Markets just seem to love bubbles. One of the first recorded financial bubbles was the Dutch Tulip bubble. At its peak in January 1637 particularly desirable tulip bulbs traded for ten times the annual average wage of a day laborer. For one bulb. The best (stupidest) part of the tulip bubble is that properly cultivated, the number of tulip bulbs in existence will continue to grow. Unless the demand for bulbs grows faster than supply over a long period of time, the price is bound to fall.
The long dated Treasury market is today is like the tulip market in January 1637. It seems great, people have made a lot of money, but its only straight down from here. The 30 year bond is currently closing right around a 4.0% yield. To put this in perspective twenty years ago in the 30 year cost of borrowing was 8.61%. At its peak in 1981 the cost borrowing was over 13%. Can the United States Government really be a more creditworthy borrower today than in 1990?
Yesterday the Fed announced that it will purchase $600BB of long-dated Treasuries. The market in the 30 year promptly reacted by dropping over 150 basis points. In a normal market, when a buyer announces that they are purchasing ~4.4% of all outstanding assets in a market ($600BB purchases divided by $13.6TT of debt total US sovereign debt), the price of the asset rises. However, the market is starting to question the creditworthiness of the government.
The creditworthiness of a sovereign with debt denominated in its own currency is not based on whether it will pay interest and principal. The ability of central banks to print money assures that. The creditworthiness of that sovereign is based on whether the coupon and principal payments deliver a return that allows the holder of the bonds to purchase more goods and services when received than when the investment was made. Because the government can print money it can debase that money and what is received from the bond can lose much of its purchasing power.
The market’s reaction suggests the Fed has lost the ability to move the market. Expectations of increasing inflation spurred by the Fed funding the Federal Government have decreased investors view of the government’s creditworthiness. The only way the government can repay its debt is by increasing the price level. In 1981 inflation ran 8.05% while the 30 year bond yielded in excess of 13%. The coupon of the 30 year bond therefore returned over 5% in real after inflation returns. Today, inflation is running right around 2%. The 30 year bond is returning around 2% in real, inflation adjusted returns. While it is likely that investors will demand a far higher real return "premium" in a volatile environment, let us assume that they will continue to accept a 2% real return and that inflation will run a moderate but stable 5%. Yields on the 30 year will increase to 7%.
What will happen to the price of the bond that was issued with a 4% yield? Prices of bonds move inversely to yield. If you have a $1000 that pays $40 a year and investors demand a return of 7% they will pay less than $1000 for the bond. They will pay a price where the $40 coupon plus the appreciation of the investment when principal is paid at maturity returns 7% on invested capital. In this case the value of a just issued 30 year bond would fall from $1000 to $622 - a 38% decline.
Based on projections of future budget deficits the supply of Treasury securities will grow indefinitely. Meanwhile its highly likely their purchasing power will fall reducing demand. Today it might not be such a bad idea to buy some Tulips. At least you'll have something pretty to look at when your savings are worthless.
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