The Fed's Bond Bubble Doomsday Machine

[g5000]

When you buy a bond, you are making a loan to the issuer. That bond is money owed to the buyer, making it an asset.

When the Federal Reserve buys a US Treasury bill, note, or bond, it is making a loan to the federal government because the federal government has appropriated more spending than it has received in revenues.

This is called "monetizing the debt". Putting more money into circulation.

Because of the crash resulting from the global derivatives bubble, the Federal Reserve has also been buying Mortgage Backed Securities (MBS) from Wall Street. Yeah, the Fed owns mortgages. Maybe even your house. This is also printing money and putting it into circulation.

So how much money has the Fed printed? What is the book value of its assets?

3 trillion dollars.

With that much extra cash in circulation, inflation is a real concern. There are those who claim inflation is the reason the price of gas or stock prices are so high, but they are making a common mistake, confusing rising relative prices with inflation.

The price of oil has always been volatile, but we rarely hear anyone making panicked cries of doom over "rapid deflation" when the price of oil plummets. Instead, there is dead silence when it does. We only hear panicked cries of doom when the price of oil jumps. A simple observation of the price of oil over long periods of time reveals there is obviously something greater than inflation at work there.

A key component of inflation that is almost always overlooked is something called "the velocity of money".

If the Fed gave you a trillion dollars, and you buried it in your backyard, then that trillion dollars will have absolutely no effect on the value of the money in circulation. The velocity of that trillion dollars is zero.

Just so since the crash of 2008. The velocity of money slowed considerably. Which is precisely why the Fed has been printing so much more of it. The Fed is attempting to get more cash out there to increase the sluggish movement of money.

Put more money into more hands and some of it is going to move around.

A great deal is being hoarded, though. Just as though it was buried in someone's back yard.

More to come...

 

[g5000]

When the Fed buys a bond, it is putting more money into circulation. This makes people who hate the Fed crazy. "They are debasing the currency!!!"

However, the Fed sells its bonds, too. And when it sells the US Treasuries it owns, it takes the principal it receives from those sales and...destroys it! But you never hear the people who hate the Fed crying, "They are strengthening the currency!!!"

Most of the profits from the interest earned on the assets it owns go to the US Treasury. That's right, to the federal government.

By buying and selling Treasuries, the Fed maintains an inflation rate of about two percent. That two percent is to accomodate economic growth.

As I mentioned in my last post, the Fed holds about $3 trillion in assets. That's an extra $3 trillion of money that would not ordinarily be in our economy.

That extra liquidity is not causing any inflationary problems right now. In fact, it prevented runaway deflation.

We can debate all day long over whether we should have allowed that deflation to occur, but that's another topic.

Anyway, as I said, the velocity of money is sluggish, and so inflation is not getting away from us...yet.

But what happens when the economy begins warming up again? What happens when people start digging up that $3 trillion from their backyards and begin spending it, increasing the velocity of money in our economy?

Inflation happens, that's what.

And that is when the Fed would start selling its assets and soaking up all that cash flying around and destroying it.

But...we have a problem.

More to come...

 

[TNHarley]

Quit making me wait!

 

[Avorysuds]

There are bigger issues as well.

Like cheap money makes people borrow and thus putting themselves in debt, that is very very risky.

It inflates the prices of many things, like your house, college, vehicles, starting a small business... It does this by creating a false sense of demand and a false sense of capital.

The cost of food has gone up.

The FED was created to stabilize the economy, that never happened. What did happen is a slow destruction of the dollar and increased poverty while making the rich super rich. The FED never comes to you and your friends and gives you money a .02%, they go to their friends who are millionaires and billionaires, then ask them to invest the money or lend it to you for 4-25%.


Hell, the FED with the US Government made and caused the 2008 housing collapse, without them it would have never even been possible... never.

 

[g5000]

Which would you rather have: A $1000 face value 30-year bond which pays 10% interest every six months, or a $1000 face value 30-year bond which pays 3% interest every six months?

