Courtesy of The Pragmatic Capitalist

There is increasing chatter of the great “bond bubble” as U.S. Treasury bonds surge ever higher and deflation fears rise.   This is just one more myth that has persisted in recent years (decades really) due to mass misconception of the way the bond market actually operates and this propensity to label everything as a “bubble”.

Before we dive into the real meat of the argument it’s important that we define what a market “bubble” is.  A “bubble” occurs when market forces combine to generate a highly unstable position.   This results in the system entering an extreme disequilibrium and ultimately failure.  The causes of this “bubble” (or extreme disequilibrium) can be many – though primarily psychological any number of exogenous factors can contribute to the instability of the system (government policy for example).   The psychological aspect of a bubble is well explained by analysts at BNP Paribas:

“When interacting agents are playing in a hierarchical network structure very specific emerging patterns arise.  Let us clarify this with an example. After a concert the audience expresses its appreciation with applause. In the beginning, everybody is handclapping according to their own rhythm. The sound is like random noise. There is no imminence of collective behavior. This can be compared to financial markets operating in a steady-state where prices follow a random walk. All of a sudden something curious happens. All randomness disappears; the audience organizes itself in a synchronized regular beat, each pair of hands is clapping in unison. There is no master of ceremony at play. This collective behaviour emanates endogenously. It is a pattern arising from the underlying interactions. This can be compared to a crash. There is a steady build-up of tension in the system (like with an earthquake or a sand pile) and without any exogenous trigger a massive failure of the system occurs. There is no need for big news events for a crash to happen.

Financial markets can be classified as open, non-linear and complex systems. They also exhibit emanating patterns as a result of which the “invisible hand” can be very shaky.  More then 40 years ago Benoit Mandelbrot described the fractal structure of cotton prices and the emanating properties of fat tails and volatility clustering and Hyman Minsky proposed a theory for endogenous speculative bubble formation. More recently Robert Shiller and Alan Greenspan made the irrational exuberance paradigm fashionable. These all fit in the framework of Complexity Economics, which describes the properties that emerge from interacting agents. It has become clear that herding behaviour in financial markets results in positive or negative feedback mechanisms causing price accelerations or decelerations and (anti)-bubble formation, where asset prices become detached from the underlying fundamentals.”

So, we can conclude that a bubble (as it pertains to markets) is an irrational psychological  market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse.  The keys here are extreme disequilibrium and systemic collapse.  In order to have a bubble both aspects must occur.  I will revisit this later.

There is ever increasing chatter of a bubble in the U.S. bond market.  This idea of a bubble has become pervasive due to the myth that the U.S. government bond market can and will collapse under mounting fiscal burdens and the idea that bonds are “expensive” when compared to other assets.

Over the years investors have become increasingly concerned about the risk of sovereign default in the United States.  China officially “hates” us.  Alan Greenspan is frightened that the bond vigilantes are merely sleeping.  Jeff Gundlach is worried that the United States is already insolvent.  But are these concerns justified?

This brings us to a key question.  What exactly is the U.S. government bond market?  In a country with monetary sovereignty in a floating exchange rate system (USA & Japan, for instance) the bond market is really nothing more than a mechanism through which the central bank controls the money supply.  It doesn’t actually fund anything as it does in Europe or under a gold standard.  This is best understood by studying the bond auction data in the USA.  Despite constant shrieking of a potential lack of buyers in government bonds over the years we continue to see incredibly high demand for US debt.   The auctions are always oversubscribed.  They never fail.  Why is this?  Why do the buyers keep coming back for more?  The simple answer is because the government puts the buyers there. The auctions are designed not to fail.  How is this you ask?

The government bond market is merely a monetary tool that the central bank utilizes to control the cost (or supply) of money by controlling the level of reserves in the system.  So, when the government auctions bonds they are merely targeting reserves in the system.  This action is mandated by Congress as an accounting tool and so is seen as a source of funding, however, in reality the Central Bank is merely draining reserves that the Treasury already spent into existence – reserves that were deposited at various banks (read this process in greater detail here).   Therefore, it’s incorrect to argue that there won’t be buyers of U.S. bonds – with the banks earning 0.25% on their reserves and the government offering anything above that (depending on duration) the trade is a no-brainer for the banks who hold these reserves.  The government is basically offering them free money and the Central Bank keeps control of the money supply in exchange (at least in theory).  What is not occurring is some sort of funding mechanism.  The Fed could care less if the auctions are 2X, 3X or 4X oversubscribed.  They don’t get extra money when this occurs.  They don’t get a gold coin that can then be spent.  So long as they meet the 1:1 bid to cover the auction is a huge success because they drained their targeted reserves and convinced Congress that we aren’t going bankrupt.

Over the years the classic hyperinflationist or defaultista argument has been that China will stop buying our debt or that Japan will stop buying our debt.  But the problem with this argument is that China is not our banker.  Japan is not our banker.  What do we care if they buy our bonds?  They desire to net save with the U.S. and we happily send them pieces of paper with old dead white men on them to satisfy this desire.  In recent months Chinese net holdings of U.S. debt declined:

“China’s ownership of US government debt has dropped to the lowest level in at least a year, Treasury data showed Monday, in a sign Beijing is increasingly keen to diversify out of US bonds.

