When they stop buying bonds, the game is over

I took the title for this blog from an interview that James Turk of the GoldMoney Foundation conducted with Eric Sprott, a Canadian fund manager. You can see it here. (I also recommend you have a look at this interview with Doug Casey.) I think the quote is a succinct summation of the role that the bond market, and in particular the market for government bonds, now plays in this crisis.

As you know, I would not touch bonds with a barge pole, especially government bonds. After 40 years of unending fiat money expansion, the world suffers from excess levels of debt. A lot of this debt will never be repaid. My expectation is that the market will increasingly question the ability and the willingness of most states – and that, crucially, includes the big states – to control their spending and to shed their addiction to debt financing.

What happens to high-spending credit-dependent states when the market loses confidence in them has been evident in cases such as Ireland, Portugal and Greece. Among the big financial calamities of 2011 were notably government bond markets. Perversely, some of the big winners of 2011 were also government bond markets. As I explained here, market participants have so successfully been conditioned to believe in state bonds as safe assets that when some sovereigns go into fiscal meltdown it only serves as reason to buy even more bonds of the sovereigns that are still standing, even though their fiscal outlook isn’t much better. While the fate of Greek and Italian bonds should have cast serious doubt over the long-term prospect for Bunds, Gilts and Treasuries, it only propelled them to new all-time highs. Strange world.

All policy efforts are now directed toward keeping the overextended credit edifice from correcting. After decades of fiat money fuelled credit growth, the financial system is in large parts an overbuilt house of cards. What the system cannot cope with is higher yields and wider risk premiums. Those would accelerate the pressure toward deleveraging and debt deflation and default. “When they stop buying bonds, the game is over.”

They still bought bonds in 2011

2011 was another strong year for gold. Despite a brutal beating in the last month of the year, the precious metal produced again double-digit returns for the year as a whole if measured in paper dollars: up 10 percent. I believe that gold will continue to do well, as it remains the essential self-defence asset.

Amazingly, Treasuries did almost as well (+9.6%) and TIPS (inflation-protected Treasuries) did even better. German Bunds benefitted from the disaster in other euro bond markets, and they pretty much matched Treasuries in terms of total return (currency-adjusted they did less well as the euro declined slightly versus the dollar). I believe this is entirely unjustified because the EMU debt and banking woes will put considerable additional strain on Germany’s public finances. UK Gilts did better than gold and Treasuries, despite rising inflation in the UK, weak growth and a public debt load that is only ever going one way: up.

I do not believe that this can go on for long. Bonds are fixed rate investments with finite maturities. The price gains of 2011 have lowered the yields to maturity, in some cases markedly so, and thus diminished the chance of additional gain. Does that mean reversal is imminent? No. Maybe the notion, or better the myth, that the bonds of the United States, the United Kingdom and Germany are risk-free assets can somehow be maintained. Maybe yeileds can decline even further. Who knows? Personally, I doubt it.

In the case of the US, the fiscal situation seems firmly beyond repair. The Congressional Budget Office publishes its own projections on the long-term fiscal outlook. These are based on some overly rosy economic assumptions and still make for rather grim reading – hundreds of billions of dollars in deficits every year forever. The true path for the U.S.’s public accounts will certainly be much worse. The U.S. has now acquired a habit of running budget deficits to the tune of 10 percent of GDP year after year (more than $1.5 trillion in 2011) and there seems to be no end in sight. There is presently no deflation in the U.S. Neither does the TIPS market expect any. Yet, investors seem happy to hold U.S. government paper at what are certainly negative real yields. Investors are practically paying the U.S. government for the privilege of funding its out-of-control spending.

I have long maintained that government bonds are a bad investment because the endgame for them will either be outright default or inflation. In both cases, as a bondholder, you lose. To be precise, the outcomes are either default or default. The idea that these debt loads could be elegantly inflated away is nonsense. They are already too big for that. So either you face outright default or, if authorities try to inflate, hyperinflation and currency disaster, and then default. In either case, you will not be repaid with anything of real value.

“Let them eat bonds!”

But are default or inflation and then default really inevitable? What if the present scenario continues forever? This seems to be the new ‘hope’, if you like. It is not a pretty scenario in that it involves the ongoing confiscation of wealth from bondholders but it seems to be less drastic than default or hyperinflation. Could we not work off the excessive stock of debt by suppressing bond yields below (moderate) inflation rates for an extended period of time? Of course, we cannot rely on the self-sacrifice of the bondholder, although he appears rather willing of sacrifice at present. So the government will have to use all its might to force bond-investors into accepting zero or negative returns for an extended period of time. After all, the state is the territorial monopolist of coercion and compulsion. It makes the laws. And controls the banks.

As I stressed many times, in a state fiat money systems banks must ultimately cease to be private, capitalist enterprises. Many banks have already been fully or partially nationalized. The remaining private ones are under tight, and ever tighter, regulation by the state. Should it not be easy for the state to force banks to invest more in government bonds, even at low or negative real returns? Should it not be possible to redirect whatever saving and credit there is from the private to the public sector?

