How Bonds Work (And How Current Policy Can Wreck Them and Our Economy With It)

More than one reader has emailed me asking me how bonds work and why I am so concerned about what Obama's policies will do to them and the economy with them. I think it's time for a wonky economics lesson for all the laymen out there on how bonds work.



First, it's important to know that U.S. Treasury bonds are traded on an exchange, like the Chicago Board of Trade and the OTC, much like any other investment. As such, they work like any other investment in any market. It's ultimately determined by supply and demand. If there are more buyers than sellers the value of bonds goes up and vice versa.



The value of bonds works in the opposite direction of the interest rate attached to it. In other words, the lower current rates on bonds are the higher the value of each bond. This makes sense. If you bought a bond that paid 3.5% yearly and now bonds only pay 3.25%, then of course, yours is more valuable. When an individual, or entity, buys a bond, they get a yearly rate and then they receive all their money back at the end of the term. (that's if they happen to hold the bond till its maturity)



Economically, the value of bonds is determined by the supply and demand of money. The more demand for money there is, the more expensive bonds will be. That means the rate will be higher. This also makes sense. If you are a debtor, then you'll expect a higher rate of interest as more money is borrowed. The same principle is in play here. The more money the goverment will need the higher the rate.


Let's think about it another way. If the government suddenly needs to borrow another trillion dollars, they will need to create that much in bonds. That's how the U.S. Government borrows, by issuing bonds. Unless the government magically creates new buyers of the bonds, they'll create more demand for money without having more supply. The rate will go up.


Quantitative Easing: Magically Creating More Bond Buyers
What if the Federal Government could magically create new buyers of these bonds? In fact, the government can? It's a process known as quantitative easing. In this process, the Federal Reserve, our central bank, buys up trillions worth of these bonds. Where does the Fed get the money to buy them? Usually, the Fed creates it out of thin air. The process of quantitative easing creates two different outcomes. First, it keep interest rates artificially low. That's because the Fed swoops in to buy a great majority of these bonds. As such, the Fed is the magic new buyer of bonds. Second, money is filtered into the economy. The Fed hopes it moves through the economy to stimulate it.

Inflation and Bonds
Bonds hate inflation. There are many reasons. The most basic is this. Bonds have to give the investor a reason to buy. If inflation is 3%, then bonds have to be at least that or no one will buy them. As such, any inflation fear immediately shoots up the rate on bonds. Ah, but you say, there is currently no inflation. That's true but bonds are often long term investments, up to ten years. As such, policies that are inflationary can cause the rates on bonds to go up now because the market views inflation in the same term as the length of the bond. So, a ten year bond can be affected by inflationary policies even if there isn't any inflation now. That's because the investment is long term and the market can take that view. That's why currently short term bonds, 2 years and less, have very low rates, while longer term bonds have relatively high rates. In the short term, there is little inflation fears. In the long term, there is a lot more.

The Yield Curve
The yield curve is the relationship between interest rates on bonds and their underlying maturity. In other words, the yield curve measures the difference between the interest rate on 1, 2, 5, and 10 year bonds. The yield curve can tell us a lot about the state of the economy, and what the bond market views in the future. For instance, starting in early 2006, the bond market created what is known as an inverted yield curve. In this case, the rate on long term bonds is less than on short term bonds. This of course makes no logical sense. Since you have to hold a bond for a longer term, you should expect to make more interest on a bond. In 2006, a ten year bond had a lower rate than a two year bond. An inverted yield curve indicates an upcoming recession. That's because interest rates in the distant future will be significantly less because inflation pressures will give way to recession pressures. Of course, that's exactly what happened within two years if the inverted yield curve.

Currently, the yield curve is normal but steepening. Everyone should watch the yield curve. If we see it steepening any more (in other words, short term bonds rates will go down while long term rates go up), that is a sign of upcoming inflation.

Russia, China, and our other foreign creditors
There's been a lot of talk about how China owns our bonds. There's all sorts of conspiracy theories about this. It's true that China owns a great deal of U.S. Treasury bonds. Yet, there is really no conspiracy about this. The Chinese bought these bonds because they were looking for a safe investment. What's also true is that the Chinese, Russians, and most other foreign investors in bonds just about stopped buying any new bonds. That's because all of the massive new borrowing caused the Chinese to fear inflation and even possibly that the U.S. won't pay them back. Think of the Chinese as a big bank that finally cut off its biggest borrowing customer.