The cash-rich Chinese government reduced its US Treasury bond holdings to 843.7 billion dollars in June, the lowest level since at least the same month last year, the Treasury said in a report on international capital flows.

The June data was lower than the 867.7 billion dollars in Treasury bonds held by the Chinese in May and 900.2 billion dollars in April.”

But U.S. treasury yields continue to plunge.  The demand for this paper is enormous even though the largest holder of these bonds appears to be getting scared off.  The demand is well beyond what the Fed even requires (as previously explained).  While the Chinese fret about U.S. insolvency we’ll gladly keep sending them pieces of paper in exchange for real goods and services.  If they desire to save less (which actually benefits their citizenry) then the United States will save more domestically (not all bad if you ask me).  But ultimately, what they decide to do with those pieces of paper is their business and is not going to sink the U.S. economy.

Many of the arguments in favor of a bond bubble can be debunked by reviewing the hyperinflationist argument over time.  For instance, in January of 2009 The Telegraph had a provocative piece titled “The bond bubble is an accident waiting to happen“.  The author, Ambrose Evans-Pritchard, said the bond vigilantes were asleep and that China and Japan would soon stop funding the US need for debt:

“The bond vigilantes slumber. As the greatest sovereign bond bubble of all time rolls into 2009, investors are clinging to an implausible assumption that China and Japan will provide enough capital to keep the happy game going for ever.

It is lazy to think that China, Japan, the petro-powers and the surplus states of emerging Asia will continue to amass foreign reserves, recycling their treasure into the US and European bond markets.”

The only thing that appears lazy in this whole argument (aside from the argument itself) is the bond vigilantes, who, 18 months after this piece was penned, just refuse to wake up!     Unfortunately for Mr. Evans-Pritchard China has already begun reducing their holdings of treasuries and the bond yields have continued to tick lower.    He went on to describe how Mr. Bernanke was about to be the cause of horrid inflation and how we weren’t at all similar to Japan:

“Investors have drawn a false parallel with Japan’s Lost Decade, when bond yields kept falling, forgetting that Tokyo waited seven years before resorting to the printing press. Mr Bernanke has no such inhibitions. He has hit the nuclear button in advance.”

Unfortunately, that nuclear option did not prove inflationary at all and we are looking more and more Japanese by the day.  Although the Fed’s actions changed the composition of bank balance sheets and helped trigger a mean reverting move in some asset prices it has not caused even one iota of inflation.  In fact, recent data shows that the private sector appears to be at serious risk of retrenching and could take prices down with it.  In a de-leveraging cycle, the Fed has far less control over the money supply than many presume.  Bernanke’s great monetarist gaffe was based on this idea that saving the banks would save the economy which would save the private sector.  But that has been proven entirely false as Bernanke’s focus on saving the banks has actually translated into very little private sector good.  Without a steep acceleration in borrowing I would argue that Mr. Bernanke has failed entirely.  Hence, his frustrating battle with disinflation (and risk of deflation).

Some market participants have gone so far as to compare the U.S. bond market to the Nasdaq bubble.  This is simply not a fair comparison.  The Nasdaq declined 90% from peak to trough.  If you buy a 10 year government bond and hold it to maturity you will receive your principle back in full in addition to the coupon payments.   If inflation jumps from the currently low levels to 5% you will be sacrificing 2.5% per year in real terms.  Certainly not a winning pick, but nowhere near what the apocalyptic results of the Nasdaq bubble were.  To reinforce this point I would highly recommend reading this paper from Vanguard which nicely summarizes the risks of the current low rate environment:

“When evaluating the potential risks in the bond market, it is critical to remember exactly why bonds are an integral part of a well-thought-out asset allocation plan—to diversify the risk inherent in the equity markets. Simply put, while the fear of rising interest rates may be legitimate, a potential bear market in bonds is dramatically different from a bear market in stocks (or other risky assets). In fact, unlike stocks, where the common definition of a bear market is a 20% decline in prices, to most investors a bear market in bonds is simply a period of negative returns. And to date, the broad U.S. bond market has never experienced a –20% return. Indeed, it’s the magnitude of returns that is the key differentiator between bad periods for bonds versus stocks. For example, the worst 12-month return for U.S. bonds since 1926 was –9.2%, while the worst 12-month return for U.S. stocks was –67.6% (12 months ended
June 1932).

In another example, the worst calendar year for the broad bond market was 1994, when due to an unexpected upward shift in interest rates, the bond market returned –2.9% (in 1995, the bond market returned 18.5%). Contrast this to the experience of stock investors in 2008, when the Standard & Poor’s 500 Index lost more than –2.9% in 27 individual trading days.”