Such a strategy has been outlined – not advocated- by Russell Napier of CLSA. He calls it ‘repression’. It ultimately involves rather draconian market intervention in order to continuously force the diversion of capital from private use to public use at artificially low levels of compensation. At some stage it will require capital controls. But let’s face it: most of what we have experienced over the past three years in terms of government intervention would have been simply unimaginable only five years ago. We should therefore not be surprised if market intervention becomes ever more heavy-handed and is used increasingly to favour the funding of the public sector. Gillian Tett in one of her recent Financial Times articles also discusses the strategy of ‘repression’ and predicts that we will see more of it.

That such a policy will be implemented, and ever more boldly, I have no doubt. In fact, I predicted it in my book. See chapter 10 of Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, in particular pages 226 -228. I called it ‘the nationalization of money and credit’. It is a phase in the crisis but it is not an endgame. Where I disagree with the above mentioned writers is the following: repression, to the extent that it works, will not reduce government debt, and besides, it won’t work.

Consider the recent environment: certain governments have been able to borrow directly from their central banks via quantitative easing and in the bond market at low or even negative real interest rates. Does that mean they have reduced the amount of outstanding debt? Are such hugely advantageous conditions used to cut back the debt load? No. The opposite is the case. Access to cheap credit, whether that credit was provided by the printing press, obedient bond investors or hyper-regulated banks, has allowed states to run larger budget deficits and accumulate more debt. Remember, we are not talking here about the workout of a debt-situation resulting from a war, a natural disaster, or some other one-off event. We are talking about the modern welfare state with its ever-growing commitments and increasingly out-of-control spending. Only cutting off the state from cheap funding will ever constrain it, not giving it access to more resources more cheaply.

And then there is this: we do not live in Paul Krugman’s parallel universe of Keynesian fiscal stimulus, where every dollar spent by the government magically translates into 2 dollars of real GDP growth. Here, on planet Earth, the constant shift of resources from private markets to the state bureaucracy weakens the economy. Shrinking the private sector and growing the public sector kills economic growth. In the perverse logic of the modern welfare state, this then requires even more state spending in the next period. As the economy continues to struggle, public sector outlays will grow while tax receipts will shrink.

‘Repression’, to the extent that it succeeds in shifting resources from the private market to the state, makes the crisis worse. It must lead to more debt, more capital misallocation and a weaker economy. We will not save our economy by trampling on the remaining bits of functioning capitalism and by confiscating more resources from the private sector. ‘Repression’ is self-defeating.

Additionally, it won’t work. Private wealth-holders will not sit on their hands forever while their hard-earned savings are being confiscated by the state. If banks become mere tools to fund the state and thus provide zero or negative real returns to shareholders and depositors, shareholders and depositors will pull their money from the banks.

But there are no alternatives for the depositors, are there? Of course, there are: gold.

As the enemies of gold in the establishment financial press never tire of reminding us, gold pays no interest and no dividend. Because of storage and insurance costs, it is a ‘negative carry asset’. But in an environment of ‘repression’, so are government bonds and bank deposits. With zero or negative returns guaranteed on supposedly ‘safe’ government bonds and bank deposits, ever more investors, including small savers, will turn toward gold which has the additional advantage that its upside is practically unlimited – its price can double, triple or quadruple (all of which I expect) as long as paper money debasement continues, which I consider a near certainty.

Of course, a determined state will counter any evasion of controls with more controls. Maybe we will see taxes on gold investment or even restrictions on trading and owning gold. Via capital controls the country could be locked down. All of this is, of course, hugely destructive for the economy and ultimately self-defeating. I expect that we will see quite a bit of this stuff in coming years. Try and be prepared! But this will not be part of the solution. It will make matters worse. And it means that the endgame is still either voluntary default or hyperinflation and default. ‘Repression’ or ‘nationalization of money and credit’ is a policy of desperation. It is not a solution. It won’t be the endgame.

The greater fool theory

At the present juncture, any investment in government bonds requires that you adopt the ‘greater fool theory’. You must believe that there is always some greater fool out there to buy the bonds off you when you want to get out.

Earlier this week, The Wall Street Journal Europe reported about the investment views of Robert Prince, co-chief investment officer at hedge-fund giant Bridgewater. The Bridgewater guys are no slouches, having produced some excellent returns and also, notably, being long gold. Yet, I was surprised by their bullish view on bonds. Here is an excerpt:

“In the U.S., leveraged investors who can borrow money at rates near zero could find a good deal in Treasurys, Mr. Prince says.

Mr. Prince points to the example of Japanese government bonds. An investor who was leveraged three-to-one and bought Japan’s bonds at a 2.5% yield in the mid 1990s would have earned a compound average annual return of 12% a year for 15 years, he says.”

It is no sign of health for any asset market if you have to leverage three-to-one to make a good return. Additionally, you need a greater fool: Mr. Prince may use his $4 to buy $12 of US Treasuries but that means somebody else is lending him $8 at zero rates and with no chance of any upside. Surely, that must be a fool!

