The Economy

US Treasury bonds, the bellwether indicator for the market’s interest rate expectations, appear to have put in a double top. Neither of these tops reached as high as 1998’s peak. This is all odd, because it hints that the market expects higher interest rates, even in the face of the Fed’s established pattern of lowering rates to support the stock market and ward off the Recession Demon.

Actually, the threat of lower bond prices might not necessarily mean higher interest rates. It merely forecasts lower bond values, and higher interest rates are not the sole cause of lower bond values.

EVERYBODY KNOWS WHAT AIN’T SO

Generally folks think that interest rates alone determine the price of bonds. When rates rise, bond values drop; when rates fall, bonds rise, just like turning on water in your bath tub or pulling the plug. When other interest rates rise, a bond must increase its return (yield) to match the market, so the price of the bond drops to offer a greater return. When interest rates fall, a bond must reduce its return to match the rest of the market, so bond prices must rise.

(Think about borrowing a dollar for a year. If the interest rate is 10%, and you owe a dollar one year from now, the discounted value of that debt today is only 90¢. If the interest rate rises suddenly to 15%, then the value of the debt drops to 85¢. Bonds work the same way).

From this simplistic notion that considers only one cause of changing bond prices the public has built a false and deficient mechanistic view of the way markets price bonds. Likewise the Fed derives much propaganda mileage from raising and lowering interest rates. That manipulates the widespread but false assumption that the Fed controls interest rates.

The Fed does not control interest rates, other than the rates it charges its own borrowers. In the end the market controls interest rates and bond prices, and in that pricing the market takes much more into account than interest rates alone.

WHAT ELSE IS THERE?

The value of a bond (a promise to pay a principal sum at a fixed future date and to pay periodic interest in the meantime) depends on three factors:

Interest rates – Compared to other bonds of the same quality, the bond must offer the same or better interest rate than currently prevails in the market. If it offers more, its price will rise; if it offers less, its price will fall.

Creditworthiness – How reliable is the bond issuer’s ability to repay? If it is sovereign debt, how reliable is the borrower’s will to repay? Think of it as "credit rating." Better credit risks get better interest rates. Higher interest rates imply riskier bonds.

Currency – How stable is the value of the currency that the bond promises to repay? What is the outlook for that currency’s value?

CREDITWORTHINESS

You’ve read somewhere that "the full faith and credit of the government" back the obligations of the United States. Think about that. When you borrow money to buy a car, the bank takes the title away from you and doesn’t give it back until you finish paying off the note. Your car backs the note, not the bank’s belief that you will pay back the note. If you fail to pay them, they will come collect their car.

"Faith" on the other hand, like "credit" denotes "belief" and "hope" that the debt will eventually be repaid. And this particular hope may disappoint.

What happens when faith dissipates? What really backs the government’s promise to repay? The ability to tax and to print money. Ignoring for a moment that second item, what happens to "faith & credit" when government tax revenues drop? Or economic conditions weaken its ability to collect taxes? Fewer and fewer people have "faith" and the government loses "credit."

Deadbeats have to pay a higher interest rate when they borrow, for one simple reason. History shows that they are very likely to stiff the lender. Things work the same in the high-toned world of bonds, folks just use different jargon. When a bond pays a rate of interest higher than the prevailing market, the wary understand that it warns them that bond is much riskier than its brethren. Whenever the ability or willingness of the government to pay its debts comes into question, the value of its obligations ("bonds") falls because they have become riskier.

And there ain’t no risk like "sovereign risk."

Sovereign risk is what you incur when you loan money to a government. Why? In its power as "sovereign" or "king," the government may just stiff you altogether. Since it owns and runs the courts, where will you bring suit to force it to pay? You can’t. You have to mount an invasion to recover your dough.

By the way, don’t listen to people who tell you the United States government has never defaulted. That’s just hogwash. At every historical juncture when the US government has found itself in a bind, it has stiffed the bondholders. During the Revolutionary War the government stiffed the whole country by inflating the currency. During the War Between the States the Yankee government stiffed the bondholders by (1) inflating the currency (the Greenback Act and the National Banking Act), and (2) reneging on its promise to pay the bond principal in gold. During the Great Depression the government stiffed bondholders by (1) reneging on its promise to pay interest in gold, (2) reneging on its promise to pay principal in gold, and (3) inflating the money supply to cheapen the value of the paper dollars it repaid. Since the Great Depression the US government has steadily, day in, day out, month in, month out, year in, year out, stiffed all its creditors by a conscious policy of cheapening the dollar by inflation. It borrows dollars worth 100¢ and repays with dollars worth 95¢. Since 1940 the US dollar has lost all but about one-twentieth of its value. The government has inflated that value away on purpose, not through error, poor management skills, or ignorance.

So when you buy a government bond, or any bond, the value of the promise to repay principal and pay interest depends on the borrower’s ability and willingness to repay, not just on the interest rate.

CURRENCY

Finally, the value of a bond depends on the currency it promises to repay. For example, pre-World War I German bonds promise to pay so-and-so many Reichsmarks, but Reichmarks no longer exist. Therefore today the bonds will only make good wallpaper.

Today the whole round world sports not a single currency backed by anything other government debt. Therefore the value of each and every one depends wholly on the creditworthiness of that debt today. The value of every currency floats against every other one, every day.

If you expect that the value of the yen, for example, to fall soon, you’re not likely to loan money to the Japanese government unless you build in a premium large enough to repay you for the loss you foresee in the yen’s value. Think about it. When you discount a currency’s future value, that will show up in the bond’s price looking just like a higher interest rate. The bond price will drop.

BOTTOM LINE

You may think that you’re safe in T-bills or other US government obligations. For the time being that may be true, but keep in mind that it’s you’re not just risking interest rate changes. You’re also at risk for creditworthiness and currency. Right now the bond market is whispering a warning: look out, lower bond prices may be coming. With interest rates dropping, and the expectation that the Fed will lower rates even further, bonds still look ready to fall.

What does the bond market see? Economic uncertainty? Much higher inflation? Currency risk in the US dollar? A government default? We’ll have to wait to see.

Still, be warned. Be wary. Be ready to jump.

-- Franklin Sanders

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