Clearly, the first one is a superior asset.

The price of a bond is inversely proportional to its yield. The lower the interest rate it pays, the more expensive it is. The higher the interest rate it pays, the cheaper it is. That is because the higher interest rate is giving you more money, while the lower interest rate is giving you less money.

Now take a look at this:

The price of a 30-year US Treasury bond has been steadily increasing for the past 30 years.

If you own a 1997 7% interest bond, that is providing you with more income than a 2009 2.83% interest bond.



Remember when everyone thought the price of houses would just keep going up forever?

Now we have people who paid $450,000 for a house that is now worth $195,000. They are seriously underwater. And if they sold their house, they would have to sell it at a much lower price than they paid for it. They would take a loss.


The same is true for bonds. Except bond prices do have a ceiling. You can't go lower than 0% interest on a bond.

Well, you can go into negative interest territory, but who is going to pay the issuer money to own their bond? That would be nuts, right?

Okay, so bonds have a price limit.


Now, back to our inflation problem.

The economy starts moving, which means the velocity of money starts picking up. And just like that, inflation begins to take off.

So now the Fed needs to start soaking up all that cash it had injected into the economy.

It does this by selling its assets and destroying the proceeds.


When you start flooding the market with a product ($3 trillion worth), what happens to the price of that product?

That's right. It drops.

Yields being to climb. The interest rate on bonds begins to go up.

Which means a 2.83% interest bond is now a piece of crap. No one wants a 2.83% interest bond when there are 5% interest bonds on the market.

Which means the Fed is upside down on its assets. Which means they have to sell them at a loss.


Why doesn't the Fed just hold them until maturity, you may be asking.

Because the whole point of selling those bonds was to soak up excess liquidity to keep inflation down.

Except now that bonds are suddenly cheaper, the Fed is pulling less cash out for each bond it buys than it put in when it bought that same bond.

Which means it cannot possibly soak up all the liquidity it put into the market.

Which means inflation is inevitable.

Not only that, who's to say there will be $3 trillion worth of demand for US Treasuries and MBS?



And (cue conspiracy music)...inflation is the most favored method for heavily indebted countries to get out of debt.


So there you go. The Fed's Bond Bubble Doomsday Machine.

Coming to a neighborhood near you.

Keep your eye on the Fed interest rate!

 

[g5000]

It is also important to note that the Fed interest rate, the yield paid on US Treasuries, is the benchmark for every other bond issued.

Corporate bonds, for example. Trillions and trillions of dollars of corporate bonds.

So when the yields start climbing on US Treasuries, all those corporate bonds will suddenly be toxic as well. No one will want to buy them unless they are discounted.

And that means trillions in losses for the people who trade bonds every day.

So the Fed won't be the only one losing its ass.

And don't even get me started on the exponentially higher amounts of nominal cash tied up in derivatives tied to interest rates! Maybe I'll get into interest rate swaps later. This is what will cause many companies to go under. And God knows how many city and state treasurers have been conned into entering into these time bombs.

 

[Avorysuds]

Good thread G5. Many of us keep talking about how the FED is dumping 40 billion a month on the markets, floating them to and unsustainable unrealistic level but too many progressives just want good news so badly they accept anything.

 

[Avorysuds]

The other big problem is during something like the housing bubble there was assets, something tangible... So even at a loss you had a house. Now, we have numbers and a peice of paper, no physical product. This is why if we have another crash it will be worse than 2008, there is nothing of use to sell off.

 

[JimmieD]

When you buy a bond, you are making a loan to the issuer. That bond is money owed to the buyer, making it an asset.

When the Federal Reserve buys a US Treasury bill, note, or bond, it is making a loan to the federal government because the federal government has appropriated more spending than it has received in revenues.

The Fed doesn't purchase from the Treasury. The Fed buys Treasuries from dealer banks.

