The Coming Destruction of U.S. Bonds   (October 3, 2008)

In the fantasy-world of market cheerleaders and "experts", interest rates will remain low indefinitely because the Fed will lower the Fed fund rate to near-zero. Nice, but the Fed doesn't control interest rates--the bond market does, and the bond market is set to reverse course, destroying the value of all existing bonds.

Many observers, myself included, have long contended that all three asset classes--stocks, bonds and real estate--having risen in unison in the phony credit-bubble "prosperity" of the past decade, will also fall in unison.

The housing bust has started--yes, only started--deflating the bubble-era valuations of both residential and commercial real estate, and global stock markets have already witnessed declines of between 20% and 65%. They are far from bottoming, too. Here is a chart which illustrates analyst Louise Yamada's view that the market is poised for a 50% decline along the lines of 1937's "echo bubble" collapse:

It will soon be bonds' turn to decline rapidly in value. Correspondents Craig M. and U. Doran have recommended the always-worthy Jesse's Cafe Americain's entry, The Mother Bubble: The US Long Bond. The charts reveal a 25-year long Bull market in bonds which appears to have double-topped: a sure indication that the top is in.

To provide context for the coming destruction of bond values, here is a chart which illustrates the vast indebtedness of the U.S. economy:

In other words, even before this insane $850 billion bailout (counting the $800 billion the Fed has already thrown down other ratholes, it's more like $1.6 trillion and counting) we were already up to our eyeballs in debt.

To refresh our memories of how bonds valuations work: picture a see-saw. When rates fall, a bond's price increases. When rates rise, a bond's price decreases.

For example: if a $100 30-year bond has a yield of 5%, then if rates fall to 2.5% the market value of the bond will almost double to around $200 because the effective yield of the bond at $200 is 2.5%. That is basically what has happened since the bond yield topped in 1981: face values of all bonds has been rising as yields have fallen from 16% to 3%.

If rates doubled from 5% to 10%, then the price of the bond would fall in half to $50, rendering the effective yield 10%.

At the risk of boring longtime readers, here is my oft-published chart of the U.S. bond yield and the staggering rise in Chinese ownership of U.S. debt:

What this chart illustrates is that the only reason interest rates haven't skyrocketed along with rising U.S. debt is that China and other non-U.S. players with hundreds of billions of trade-surplus dollars have been soaking up that debt (bonds) with their dollars.

This can be seen as manipulation for the benefit of oil exporters and Asian exporters equally anxious to prop up American consumers with low interest rates, or as intervention to keep their currencies lower than the dollar, or as a combination of manipulation/intervention and "safe haven" parking of stupendous hordes of dollars.

Regardless of the perspective, one thing is clear: as soon as that foreign buying declines, U.S. interest rates will start rising.

What could cause foreign entities to cut back on their purchases of U.S. debt? How about their flood of dollars suddenly drying up? As noted in Henry Paulson's recent essay in Foreign Affairs, The Right Way to Engage China, China has until recently generated astonishing surpluses of 11% of their entire GDP.

Though I consider Mr. Paulson's bailout of Crony Capitalism unconscionable (including our Chinese "friends" in the circle of cronies to be saved was key), he does have a keen understanding of the dysfunctional c0-dependency of China and the U.S. and a remarkably objective view of China's challenges, strengths and weaknesses:

One of the most notable indications of China's imbalanced growth is its large current account surplus, which last year amounted to over 11 percent of the country's GDP. This reflects the fact that China spends much less than it produces and earns and that it has a high rate of national saving. Chinese household consumption was only 35 percent of GDP in 2007, down from roughly 50 percent 30 years ago, when Beijing started market reforms. (Household consumption is roughly 70 percent of GDP in the United States and 60 percent in India.)

On the other hand, household savings are high, as individual Chinese try to compensate for the country's thin social safety net, limited options to finance major expenditures such as education, and few investment options other than bank deposits. Demographics will only exacerbate these trends: as China's population ages, the traditional source of support in retirement -- children -- will become increasingly scarce.

Here are the key take-aways: China has generated astounding surpluses of dollars via huge trade surpluses with the U.S., and very soon China will need to start investing whatever surpluses remain after a global Depression has gutted their exports in their own nation.

(If you'd like some context for considering China's dilemmas, please read my 2005 report, China: An Interim Report: Its Economy, Ecology and Future . You can also scan dozens of entries on China in the archives links in the left column.)

A few years ago I engaged in online debates with various smart people who were adamant that China had "decoupled" from the U.S. and would prosper on domestic demand/growth alone. Unfortunately, their case is about to be proven catastrophically incorrect. As Hank noted in his article (excerpt above), the Chinese people are keenly aware of their financial insecurity and therefore they are saving rather than spending; the domestic consumption share of their GDP has actually dropped.

That basically removes the key prop in the "decoupling" position. As U.S. demand for Chinese exports plummets (along with demand for all exports and indeed, all goods), the primary driver of China's surplus--$250 billion trade surpluses with the U.S.-- will shrink rapidly.

