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April 13, 2004

Bondmarket Implosion!
by Magnus Ekervik

Alan Greenspan, the No.1 debt builder of the world, has been able since he took office in 1987 to help America create not only 15 years of almost non-stop prosperity, but also an enormous load of debt.

Fighting every setback or difficulty with more liquidity, Greenspan has been crowned the hero of Wall Street and have become mightier than the president. The problem that the Federal Reserve has been facing lately is the fact that the weapon they are in control of has started to malfunction. The interest rate weapon have been used so frequent lately, it is starting to be worn out.

When interest rates drops close to zero, the power of the Federal Reserve slowly fades away. The only thing they can hope for is that the consumer and business sector keeps adding to their debt, so the debt balloon can be kept aloft and the economy on recovery path. That is where we are right now.

When rates are set by the market and not artificially manipulated down like today. The rate weapon can be aimed like a canon (illustrating power but not perfect precision) targeting primarily consumers and businesses with good payback abilities. The public can buy new cars or houses with their new debt, thereby boosting the economy. Businesses can invest in new equipment, creating new job opportunities and increasing productivity and industrial output. These actions will help the economy turn around in distressed times and create a self-sustaining recovery.

With rates artificially low and close to zero, the rate weapon starts to malfunction. Instead of a canon it will behave more like a cluster bomb (still powerful but with even less precision), hitting all kinds of possible debtors. Since most of the strong debtors are already saturated with debt. The banks will offer their debt even to the weakest debtors. This category of consumers/debtors will be happy to get a loan, and start piling on all the debt they can handle and then some. This last wave of debt bonanza will primarily hit the consumer sector, the smarter business sector, has felt the beginning of deflation putting a lid on sales prices, and has steadily decreased debt levels since the last recession in 2001.

When the consumer has taken on all the debt he can handle (a lot of them take on more than they can handle) the rate weapon ceases to function. With no one left to borrow, in combination with the bond market revulsion in July 2003 (increasing rates on house mortgages). The monetary growth rate starts declining and then reverses. This decline could be seen in the M3 money stock during the last two quarters of 2003. Declines in M3 are rare, the size of this decline has not been seen in at least 50 years. Something ugly is approaching!

Thanks to the Bank of Japan, buying large amounts of US Treasury debt in the beginning of 2004 to protect the JPY from increasing in value against the USD, thus protecting there own economic recovery. They have temporarily managed to reflate the US bond market, thereby lowering interest rates. This has helped the consumers that missed the chance to refinance mortgages before interest rates started increasing in July last year, to get a last chance. They jumped in with both feet to refinance their mortgages, and successfully managed to turn the M3 back up to new highs. With The Bank of Japan acting as a respirator, the sick patient has received one more round of oxygen.

When the March job figures showed a strong 308,000 jobs were created, the large bond market players once again sensed the awful smell of inflation approaching and started selling at a rapid pace. With the fading interest from Asian central banks to buy new debt, the Treasury Dept. have had increasing problems getting all the new debt sold to finance the budget deficit. With recent signs of inflation creating a sell off in bonds and Asian central banks losing interest in buying, there is no longer anything propping up the bond market bubble. Adding to the problem is the leveraged carry trade by major banks and hedge funds. The approaching inflation will keep pressure on bonds in the coming months, thus forcing leveraged players to sell at increasing pace, driving prices lower and pushing interest rates to painful heights.

The coming bond market implosion and rising interest rates is expected to almost completely stop the refinancing of home mortgages. With minimal wage increases and no more access to cheap money the consumer will have to cut back on spending. With rapidly increasing bankruptcies in both the consumer and business sector, with todays record low rates. The sharp increase in interest rates will force a large group of weak debtors that has borrowed on the margin, to default on their loans. The banks will act as they usually do and halt their credit lending to all but the strongest debtors, fearing more defaults. This action will kill consumer demand and force businesses to lower prices. The consumer now noticing the lower prices will figure, if he waits he can get even lower prices. US businesses struggling to survive in the competition from Asian manufacturers will lower prices even more. The consumer being right in his conclusion waits some more and the bad cycle of deflation is born. This will once again be seen in the declining M3, this time however one would expect more like a collapse.

This is the first time in 70 years that the US has reached debt saturation at one percent overnight interest rate. The Federal Reserve using the interest rate weapon like a machine gun since the 2001 recession, in order to desperately try to reflate the collapsing economy, will have no ammo left when the economy begins to deflate later this year.

Summary: As the approaching inflation becomes more obvious, the sell off in the bond market will increase, and start to unwind the leveraged carry trade by the large players. The exit will seem very narrow when everyone tries to get out at the same time, soon creating a panic, forcing prices way lower and interest rates a lot higher. The stock market will resume the bear trend that started in 2000 and will reach new lows, increasing the panic even further. Commodities and precious metals will also be dragged down. In the ravaging debt deflation ahead, all assets will fall together. In this environment, cash will be king, as it will rise on a relative basis against all assets. The chain of events will rapidly lead the US to a new recession, that eventually to the surprise of many, develop into depression....

Magnus Ekervik

Magnus Ekervik offers independent research and analysis of macroeconomics to financial corporations and financial newspapers. For more information please contact: mefinance@bostream.nu

Copyright © 2004 - 2005 Magnus Ekervik. All rights reserved.

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