This is called "monetizing the debt". Putting more money into circulation.

Because of the crash resulting from the global derivatives bubble, the Federal Reserve has also been buying Mortgage Backed Securities (MBS). This is also printing money and putting it into circulation.

The "money" that the Fed uses to purchase Treasuries or MBS' isn't "put into circulation." That money sits on the bank's accounts at the Fed and only circulates among banks. The net financial assets of the private sector have not changed. The Fed has exchanged one financial asset (a T-bill, bond, or MBS) for another financial asset (bank reserves).

What this does do is change change the capital structure and maturity profile of bank balance sheets. It would become inflationary if banks increased their lending.

A key component of inflation that is almost always overlooked is something called "the velocity of money".

If the Fed gave you a trillion dollars, and you buried it in your backyard, then that trillion dollars will have absolutely no effect on the value of the money in circulation. The velocity of that trillion dollars is zero.

Just so since the crash of 2008. The velocity of money slowed considerably. Which is precisely why the Fed has been printing so much more of it. The Fed is attempting to get more cash out there to increase the sluggish movement of money.

Put more money into more hands and some of it is going to move around.

The traditional measures of velocity of money are outdated in that they are too narrow. When we talk about "money" now we must consider things like collateral and collateral chains.

 

[g5000]

When you buy a bond, you are making a loan to the issuer. That bond is money owed to the buyer, making it an asset.

When the Federal Reserve buys a US Treasury bill, note, or bond, it is making a loan to the federal government because the federal government has appropriated more spending than it has received in revenues.

The Fed doesn't purchase from the Treasury. The Fed buys Treasuries from dealer banks.

Yes, they buy it from the market like everyone else. I was just keeping it simple. The end result is the same. Monetizing the debt.

This is called "monetizing the debt". Putting more money into circulation.

Because of the crash resulting from the global derivatives bubble, the Federal Reserve has also been buying Mortgage Backed Securities (MBS). This is also printing money and putting it into circulation.

The "money" that the Fed uses to purchase Treasuries or MBS' isn't "put into circulation." That money sits on the bank's accounts at the Fed and only circulates among banks. The net financial assets of the private sector have not changed. The Fed has exchanged one financial asset (a T-bill, bond, or MBS) for another financial asset (bank reserves).

What this does do is change change the capital structure and maturity profile of bank balance sheets. It would become inflationary if banks increased their lending.

That was actually the whole purpose of purchasing the MBS. To get banks to increase lending because lending had ground to a halt.

The whole intent was to get banks to stop hoarding cash and get it out there. That is why the Fed keeps talking about lowering the interest rate it pays on Reserves.

When the economy heats up, the Fed will raise the interest it pays on Reserves to cause the price of borrowing from banks to rise.

A key component of inflation that is almost always overlooked is something called "the velocity of money".

If the Fed gave you a trillion dollars, and you buried it in your backyard, then that trillion dollars will have absolutely no effect on the value of the money in circulation. The velocity of that trillion dollars is zero.

Just so since the crash of 2008. The velocity of money slowed considerably. Which is precisely why the Fed has been printing so much more of it. The Fed is attempting to get more cash out there to increase the sluggish movement of money.

Put more money into more hands and some of it is going to move around.

The traditional measures of velocity of money are outdated in that they are too narrow. When we talk about "money" now we must consider things like collateral and collateral chains.

Good luck measuring collateral chains. There is a lot of cheating going on with collateral, with some collateral being double or triple pledged, or God knows how many times.

 

[JimmieD]

Good luck measuring collateral chains. There is a lot of cheating going on with collateral, with some collateral being double or triple pledged, or God knows how many times.

It's not cheating if everyone involved agrees that it's OK. It is fragile in that there there is systemic risk in the event of som number of defaults.

 

[oldfart]

The price of a bond is inversely proportional to its yield. The lower the interest rate it pays, the more expensive it is. The higher the interest rate it pays, the cheaper it is. That is because the higher interest rate is giving you more money, while the lower interest rate is giving you less money.

