With the 10 year US Treasury Yield flirting with the 4% mark once again, some commentators are calling the end of a three decade long bull market. The US Government looks set to grow borrowings for the foreseeable future as it steps in to take the lead in the Debt Supercycle Buildup. With total debt at unprecedented heights and growing at rates not seen in several generations, either bond buyers start demanding higher interest rates soon and/or the US “restructures” the terms of the debt by inflating or monetizing (which will in turn force nominal interest rates higher later). When interest rates rise in the market, assets with fixed rates of return (like bonds) generally fall in value.

The Debt Super Cycle

Source: John Mauldin

What will cause things to crack?

Inflation, demand for capital and/or a buyers’ strike are the common culprits. While inflation and demand for capital don’t look like a problem today, the risk of a buyers’ strike in the not too distant future cannot be ruled out.

Of course, this doesn’t mean that everyone agrees. Bond Bulls argue that interest rates aren’t going to fall much from this point but they think a continued weak economic recovery will keep interest rates from rising. The best example of what they expect is the Japanese Government Bond (JGB) market which has delivered razor thin interest rates year after deficit spending year. For nearly 20 years, JGB bears have scorched their fingers betting against the bond market. (for more read Alicia Ogawa’s piece in the Wall Street Journal)

So who is right?

The answer lies in what is different about the two markets rather than what appears to be the same.

To start with, the US dollar is the global reserve currency. The US dollar is used to trade commodities (especially Oil), settle trade accounts between non-US parties, and even as the legal tender in several smaller countries around the world. The Japanese Yen, while fully tradable, is not really of much use outside of Japan.

Next, we look at the decades’ long current account surpluses in Japan vs. deficits in the US. The result? The JGB market is largely a clubhouse affair. Only a very small proportion of the bonds are held outside of interlocking government agencies and the big Japanese banks. Despite the best efforts of the US Government to turn money center banks into the willing tools of US financial policy (and the latter’s willingness to be so co-opted), the US Treasury and the Federal Reserve will never enjoy the captive audience that their Japanese counterparts do.

So who will trigger the next move?

Perhaps the largest single holder of US paper? Actually, that is not likely. A Chinese clearance sale of US Treasuries and Agencies is a pretty remote possibility at this point in China’s economic and political development. Although no one likes to talk about it, the value of China’s currency (the RMB) is directly derived from the pile of US treasuries sitting in Chinese Government accounts. How about a buyer’s strike? That is more likely only because China’s current account surplus is shrinking and may even show a few monthly deficits this year.

The trigger will probably come instead from Europe. As the Greek crisis has shown, European banks are very well exposed to the government debts of the PIIGs (Portugal, Ireland, Italy, Greece) markets. Part of the Global Solution to the Global Financial Crisis has been to pretend that credit assets (loans, bonds, MBS, CDO’s, real estate collateral, etc.) are worth face value while opening up a central bank arbitrage window to allow banks to quietly rebuild capital bases. If the Greek crisis gets much worse, we could see European banks selling off treasuries not because they have lost faith in the paper but because US Governments and Agencies can still be sold at something approaching the values carried on the books.

Look for US interest rates to rise and all financial markets to get more volatile as a result.

Sources: Stock Charts.com and Investment Postcards Blog


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