4.5% will be worth? Of course that's nothing to worry about since FASB and BIS will let them record them at "face" for the purposes or working out their capital adequacy, the other word for that is a "Stress Test".

But the way it looks to me, the Greatest And Most Powerful Nation on Earth the one that everyone said was "To Big To Fail", show signs of running out of cash to feed its habit.

In which case pretty soon no one is going to want to lend it any more to continue with it's self indulgence, except of course the Fed, thank God for the Fed.

Of course perhaps I'm being alarmist, perhaps the "team" that created the housing bubble and the credit crunch, finally figured things out, but is it worth taking that chance?

By Andrew Butter

Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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