I think you have some confusion here. If you compare bonds which are identical in all respects except coupon yield (i.e. without regard to relative safety, the same term, etc) the yield with respect to the current purchase price will be equal for all such bonds. Once issued, the price of bonds will rise and fall to equalize the yield to that of the most recently traded or issued bonds. So if interest rates fall, the yield of EXISTING bonds will rise.

For example, suppose you bought a ten year note five years ago at par and carrying a coupon rate of 6%. A $10,000 bond will pay $600 per annum interest for the next five years and then mature and pay you the $10,000 back. But suppose a new five year bond sells at auction for a yield of 3%. Your old bond is worth more than the new one because it pays a higher yield. It's price will rise above the $10,000 price until its yield matches the new note.

For fun, the limit to the value of a bond, regardless of the length of the term is one divided by the interest rate. A 30-year bond is worth almost the same as a 50-year bond of the same coupon rate. As interest rates go higher this yield curve gets steeper. At one time, such a bond actually existed. In 1814 the Napoleonic wars had so devestated the British Treasury that it issued refinancing bonds that paid an interest rate in perpetuity and had no maturity date. They were called "Consolidation bonds" or "consols" for short, and their price was exactly the coupon divided by the current interest rate. Eventually the consols were retired at a premium, but the concept remains for us math challenged anal-retentive types who can't remember the formulas for a bond of a given fixed term.

 

[iamwhatiseem]

But yet this administration (as well as the last) have denied they are monetizing the debt.
Sorta like saying you don't smoke...while holding a lit cigarette and smoke rolling out of your mouth as you speak.
Like I have been saying for the past 5 years plus - we are no longer a representative republic, we are an oligarchy pretending to be a representative republic. And as an oligarchy, the priority and resources of the government is reserved for the oligarchs.
Every single month the FED is handing over $85,000,000,000 to the top financial corporations in the world in the form of buying toxic assets. (Despite the sequester)
There is only one reason this is being done - and that reason is to prevent a much larger financial collapse by propping up the current system that grossly rewards the top-top-top financiers no matter what the market does.

 

[g5000]

The price of a bond is inversely proportional to its yield. The lower the interest rate it pays, the more expensive it is. The higher the interest rate it pays, the cheaper it is. That is because the higher interest rate is giving you more money, while the lower interest rate is giving you less money.

I think you have some confusion here. If you compare bonds which are identical in all respects except coupon yield (i.e. without regard to relative safety, the same term, etc) the yield with respect to the current purchase price will be equal for all such bonds. Once issued, the price of bonds will rise and fall to equalize the yield to that of the most recently traded or issued bonds. So if interest rates fall, the yield of EXISTING bonds will rise.

For example, suppose you bought a ten year note five years ago at par and carrying a coupon rate of 6%. A $10,000 bond will pay $600 per annum interest for the next five years and then mature and pay you the $10,000 back. But suppose a new five year bond sells at auction for a yield of 3%. Your old bond is worth more than the new one because it pays a higher yield. It's price will rise above the $10,000 price until its yield matches the new note.

Yes, all true. Again, I simplified the explanation, but you will note I discussed the lower interest rate bond would have to be sold at a "discount" when interest rates rise. This is the term used for a bond sold below par. And that is the scenario we are going to be facing. Interest rates rising, not falling.

For fun, the limit to the value of a bond, regardless of the length of the term is one divided by the interest rate. A 30-year bond is worth almost the same as a 50-year bond of the same coupon rate. As interest rates go higher this yield curve gets steeper. At one time, such a bond actually existed. In 1814 the Napoleonic wars had so devestated the British Treasury that it issued refinancing bonds that paid an interest rate in perpetuity and had no maturity date. They were called "Consolidation bonds" or "consols" for short, and their price was exactly the coupon divided by the current interest rate. Eventually the consols were retired at a premium, but the concept remains for us math challenged anal-retentive types who can't remember the formulas for a bond of a given fixed term.