Simply put: China will no longer have the luxury of huge surpluses of dollars. It is astonishing how otherwise intelligent analysts make the basically unsound assumption that China will always have hundreds of billions of surplus dollars to park in U.S. debt. The global Depression will cut so deeply into Chinese manufacturing that China may well sink into a current-account (trade) deficit.

In any event, China is already feeling growing domestic pressure to start spending its surpluses on domestic needs rather than on a now-hopeless propping up of U.S. consumer spending.

The Chinese dilemma is this: if we stop propping up U.S. consumers via buying bonds to keep their interest rates low, then we risk losing half of our export economy. But if we keep pouring much of our surpluses into U.S. debt, if either the bonds or the dollar implode then we lose hundreds of billions of dollars.

From the Wall Street Journal: Financial Troubles Humble U.S.
The success of the pending rescue of the U.S. financial system probably depends as much on the central banks of China and the Middle East as on Congress and the Federal Reserve. The U.S. is turning to foreign governments and other overseas investors to buy a good chunk of what could total $700 billion in Treasury debt expected to finance the bailout. Foreign investors also are needed to shore up the depleted capital of the nation's financial institutions.

Frequent contributor Michael Goodfellow pinpointed an apt analogy to China's dilemma via a recent film:

From the WSJ article above:

China, Saudi Arabia and other big foreign holders are unlikely to take antidollar measures precisely because they own so much U.S. debt. To the extent the dollar declines, so does the value of those nations' holdings. Mr. Summers calls this situation "the financial balance of terror."

But it is naive to assume that this so-called balance will protect U.S. interests indefinitely. Senior Chinese economists have voiced growing dismay about the outlook for the dollar, and the introduction of an additional $700 billion in debt might drive the currency's value down further, at least in the short term. "I think foreigners are being taken for a ride by the U.S. government," says Andy Xie, an independent economist in Shanghai.

Early in the movie "Lock, Stock and Two Smoking Barrels", one of the guys sits down at a poker table, with a big stake collected by his friends. He's the best, but the game turns out to be totally crooked. He loses all the money. Then, when he's about to get up and leave, crushed, the boss of the game tells him to stay put. And he makes him play another round, with money he doesn't have, so that he ends up not just broke, but owing the boss twice what he came in with.

China must look at this bailout the same way. They can't win, and now they can't get out of the game.

They must wonder what happens if they pony up the money and lose it all because we crash anyway. Let's hope they don't snap and decide to let it all burn now.

Thank you, Michael. So the endgame is already visible: either way, China loses big. Even if the central bankers wanted to keep propping up U.S. bonds, they will very soon find their gusher of export-generated dollars has dried to a trickle.

The other prop under the U.S. debt market has been Saudi Arabia and the other Oil Exporters. As oil plummets to half its recent price, they too will find their gusher of dollars has suddenly gone dry.

For quite some time I have contended that a global Depression would cause demand for oil to drop so severely that Peak Oil's influence over oil prices would temporarily by cut in a "head fake":

Exacerbating the supply/demand imbalance: the exporters' desperation to keep funding their bloated welfare state and energy subsidies to their own populace. The political elites' legitimacy in oil-based welfare states like Venezuela and Iran depends on providing their restive citizenry with subsidized food and oil. Once their incomes are cut in half as oil plummets, they have an unsavory choice: either cut production in an attempt to prop up oil prices, thereby cutting their own throats by reducing incomes, or pump as much as possible to compensate for the lower prices.

They really have no choice but to pump as much as possible, which will only drive prices even lower. Thus we can expect massive social and political turmoil in the exporting nations as their income is halved.

Here is a chart of the dynamic:

Lastly, there is a gaping, unprecedented divergence between the 10-year bond and gold, as shown here on a chart courtesy of Harun I:

This divergence could be resolved by gold plummeting, but with currencies all declining against gold, the more likely rebalancing will be a rise in bond yields (interest rates).

So place your bets: on gold and silver either rising or at least maintaining their value, and the bond plummeting, or on bonds holding their value and gold dropping. I personally will bet on gold and against bonds, for all the reasons outlined above.

Reader Comments:


I have been struggling with the name of the bailout, somehow TARP doesn't seem to cover the occasion. So last night I woke up at 4 a.m. and came up with the appropriate name: Congressional Rotten Assets Ponzi Scheme, or CRAPS for short. (Emphasis added: CHS) And of course when the treasury buys these bundles of mortgages/securities they will be known as Congressional Rotten Assets Packages, or CRAP for short. Helps to understand the game and the stakes. Let the dice roll.

I personally favor Buffet's deal as a model for the banks anyway.

Informative Blog, keep it up.

Bob Z.

The Depression is not just baked in. It is already here, though few realize it just yet. Here is some evidence that my friends in academia would dismiss as "anecdotal," but it is compelling.

I drove north from San Diego to Las Vegas on Sunday September 14. Back in the days of America's debt-fueled "prosperity," driving from Las Vegas back to Southern California on a Sunday afternoon used to be like sitting in a parking lot for 8 to 10 hours. Yet as I drove north on this September Sunday, I was shocked to see how little traffic was headed south from Vegas back to California. Southbound traffic moved quickly, and frequently I saw quarter-mile stretches of freeway with little or no traffic at all. Since I used to work in the gaming industry, I made a couple of calls when I got to Vegas, and my sources hinted that weekend business was down over 20%, due to fewer visitors and lower hotel room rates.

