The Coming Bond Bust
The Timing and Pattern of the Coming Bond Bust is Unpredictable
In this article we would like to address an important question from a reader Darin A. that deserves a detailed answer:
Dr. Petrov, I recently read your responses on http://www.caseyresearch.com/articles/investment-legends and am curious about your last one. You stated that spiking yields will trigger the next stage of the crisis. What are the coming stages, and how high do you think rates will go and in what time frame?
Darin, it impossible to predict the time frame of the bond bust. It may last only 2-3 years, but it my easily last 10-20 years. The bust may come as a slow and painful process; it may come in a series of crashes like a waterfall decline. While the outcome is fairly easy to forecast, the path is uncertain.
To understand the unpredictability of the coming bond bust, you need to remember the basic lesson that bond prices are determined by demand and supply for bonds. While there are over a dozen of critical factors determining bond demand and supply, it is sufficient to provide only three such dominant factors, each of which is highly uncertain and unpredictable. More specifically, you need to recognize that bond fundamentals (demand and supply) are driven by monetary policy, fiscal policy, and currency policy. Then you need to recognize that each policy itself is driven by faulty pseudo-economics and often trumped by pure politics. Here are the three factors:
- FISCAL POLICY. Fiscal policy determines a big chunk of bond supply. Government deficits are financed by issuing (supplying) bonds, so larger fiscal deficits result in lager bond supply, while fiscal surpluses result in falling supply. If there is something that is certain these days, it is that fiscal policy is driven by pure politics and totally unpredictable: one day the government is on the verge of shutting down, but the next "disaster" is averted; one year the government adopts an expensive prescription-drug bill, the next year it modifies it completely; last year the government was pulling troops out of Afghanistan, this year it reverses course; earlier in the year the government was spending a fortune on two wars; now it is spending on three.
The reality is that fiscal deficits are out of control and the government has to get its act together, but only God know if this would happen two or twelve years down the road, thus rendering the supply of bonds totally unpredictable.
- MONETARY POLICY. The Fed, with its "Quantitative Easing" programs, has become the largest buyer of bonds and completely dominates bond demand. Their schizophrenic policy is totally unpredictable: they implement quantitative easing, declare victory and announce an exit strategy, but six months later they reverse course and announce QE2; now Fed declares success and discusses the possibility of early exit from QE2, while later they will likely decide to extend the size and scope of QE2 and transition to QE3; now Fed focuses on unemployment, then it focuses on runaway commodity prices. The Fed's stop-and-go policy is driven by its dual mandate of employment and inflation and very long policy lags, which make it prone to destabilizing overshooting and manic-depressive behavior. Good luck trying to predict the timing of monetary policy.
Who knows if and when the next Volcker will be appointed in order to engineer a bond collapse and conquer inflation. Voclker’s experience in 1980 is especially instructive: when he raised interest rates in 1980, things went so horribly wrong that he flinched and reversed course in 1981 to calm down the markets, and then tightened mightily in 1982 in order to finish the job and slay the inflation monster.
- CURRENCY POLICY. The currency policies of countries like China and Japan are driven by economics, policy, internal politics, and geopolitics. Intervention on the currency market is usually coupled with buying or selling of bonds. If the Japanese or Chinese run a trade surplus, they may sell their currency and buy dollars to keep their currency from appreciating; then they would recycle the surplus dollars into the bond market, thus increasing demand for bonds. While the Chinese and Japanese are getting sick and tired of watching their dollar holdings lose value, it is impossible to predict when they will snap out of their mercantilist dream and decide to dump those bonds and the dollar. Thus, you can see them for many years buying, then suddenly reversing course and selling. The problem is that the timing of selling is completely unpredictable: it could result from a shift in economic policy, could betriggered by internal politics, or could be forced by sudden and uncontrollable external geopolitical events or Acts of God, like earthquakes, tsunamis, and nuclear disaster.
More importantly, not only the timing of their selling is uncertain, but also their mode: they may decide to sell slowly and steadily, without upsetting the markets too much; or their selling may trigger panic selling amongst other bond and dollar holders precipitating a disastrous crash in the bond market and a currency crisis. In all the mayhem, even more uncertain is the intention of foreign governments: they may want to stem losses and mitigate the bond/dollar crisis, but they may see a wounded empire and go for the kill by carpet-bombing the bond and currency market to destroy their geopolitical enemy for good.
Now, that it quite clear that each of these policies is totally and completely unpredictable in terms of timing and magnitude, try to think about predicting feedback loops of one policy with another. For example, what would be the monetary response to an excessive fiscal deficit? Or, what would be the currency response to an excessive quantitative easing? How do you predict an unpredictable policy response to an unpredictable policy, effectively overlaying unpredictability on top of unpredictability?
Thus, the stages and the timing of the coming bond bust are to a large degree unpredictable. However, if history is any guide, these bond busts typically last for 10-20 years. So, don't expect it to be short and swift; prepare for a bust that is long, painful, and largely unpredictable.