There have even been 100 year bonds, and you don't have to go back to 1814 to find them. Many corporations and universities have issued them.

Univ Of Pennsylvania Nabs Lowest Yield Ever On 100-Year Bond


Century bonds.

 

[g5000]

But yet this administration (as well as the last) have denied they are monetizing the debt.
Sorta like saying you don't smoke...while holding a lit cigarette and smoke rolling out of your mouth as you speak.
Like I have been saying for the past 5 years plus - we are no longer a representative republic, we are an oligarchy pretending to be a representative republic. And as an oligarchy, the priority and resources of the government is reserved for the oligarchs.
Every single month the FED is handing over $85,000,000,000 to the top financial corporations in the world in the form of buying toxic assets. (Despite the sequester)
There is only one reason this is being done - and that reason is to prevent a much larger financial collapse by propping up the current system that grossly rewards the top-top-top financiers no matter what the market does.

I don't recall this Administration denying they were monetizing the debt. The Fed has said that inflation is not out of control yet, and they have discussed the ways they will fight it when it does happen, but there are doubters like myself who feel their are whistling past the graveyard.

Every Congress that does not balance the budget is forcing our debt to be monetized, not just this one. When Congress spends more than it has, it is printing money.

That is not usually a problem as long as the pace of GDP growth exceeds the growth of the deficit. However, for the past several years, that has not been the case.

 

[iamwhatiseem]

But yet this administration (as well as the last) have denied they are monetizing the debt.
Sorta like saying you don't smoke...while holding a lit cigarette and smoke rolling out of your mouth as you speak.
Like I have been saying for the past 5 years plus - we are no longer a representative republic, we are an oligarchy pretending to be a representative republic. And as an oligarchy, the priority and resources of the government is reserved for the oligarchs.
Every single month the FED is handing over $85,000,000,000 to the top financial corporations in the world in the form of buying toxic assets. (Despite the sequester)
There is only one reason this is being done - and that reason is to prevent a much larger financial collapse by propping up the current system that grossly rewards the top-top-top financiers no matter what the market does.

I don't recall this Administration denying they were monetizing the debt. The Fed has said that inflation is not out of control yet, and they have discussed the ways they will fight it when it does happen, but there are doubters like myself who feel their are whistling past the graveyard.

Every Congress that does not balance the budget is forcing our debt to be monetized, not just this one. When Congress spends more than it has, it is printing money.

That is not usually a problem as long as the pace of GDP growth exceeds the growth of the deficit. However, for the past several years, that has not been the case.

And will continue being the case.
We had a false economy for almost 30 years.
We had a glorious run that depended on most people treating debt as income, both as individuals and as a nation. There was little to no distinction between current income and "borrowing" from future income. Just like you said above, all is fine and dandy as long as everyone's income climbed as fast as their debt.
The problem with this method is obvious - eventually you run out of "future income" to borrow from or the debt load reaches a point where you have to actually start paying the debt off.
The government, however, has the ability to print money. So it is a bit more complicated, but the end is just as easy to predict.

 

[g5000]

But yet this administration (as well as the last) have denied they are monetizing the debt.
Sorta like saying you don't smoke...while holding a lit cigarette and smoke rolling out of your mouth as you speak.
Like I have been saying for the past 5 years plus - we are no longer a representative republic, we are an oligarchy pretending to be a representative republic. And as an oligarchy, the priority and resources of the government is reserved for the oligarchs.
Every single month the FED is handing over $85,000,000,000 to the top financial corporations in the world in the form of buying toxic assets. (Despite the sequester)
There is only one reason this is being done - and that reason is to prevent a much larger financial collapse by propping up the current system that grossly rewards the top-top-top financiers no matter what the market does.