You simply cannot explain current market levels with the presence in the market of the likes of Mr. Prince alone. And who is going to assure that bond prices will stay at these levels when the leveraged investors want to exit? Mr. Prince must be sure that prices will stay up here for the long run. Okay, they did so in Japan, which is remarkable but not necessarily easily repeatable. Remember that the Bank of Japan reflated much less aggressively than the Fed does at present, inflation remained at around zero in Japan while the personal savings rate was constantly strongly positive over the period in question, if declining on trend.

I agree with the assessment of one of my readers that Japan is a bug in search of a windscreen. That the bug has kept flying for so long is astonishing but gives us little comfort as to its chances of ultimate survival. That the US bug can fly unharmed for as long appears to be a rather heroic assumption.

The government bond market is still skating on thin ice – and so is the entire financial system.

In the meantime, the debasement of paper money continues.

This article was previously published at Paper Money Collapse.

6 comments to When they stop buying bonds, the game is over

  • “When they stop buying bonds”, I suggest there is not much of a problem for a monetarily sovereign country (that’s one – like the UK – that issues its own currency).

    First, if lenders refuse to lend to the UK at anything less than 15%, that has no effect on the interest we pay on EXISTING government debt.

    Second, as to Gilts due to be rolled over there is a simple solution. Step one: don’t roll them over and instead, just print money and pay back bond holders. And that on its own would almost certainly be too inflationary. So step two: raise taxes by an amount such that the deflationary effect of the extra tax cancels out the inflationary effect of the extra money.

    There are possible POLITICAL problems in doing that: the citizenry might object to the extra tax even though the “extra money plus extra tax” wheeze would have no effect on their standard of living. But there is no TECHNICAL problem.

    As to foreign holders of Gilts, I doubt they sell Sterling in droves. Why did they make a Sterling denominated investment (i.e. Gilts) which brings them a NEGATIVE real return? Hardly the way to make a fortune is it? I suggest such investors are unimaginative investors desperately trying to cling to their worldly wealth by adopting the conservative strategy of spreading their investments across different currencies.

    But even if there was a bit of a flight from Sterling, what of it? Sterling was devalued by 25% in 2008 and scarcely anyone at the time noticed.

    As to EZ counties, they are a totally different kettle of fish from monetarily sovereign countries.

  • Paul Marks

    Basically all the major governments are playing the same game – they are lending banks (and other such) newly created money (money created from NOTHING by Central Banks) on the understanding that it will be used to buy government bonds (at a higher rate of interest – so the banks, and other such, gain by the deal).

    The Federal Reserve and Bank of England have long been playing games of this sort – but the ECB has now joined them in a big way.

    The Euopean Central Bank has long been lending (newly created) money to banks – but before Christmas (as we all know) it lent out another almost 500 billion Euros (“not much if you say it quick”) to the banks – telling them that government bonds would be acceptable as security (nudge,nudge, wink, wink). They might as well just create new money and buy the bonds themselves (which the Fed has) – or not issue any bonds and just print money and spend it.

    There appears to be no limit to the depravity of these people (either of the government Central Banks and so on – or of the private bankers and so on) – of course they believe that economic life and morality can be kept in different boxes (indeed that anyone who thinks that right and wrong is relevant to economic matters is a fool).

    They will find out, the hard way, that they are mistaken.

    However, all of us (not just them) will suffer in the days to come.

  • On second thoughts, the above mentioned problems relating to foreign holders of Gilts and lenders demanding a much higher rate of interest would not arise if there was a WORLDWIDE reluctance to invest in government debt. I.e. those problems would only arise where the country concerned (e.g. the UK) was out of line with worldwide trends.

    Put another way, the above mentioned devaluation would only arise if the UK did something spectacularly MORE silly than other countries, which caused lenders to shun UK government debt: in which case the fundamental cause of the problem would be the UK’s silliness, not a reduced willingness to buy government debt.

  • Karl

    I agree with Ralph. Inflation and taxation are excellent policies! I’m sure the public will agree.

  • Paul Marks

    I see Ralph – Britian is only in trouble if the government acts substanially worse than other governments.

    So – if I cut my throat I will be fine, as long as everyone else has also cut their throat?

    I do not agree.

    The sillyness of the British government will wreak Britain (is doing so already) and the fact that other governments are just as silly will not help us.

  • Karl, As far as inflation goes, you clearly have not understood the point I made above. I said that as long as the “effect of the extra tax cancels out the inflationary effect of the extra money” there is by definition no extra inflation. Thus the “inflation” you refer to is a myth.

    As regards the public’s distaste for extra tax, I covered that point as well. You don’t need to be too politically astute to know that whatever changes a government makes, some interest group will jump up and down with contrived indignation. And certainly, given a rise in tax there could (as I said above) be political problems.

    My point (to repeat) was that there are no significant TECHNICAL or strictly economic problems arising out of creditors ceasing to lend to a monetarily sovereign country.

    Paul Marks, I didn’t say that “Britain is only in trouble if the government acts substantially worse than other governments.” I said that basically there is no technical or strictly economic problem arising from a reluctance by creditors to lend. I then added that if we do something significantly more silly than other countries there is a SLIGHT problem (the need to devalue).

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