THE BEAR'S LAIR The great bond market crash of 2009 By Martin Hutchinson
Investors have spent the past few weeks bemoaning the devastation to their
portfolios caused by the stock market downturn, which if it does not produce
recovery by year-end will have made 2008 the worst stock market year since
1937. Their misery would be compounded if they knew that next year, while it
may avoid more than moderate stock market mayhem, is likely to produce the
worst bond market carnage in US history.
By bond market carnage, I am not referring to carnage in the market for
securitized subprime mortgages, defaulted credit card receivables, Russian
subordinated debt and Venezuelan trade paper. That has by and large already
happened, although only a portion of the losses in those markets have already
been admitted
to - no more than US$600 billion of the eventual total of perhaps $2.5 trillion
to $3 trillion in losses.
The rest of the market is taking Blackstone's Steven Schwarzman's approach of
demanding that "market-to-market" accounting rules be reversed immediately.
Tough, guys, you were happy enough to have the spurious mark-ups from
mark-to-market in good years, which enabled you to pay yourselves fat bonuses
without actually having earned anything. It's only fair that the inflated
prices at which your portfolios were valued at the top of the bubble should be
marked down to reflect the new and unpleasant reality.
Next time, perhaps we can stick to the old rule that assets don't get marked up
in value until they are sold, but that clear impairment in value results in a
mark down. It will mean fewer bonuses for Wall Street traders, but never mind,
they'd only have to pay them all away in taxes - making Wall Streeters pay more
tax was the principal "change" president-elect Barack Obama and his supporters
have been calling for.
British experience in 1973-75, long before mark-to-market had been thought of,
was that eventually all excesses in financial institutions' balance sheets must
be paid for, and that once recession hits it's quite possible to go bankrupt
while presenting a balance sheet of unspotted solidity to the unsuspecting
public.
The $2.5 trillion to $3 trillion loss from value impairment of junk debt is
however less than the value impairment that can be expected in the next year
from the decrease in value of Treasury bonds and other prime quality debt. This
prime debt has been used as a safe haven by investors for the past 20 years,
and it is nothing of the kind.
At present, the 10-year Treasury bond yields a pathetic 3.78%, well towards the
low end of its long-term historic range and well below the US inflation rate of
about 5%. Including the $5 trillion or so debt of housing finance agencies
Fannie Mae and Freddie Mac (which is now explicitly government guaranteed) and
the $4.3 trillion held in the social security trust fund, there is about $15.6
trillion of US federal debt, a total that increased by over $1 trillion in the
year to September 2008 and is increasing even more rapidly currently.
Add about $9 trillion of home mortgage debt and $6 trillion of high quality
corporate debt (and ignoring debt of financial institutions, which can be
expected to be largely matched against other debts) and you have a total
outstanding amount of $30 trillion of debt subject to interest rate risk,
excluding the junk and near-junk that is currently in the process of
defaulting.
There are a number of reasons why Treasury bond yields and the yield curve in
general are likely to rise sharply in 2009:
Borrowing requirements. The US Treasury borrowed over $1 trillion
in the year to September 2008; it is expected to borrow close to $2 trillion in
the year to September 2009. That's 13% of US gross domestic product. Not all of
this is deficit; about $500 billion is refinancing and another $500 billion is
for bailout schemes, some of which the US taxpayer may eventually see back.
Still, in terms of GDP, that's far more debt than the US capital market has
ever been asked to absorb, other than during World War II. At some point,
"crowding out" must occur; we certainly cannot assume that Asian central banks
will want to take the entire load, at interest rates less than zero in real
terms.
Inflation. The Fed appears to believe that the current recession
will bail the United States out of its inflation problem. The example is given
of Japan in the late 1990s, after which the Fed explains that it will avoid the
mistakes of the Bank of Japan, thus preventing damaging deflation.
