In the 1990s, the big bubble was in Nasdaq stocks. It burst. From 2003 to 2005, the bubble was in housing. It’s popping before our eyes. Now, I want to talk about a third bubble, one you may not even have noticed — in bonds.
Traditionally, bond prices go up and down based on inflation. Here’s the formula:
- Less inflation is good for bond investors. It means the value of their principal won’t be eroded. And so they bid up bond prices. (Result: Lower yield and interest rates.)
- More inflation is bad for bond investors. It means the value of their principal is threatened. So they bid down the prices of bonds. (Result: Higher yield and interest rates.)
That’s what’s supposed to happen. Instead, what’s actually happening right now is that …
Bond Investors Have
Continued Buying Bonds
No Matter What
Here’s the scoop: In the last few years …
We experienced the strongest global economic growth in three decades (a precursor of rising inflation).
We got 17 straight Fed rate hikes.
Home prices surged at the fastest rate in history.
On top of that, oil vaulted to $75 a barrel from $25 a barrel … gold more than doubled … and the “official” measures of producer and consumer price inflation climbed at the fastest pace in years.
And most recently, more and more people have been defaulting on their mortgages and other debts.
With all of this going on, bond investors should have been running for the hills. Remember: More inflation is bad for bond investors. It means when they eventually get their money back, their money will be worth a lot less.
So by rights, they should be dumping their Treasury bonds. And they certainly should be unloading their higher-risk bonds (mortgage debt, junk bonds, etc.) as housing headed south and defaults climbed.
But so far, instead of dumping bonds, most investors have been holding on or even pouring in more money. No, bond prices are not surging like tech stocks or home prices. But they’re sure a lot higher than they should be given the forces I just told you about.
And as you probably know …
When Bond Prices Go Up
Their Yields Go Down
That’s why ten-year Treasuries are yielding only about 4.79% right now. That’s
- Nowhere near the levels of the early 1980s, the last time commodities prices were in this range.
- Far lower than the level of the mid-1990s, the last time the Fed was raising interest rates.
- And even below what we saw in the late 1990s, the last time we saw that kind of bubble-land growth.
Another anomaly: Higher risk bonds are supposed to yield a lot more than the equivalent Treasuries. To get you to take more risks, they’re supposed to pay you a lot more.
Instead, the extra yield they’re paying you is a pittance. I’m talking about the yield on corporate bonds … junk bonds … even ultra-risky mortgage debt.
What has bloated the price of long-term Treasuries? Why aren’t mortgage and junk bonds yielding far more than more conservative bonds? The answer:
Too Much Foreign Money
Pouring into the U.S.
I think it’s simple: There’s too much freaking money sloshing around out there chasing return … any return … from bonds. It’s a new 21st Century twist to an old phenomenon — asset inflation.
It doesn’t get captured in the Consumer Price Index. The average person buying eggs, milk, and gasoline, doesn’t see it. And the Fed has naively failed to focus on it.
Here’s how it works:
- As Americans, we spend much more than we earn.
- We make up the difference by borrowing from overseas investors. (They’re the main ones who are buying up all those long-tem Treasuries, mortgage bonds and corporate bonds.)
- The Federal Reserve greases the wheels by creating tons of new money.
- Result: We get deeper in the hole, overseas investors keep pouring more money into our bonds, and our bond market looks like it’s doing just fine, when it really isn’t.
We’re not talking peanuts here, either:
Central banks around the world held a whopping $4.9 trillion in reserves (i.e. money ready for investment) as of March. That’s equal to 11% of the world’s economy.
Oil producing nations in particular are flooded with “Petrodollars” — money accumulated from selling rapidly appreciating crude oil. Reserves in Russia (the second-largest oil producing nation) skyrocketed $100 billion in just the past year to $251 billion. Middle East and North African reserves grew by $43 billion in 2003, $60 billion in 2004, and $126 billion last year.
In July, China’s reserves surged 30% to a mind-boggling $954 billion. That’s nearly a trillion dollars — enough money to buy almost 10% of every publicly traded company in the U.S.
A lot of this money is flooding into Treasury bonds. But it’s also going into higher-risk bonds.
According to the Bank for International Settlements, foreign governments boosted their holdings of Freddie Mac and Fannie Mae bonds by almost 50% from 2000 to 2005. Ditto for corporate bonds — their holdings hit an all-time high.
Bottom line:
If it weren’t for all this foreign buying, our bond prices would be far lower and our interest rates far higher.
This raises a very serious question for all investors:
What Happens If the Foreign
Money Stops Coming?
It won’t matter what our economy is doing. It won’t matter if the Fed wants to lower rates, raise them or keep them the same.
All that’s going to matter is that the biggest buyers of our bonds could stop buying … or even start selling.
The reason that’s so dangerous: It could deliver to your doorstep a combination of rising interest rates and a slumping economy at the same time.
Imagine what higher interest rates would do to an already slowing economy. Imagine what they would do to a housing market that’s already busting. It’s not a pretty picture.
For Your Keep-Safe Funds, Here
Are Some Steps to Consider:
First, don’t stick a bunch of your fixed income money in long-term Treasuries. Just a 10% decline in their price wipes out two years of interest income.
Second, avoid high-risk debt, especially in the mortgage sector. I can’t stress enough what little extra return they’re offering compared to Treasuries. Just because foreign central banks and naïve overseas investors are piling into this junk, doesn’t mean you have to make the same mistake!
Third, stay away from the shares in REITs and banks that are heavily involved in low-quality “subprime” mortgages.
Fourth, if you want to sleep nights, keep your money short term.
Until next time,
Mike
About MONEY AND MARKETS
MONEY AND MARKETS (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, and Tony Sagami. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM. Nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical inasmuch as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Amber Dakar, Monica Lewman-Garcia, Wendy Montes de Oca, Kristen Adams, Jennifer Moran, Red Morgan, and Julie Trudeau.
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