I don't recall this Administration denying they were monetizing the debt. The Fed has said that inflation is not out of control yet, and they have discussed the ways they will fight it when it does happen, but there are doubters like myself who feel their are whistling past the graveyard.

Every Congress that does not balance the budget is forcing our debt to be monetized, not just this one. When Congress spends more than it has, it is printing money.

That is not usually a problem as long as the pace of GDP growth exceeds the growth of the deficit. However, for the past several years, that has not been the case.

And will continue being the case.
We had a false economy for almost 30 years.
We had a glorious run that depended on most people treating debt as income, both as individuals and as a nation. There was little to no distinction between current income and "borrowing" from future income. Just like you said above, all is fine and dandy as long as everyone's income climbed as fast as their debt.
The problem with this method is obvious - eventually you run out of "future income" to borrow from or the debt load reaches a point where you have to actually start paying the debt off.
The government, however, has the ability to print money. So it is a bit more complicated, but the end is just as easy to predict.

Yeah, of the six ways a government can decrease debt, inflation is the most used, and is the most likely choice the US government will make.

The last time our debt to GDP ratio was like this, that is what they did. From WWII to the middle of the 1950s, inflation was about 9 percent. External devaluation.

However, they also had sky high income tax rates. Internal devaluation.

If the economy takes off, GDP growth will mitigate that considerably.

 

[oldfart]

A key component of inflation that is almost always overlooked is something called "the velocity of money"....Just so since the crash of 2008. The velocity of money slowed considerably. Which is precisely why the Fed has been printing so much more of it. The Fed is attempting to get more cash out there to increase the sluggish movement of money.

Put more money into more hands and some of it is going to move around.

The traditional measures of velocity of money are outdated in that they are too narrow. When we talk about "money" now we must consider things like collateral and collateral chains.

OK, the big problem here is that the basic monetary identity PY=MV (where P is a price vector, Y is an output vector, M is a scalar measure of money supply, and V is a scalar "velocity of money")is an accounting identity and not a function. If you treat all four variables as dependent variables, the system is overdetermined. You set three as dependent variables to be explained with a function and the fourth (V) automatically comes out in the wash. You don't need a "theory" for the velocity of money. If you have one, you need to identify which other part of the identity has become the residual (price level? output? money supply?). The options don't look very attractive.

This is why a lot of monetary theory texts express the identity as V=(PY)/M, which makes clear that V is arrived at as a definition, not a function.

The statement that increases in the money supply cause prices to rise (inflation) is just another restatement of this monetary identity with the added assumption that increases in the money supply have no direct effect on output or velocity. This is where an explanatory "theory of velocity of money" might come in, but it would be a theory derived from a theory of prices and output.

Also note that if we are in a Keynesian liquidity trap, increases in the money supply are not inflationary because the velocity of money changes (through hoarding) to offset the increases in monetary base. Almost every conservative (or monetarist) economist in 2009 predicted rapid inflation which did not occur. This "natural experiment" should have been the definitive proof that we were in a liquidity trap and that the macro dynamics were very close to the 1928--1933 experience. It's a measure of the collective denial of much of the profession that five years out almost all of these false predictors stand by there model and persist in recommending ruinous policies based on wishful thinking and economic theory that comes out of a CrackerJack box.

 

[jwoodie]

Excellent posts, but I am interested in your projected timelines for inflation, etc. The semi-independent variable in these equations is an international race to the bottom, i.e., many countries are devaluing their currencies, thereby propping up US investments as relative safe havens.

 

[iamwhatiseem]

Excellent posts, but I am interested in your projected timelines for inflation, etc. The semi-independent variable in these equations is an international race to the bottom, i.e., many countries are devaluing their currencies, thereby propping up US investments as relative safe havens.

Inflation...why not stagflation?
I think we are on the precipice of stagflation, especially when you factor in the level of underemployment, not just unemployment.
Stubborn unemployment/underemployment.....check.
High inflation....check. (ignoring the bullsh*t CPI)
Slow economic growth....double check.