So here is the news flash. When visitor traffic in Vegas is down over 20%, we are not having a recession. We are already in a depression!

As Harun I. correctly observes, an economy that grows only through consumption and expanding debt eventually reaches a point where even an infinite amount of additional debt will not fuel further growth. We are now at that point. As a nation, we sated ourselves with nearly every material want during the Bush administration, and we put it all on the tab. The long and the short of it is that corporate executives reaped hundreds of billions in compensation, while what used to be the middle class is now stuck with the IOUs.

This will be a nasty depression that will last for a number of years. Reducing interest rates has not worked. Government bailouts to date have not worked. The $700 billion bailout will not work. In non-economic terms, the simple reason that no fix will work is that we already have all the "stuff" we want. We don't need more houses or more shopping centers. We don't need more toys or clothes. We just don't need more "stuff." What we do need is real wealth. That's because the piper is now calling. Unfortunately, as a nation we are broke and we can't make the payments.

Back in mid-August, you printed one of my commentaries that concluded: "Most of the optimists who think that they are seeing light at the end of the tunnel are going to be flattened before they figure out that the light they see is a runaway freight train headed straight for them." (Emphasis added: CHS) The freight train is upon us, and many have been flattened. For those who haven't been flattened yet, be alert. Your turn is coming.

Riley T.

I love National Geographic TV.

One way to catch a big snake, build a cage that the snake can barely get into, put in a good size pig, the snake goes in eats the pig and can't get out because now it's to big in the gut and the snake is caught.

One way to catch a monkey, tie a medium size jar to a tree, put in an apple that just fits, the monkey reaches in for the apple but his hand won't come out holding the apple and he won't let go of the apple and is caught.

At least we humans are in good company.

John G.L.

Thanks for posting my comment on the bail out. The megabubble has now absorbed so many asset classes and so much of the investment universe that it has reached critical mass...nothing can stop it now as the bubble investment is not just financial but psychological. (Emphasis added: CHS) People are still not prepared to let go. The bubble has absorbed 'private' enterprise, the media, and our elected officials...and, most importantly, people's minds.

Therefore, the bubble will continue to lay a swath of destruction across the landscape, and everything in its path will ultimately be destroyed. Even the Fed itself, if it chooses to fully commit to resisting this transition. It won't stop until people give up and realize that the past is dead. It's time for something different. SO maybe it has to be this way.

The pain of an economic cataclysm that threatens the existence of the republic itself might be the only thing that will convince people to accept change. Maybe it's time to shift emphasis to helping people (who are willing to listen) to prepare for the potential consequences of not just a failure of the system of banking and finance but of the solvency of the republic. I guess it sounds kind of apocalyptic but, I mean, really, the numbers don't look good. Do they?

Harun I.

The divergence I speak of is the nominal price versus the real price as set by gold. Gold is saying the Dow is only worth about 5500 while the nominal price is saying its worth over 10,000. Personally I think gold and commodities have got it right. I also think that this divergence exists because of the "hockey stick" growth of credit money (debt) but I cannot prove it. The snapback I speak of is when market participants finally realize equities and bonds are extremely overvalued and nominal price goes down to real price. I do not believe this will be orderly but I could be wrong.

The $62 trillion in CDS (credit default swaps) is exactly what my point was about exponential expansion of monetary aggregate entirely divorced from physical output. Short of putting the entire system into bankruptcy, there is no way to save the system from catastrophic collapse. It will collapse because there is not enough money in the world to keep it expanding and expand it must to survive. Down to two choices: 1) Let them fail and suffer deflationary depression or 2) Prop them up by printing money which will destroy the currency and suffer a hyper-inflationary collapse. Either way it collapses because it has to. We have lost the Red Queen's Race.

Because of the exponential function most will astounded by the speed of the onset and follow through of the collapse.

Reader Essays:

The No Banker Left Behind Bill
(Chuck D., September 29, 2008)

I have been mulling over the proposed bailout bill (which I have decided should be called the No Banker Left Behind Bill). I have the feeling that no matter what they do, something big this way is coming. I just donít know what form it will take.

There Is Ultimately No Gaming the System: When the Micro Crash Reflects the Macro Crash
(Zeus Y., September 29, 2008)
The proposed 700 billion dollar bailout cannot really ďworkĒ from a system level. I know itís real intention is to cover the butts of Wall Street investors, but you have the same problem in macro that homeowners have in micro. Nobody knows what homes are worth right now, so buyers are sitting it out. It isnít about restricted credit (even though that is a factor). It isnít about being too cash strapped to make a down payment (though that too is a factor). Itís about not wanting to be suckered into buying something that may still be overpriced.

"This guy is THE leading visionary on reality. He routinely discusses things which no one else has talked about, yet, turn out to be quite relevant months later."
--An anonymous comment about CHS posted on another blog.

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