Bonds should be yielding much more interest  than they are…so why aren’t they? Will they?  When?

Bond Yields Are Still Very Low! But Why?

Over the past year there have been a number of significant changes to the economy. One of the most significant was that the Federal Reserve began to cut off some of its direct stimulus to the economy. For a few years now the Federal Reserve was buying treasury notes to the tune of approximately  of a  half trillion dollars a year. Now technically the Fed should not do this since Treasury bills are actually government debt which is supposed to be auctioned off to the public. But the Fed, feeling that job numbers were not where they should be, decided to break the rules and begin buying Treasuries. It also bought another two and a half trillion in mortgages(actually mortgage securities) in order to boost the housing market. Also a move that is not considered by the books, but the Fed made the case that these were extraordinary circumstances and so both the President and the Congress agreed that this should be done.

Fed is now cutting back on expenditures

However, over the past year, as the jobs numbers have begun to improve, the Fed announced that it would begin cutting back substantially until it would no longer buy any Treasuries or Mortgages from the Public.  Slowly it has begun to cut down its purchases, and at present is buying about half of the securities it was buying the last few years. At present the Federal Reserve is only buying 40 billion dollars of Treasuries and Mortgages a month, whereas a few years ago it was up to 85 billion a month. When the program was in full swing, the total amount of securities being bought was 1.2 Trillion dollars a year. That is a whole lotta money.

Treasuries should see a price drop-with higher interest rates.

Now that the Fed had cut back on its purchases, it means that Treasuries and Mortgages should begin costing less. There is less demand so the law of supply and demand should mean that prices for both Treasuries and Mortgages should have gone down.  Now as the price of Treasuries goes down, interest rates should rise. That’s the special impact that Treasuries have on interest. The less they go for, the higher interest rates will be in general. But in fact they have not gone down by much at all.

At first it seemed like prices of Treasuries would sink like a rock, but then after a few months, Treasuries started to go back up again for some reason. It surprised many of the pros who were mostly betting that interest rates would at last start going North.

But Interest rates  have instead remained at all time lows despite what should have been a natural shock that should have made credit far more expensive.

Bonds go up when the economy really rebounds

So what happened? Well in reality bonds will only go up if the economy actually starts to get better. But readings have shown that in reality the economy is not getting any better. It has actually remained the same, or perhaps even dipped. For as long as the economy remains poor, people will seek a safe place for their money, and none is safer than Bonds and Treasuries. So money has gone back into Bonds, Treasuries, and Mortgages where it is considered a relatively safe place to put your money.

Will Bonds continue to be Cheap?

The answer to this question is difficult. It all depends on the economy however. If the economy gets any better, interest rates should go up very fast. However, one of the reasons why bonds are staying up is that there is so much speculative money being sent into the economy with the Zero Interest rate policy of the Federal Reserve, that it becomes quite easy for large banks to borrow cheap money from the Federal Reserve, and simply invest them at  a higher interest rate offered by large corporations, government agencies, and other institutions which need credit. Thus, for as long as corporations need the money, there will always be a supply of bonds available, and for as long as the Fed has Zero Interest policy, there will always be a profit to be be made in lending to large institutions. So even if the economy goes up, there is still going to be a very large money supply and for as long as that’s true, interest rates may not behave the way they should.

How high should interest rates really be?

Now, we  come to the next question: How high should interest rates be? Well, the fact that there are one hundred Trillion dollars of Bonds out there, and the fact that there are some 700 Trillion dollars of Credit Default Swaps out there which are insurance against those bonds defaulting, interest rates should be much higher than they are now. With all that money floating around, and all that underlying risk, and all the interconnections, it should be much harder to get a loan than it is today. There is too much complexity and too much risk in the bond market as it is, especially since the economy has not shown signs of improvement to justify these low interest rates. So, there is definitely an inherent potential for a very rapid rise of interest rates, especially if something should go wrong. Even if the Fed keeps interest rates at Zero percent, the underlying risk for collapse makes it almost certain that any small event could trigger a wave of higher interest rates as demanded by the Market.

The reality is that this credit market is corrupt. There should never have been this much credit, especially since credit availability should be a function of the performance of the economy, and the eventual likelihood of all that money being paid back. In a good economy, the likelihood is good that bonds will be repaid. In a bad economy, and in an overly indebted company, the chances of successful payback would be in somewhat greater doubt. Yet, today, we see interest rates remaining unnaturally low only because the Fed is manipulating the credit market.

“I think you think they think its unstable”

But here’s  where things get hairy. The Market may think that there is something wrong with credit being this cheap. They think that it is unnatural and abnormal given today’s circumstances for credit to be this available and so ubiquitous, but they keep playing the game because its profitable to do so. But at the first sign of anything actually resolving in the wrong direction, they will probably begin thinking of  pulling out their money very quickly. This sets the stage for another global credit event, and it may not be far at all, as each player tries, like in a John Von Neuman game to figure out what the other guy must be thinking. The atmosphere is ripe with dangerous thoughts, and thoughts eventually turn to actions.

One thing’s for sure, with interest rates filled with the potential  to rise at the first sign of either a good economy or a very bad economy, money is not going to be cheap forever, and when this economy finally resolves to go in one direction or other credit will get very expensive very quickly and when money gets expensive again, the economy is going to struggle! With this much potential for things going wrong, its just a matter of time before the monkey wrench finds the inner workings and nuts and bolts start clanking loudly. There is a very serious barrier to an economic expansion which we will probably not be able to overcome.

The game is to try to raise prices for everything in all ways, unfortunately this game has some terrible costs, no pun intended. They assume innocently that by raising prices they will somehow discharge the debt. Yet this is childish. The only thing that will happen is the underlying vitality of the economy will be severely compromised, and the ultimate result will be a severe contraction.