What does this mean? Remember, bonds prices are determined by the supply and demand intersection of buyers and sellers of bonds. If the Chinese have stopped buying bonds, that means less buyers. Less buyers mean that rates go up.

Obama's Policies and U.S. Treasury Bonds
To understand just how dangerous Obama's fiscal policies are think about this quick metaphor. Imagine your friend asks you for $5. You likely wouldn't even think about it. You would just give your friend the money. Now, imagine your friend asks you for $5000. That would give you pause. If you did loan them the money, you would likey add all sorts conditions. Now, imagine your friend asks for nearly $2 trillion. Now, you see the problem the government is creating. They are DEMANDING $2 trillion new dollars. Since, bonds are determined by the SUPPLY and DEMAND for money, the rate on treasury bonds is bound to rise, and eventually rise significantly.

Quantitative Easing, Inflation, and the Dollar
So far, none of this has happened. There are two reasons for this. First, our economy is still weak. There's no inflation pressure which keeps bond rates low. Second, the Federal Reserve has been buying up many of these bonds through quantitative easing, as I mentioned.

Of course, all of this is not without consequence. How is inflation created? It's created when too many dollars chase not enough goods and services. So, what happens when $2 trillion new dollars are created and dumped into the economy? Unless, $2 trillion in new goods and services are created along with them, we will see inflation. Now, unless you've been blinded into believing the president's stimulus will create all this economic activity, you know that eventually there will be too many dollars chasing too few goods and services.

The other thing that quantitative easing does is weaken the dollar. The dollar is also determined by supply and demand. In this case, it is determined by supply and demand of our currency itself. Well, what do you think happens to the value of each individual dollar when $2 trillion new ones are magically created? Of course, each one becomes a lot less worthy, or the dollar weakens.

This has all sorts of corrosive effects. First, foreigners have less incentive to invest in America. That's because the weak dollar makes their investment less worthwhile. Think of it this way. Let's say one dollar could get four yuan at the beginning of the investment. Then, that investment turned into two dollars, but now one dollar only gets two yuan. The final investment is even for the Chinese even though it doubled here. Less foreign investment weakens our economy.

Second, most commodities are priced in dollars: oil, wheat, and all sorts of other commodities. A weak dollar eventually causes the price of gas and food to go up. That's because it takes more dollars to buy each unit. This means the price of gasoline, bread, and all sorts of other groceries go up when the dollar weakens.
Why is the Treasury Bond so important?
The U.S. Treasury bond is the most actively traded debt instrument in the world. As such, it is a pre cursor to almost all other interest rates. While there is no direct relationship between U.S. Treasury bonds and say mortgage rates, mortgage rates are definitely affected by the movement of U.S. Treasury bonds. On any given day, there may be no relation. Over time, the direction of U.S. Treasury bonds eventually determines the direction of mortgage rates. Just think of it this way. If the U.S. government is paying 4% to borrow, you can bet you'll pay more than that to buy a house.

So, policies that cause U.S. Treasury bond rates to go up eventually mean that all borrowing becomes more expensive. Now, think about a weak economy trying to recover and all borrowing rates go up. How good does that recovery look?

Conclusion
By borrowing so much money all at once, the president has left us with no good options. The market won't allow the government to borrow this much at a low rate. Yet, there's no recovery unless borrowing rates remain low. As such, the Fed has swooped in to artificially keep rates low. Of course, this is not only inflationary but weakens the dollar.

Now, we are stuck with no good options. If the Fed continues to buy and does nothing to reverse itself, we'll eventually see massive inflation and our currency will be worthless. On top of this, interest rates will shoot up. If the Fed eventually reverses course and sells back most of the bonds, then interest rates go up. (there will then be selling pressure) If they do this before the economy full recovers, that will just contract the economy (since the Fed is now taking money out of the economy) and throw us back into a recession. The last option is for the government to raise taxes. Again, if this happens before the economy fully recovers, that will just throw us back into a recession. (raising taxes takes money out of people's pockets and thus is contractionary)

Finally, in case someone is trying to be cute, if the government were to wait for a full recovery, that would mean inflation. Waiting for a full recovery is the equivalent of the Fed doing nothing.