Actually that seems to be wrong on two counts. The main mistake in 1990s Japan
was not monetary but fiscal; government spending was allowed to expand
inexorably, producing ever larger and larger deficits. That mistake appears to
be only too likely to be repeated here. The difference is that the United
States currently has a 1% Federal Funds rate and 5% inflation, the approximate
opposite of Japan in the early years of its slump. With M2 money supply (the
one the Fed will divulge) up at an annual rate of 18.3% since the beginning of
September it seems likely that inflation will accelerate - as it did in the
recessions of 1973-74 and 1979-80.
Rising real rates of return. The yields on Treasury Inflation
Protected Securities (TIPS) have already risen from just over 1% to nearly 3%
since the beginning of 2008. Given the excess of bonds coming to the market, it
makes sense that real yields should rise. That in itself suggests that
conventional Treasury bonds are hopelessly overvalued - with the 10-year TIPS
yielding 2.82% and the 10-year Treasury 3.78%, the implied rate of US inflation
over the decade to 2018 is 0.96% per annum, for a total rise in prices by 2018
of less than 10%. If you think that's likely, I can get you a deal on Brooklyn
Bridge!
Thus Treasury bond and other prime bond yields can be expected to rise sharply
in 2009. This will cause losses to their holders. To the extent that such
holders are foreign central banks, the United States probably doesn't need to
worry. Foreign central banks have been gentlemanly holders of US debt through
periods such as 2002-08 when the dollar has depreciated; a rise in interest
rates simply gives them another way of making a loss. Personally, if I were the
chairman of the People's Bank of China and Treasuries had lost me the kind of
money they have in the last five years, I'd probably declare war on the US, but
fortunately central bankers are a phlegmatic and tolerant lot!
However, domestic holders are a more serious problem. To the extent that
pension funds have losses on their holdings of bonds, they will need to raise
contributions; to the extent that insurance companies have such losses they
will need to raise premiums. Some entities will be hedged, but by doing so they
will have simply transferred the interest rate risk to somebody else; by
definition of derivatives the total outstanding derivatives position must be
zero, however large the individual positions taken.
Assuming the $30 trillion state, mortgage and private corporate debt
outstanding has an average duration of five years, a fairly conservative
assumption, and neither the shape of the yield curve nor the premiums payable
for risk alter significantly by the end of 2009, a 1% rise to 4.74% in Treasury
bond rates by December 2009 would cause a total loss to investors in the $30
trillion of Federal, agency, mortgage and prime corporate debt of 3.9% of the
debt's principal amount, or $1.17 trillion.
That is not as bad as the credit losses. However, once rates start rising, they
are likely to rise much more than 1%. To cause a loss of $3 trillion, the same
as the estimated credit losses, 10-year Treasury bond yields would have to rise
to 6.43%. Hardly an excessive assumption; 10-year Treasuries yielded 6.44% on
average during 1996, at the beginning of the Fed's money bubble, in which year
inflation was 3.4%.
More extreme moves are certainly possible. In 1990, 10-year Treasuries yielded
an average of 8.55%, while inflation in that year was 6.3%. A rise in the yield
curve to an 8.55% 10-year Treasury yield would cost investors $5.06 trillion,
almost double the credit losses from subprime and its brethren. Should we
revert fully to the days when Paul Volcker was Fed chairman and get the 13.92%
10-year Treasury yield of 1981, a year in which inflation was 8.9%, the cost to
investors from the interest rate rise alone (we can assume a few additional
bankruptcies, I think) would by $9.33 trillion, about two thirds of the current
value of common stocks outstanding and more than three times expected credit
losses.
One can debate the probability of the various outcomes above. Inflation is
already around 5% and is unlikely to drop much, so the 1996 estimate for the
peak 10-year Treasury yield would seem low. On the other hand, while inflation
could well reach 8.9%, it seems unlikely that we will need to push Treasury
yields quite up to 1981's Volckerian levels, at least not within the next year.
So the 1990 estimate is perhaps the best, involving a loss to investors of
around $5 trillion or a little over. Such a loss will produce fewer calls for
bailouts than the $3 trillion credit losses, but just as much economic damage,
albeit much of it unnoticed by the general public.
And it is still ahead of us!
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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