When it comes to this whole debate the most important factor is the mere reality of our economic plight.  As we all know by now, we are currently confronted with the threat of deflation, 9.5% unemployment, 74.8% capacity utilization, falling home prices, durable goods orders that are more than 20% from their peak levels, rising unemployment claims, equity prices that are 30% from their peak and high historical private sector debt levels.  When your options are 0% cash, unstable real estate and equity in what appears like a weak economy that 2.6% government bond doesn’t sound so bad.  Perhaps not the best bet in the world, but irrational?  Certainly not.  As Vanguard says, when compared to the long-term growth potential of equities bonds currently look like a fairly good hedge.

So, you can see that it is not accurate to describe the U.S. government bond market as even remotely comparable to the “bubble” occurrences we have seen in other asset classes throughout history.  Even at its worst “valuations” the U.S. government bond market has performed relatively well when compared to the well known “bubbles” of history.

In summary let us remember that a bubble (as it pertains to markets) is an irrational psychological  market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse.  These characteristics are not currently attributable to the U.S government bond market.  Given the economic environment (and potential outlook for equities) it is not irrational for investors to seek a very safe interest bearing asset in a time of high uncertainty and 0% interest rates.  In addition, as shown in the examples above, it is highly improbable that the US government bond market will collapse as the market itself is designed solely as a monetary tool.  Lastly, while bond investors might be susceptible to losses history shows that it is not accurate to imply that they are susceptible to a “collapse”.  While a 10 year U.S. treasury at 2.6% might not be the world’s greatest bargain it’s entirely incorrect to argue that there is a “bubble” in government bonds.   In fact, I would argue that the term is not even applicable.

by Tyler Durden

Two days into the proposed Nikkei-SPX convergence, the ROI stands at about 4% after last night’s ramp in the Nikkei and today’s plunge in the S&P. Granted, it is disingenuous to not account for the today’s Nikkei session which is why absent a 4% down day in the Tokyo index, the trade should still be profitable. We are still confident that the BOJ will be forced to act to stop the Yen surge, unless the most recent PM wants to have a tenure even briefer than that of his predecessor, at which point the convergence will outperform further toward the goal of 10%. Regardless, those who believe deflation has a firmer foothold in Japan may be wise to unwind. The flipside is that the US will be unable to pursue further QE steps until September 21 at the earliest when the next Fed meeting will be held. Which is why the trade can likely be held for at least a few more weeks without any adverse catalyst on the horizon.

August 17

August 19

Submitted by Mike Krieger of KAM LP–H/T Zero Hedge

When God desires to destroy a thing, he entrusts its destruction to the thing itself.  Every bad institution of this world ends by suicide.

All the forces in the world are not so powerful as an idea whose time has come.

Adversity makes men, and prosperity makes monsters.

A creditor is worse than a slave-owner; for the master owns only your person, but a creditor owns your dignity, and can command it.

Common sense is in spite of, not as the result of education.

The omnipotence of evil has never resulted in anything but fruitless efforts. Our thoughts always escape from whoever tries to smother them.

- All quotes by Victor Hugo

We’re trying to figure out what the future of search is. One idea is that more and more searches are done on your behalf without you needing to type.  I actually think most people don’t want Google to answer their questions. They want Google to tell them what they should be doing next.

- Eric Schmidt CEO of Google
Welcome to Reality

Two years ago when I told everyone I knew that the United States was bankrupt and would ultimately default of its debt one way or the other (by inflation or restructuring) I was called crazy and dismissed by 95%+ of the people I met.  These days many of the same people still think I am crazy when I say that a political, financial and intelligence elite which has now teamed up with large corporations is attempting to create a global currency and world government (with them at the helm of course), but the notion that the U.S. is bankrupt is now more or less mainstream.  Even the corporatist/socialists in power are now unable to merely dismiss questions about the deficit.  The public has woken up from its slumber of consciousness and is now starting to see things as they are.  This is an extremely positive development and is why as I have said before I think the elite are in their last days as the freight train of consciousness runs them and their twisted illusions of grandeur into the sea.  The weakest link in this sick and corrupt financial system that was forced upon many of us before we were even born with its mechanics purposely hidden in the shadows so that we remained ignorant of its preposterousness, is the commodity market.  However, within the commodity market the weakest link is gold.  This is why any true attempt to force reform should revolve around a movement to dump compromised fiat paper in exchange for gold.  It is the weakest link of the controllers of humanity for many reasons but the primary reason is that increases in the price of all other commodities can be explained away by the media and financial pundits in other ways.  For example, if oil surges many can say it is global growth.  With gold this explanation doesn’t hold water because in theory most of the 160,000 tons that are estimated to be above ground since mankind started mining gold is potentially “for sale.”  This is because gold is mainly hoarded and not consumed.  Thus, it becomes impossible to say gold rising and hitting new highs is anything less than growing distrust in governments and their counterfeit money.  If it was anything else a large percentage of the hoarded gold would be mobilized and sold.  Many bears make their argument by using this fact.  They opine that since 160,000 is theoretically for sale in a market where annual production is closer to 2,500 tons that there will be a collapse.  The truth is that this is the most bullish argument of all.  The fact that smart money and central banks are unwilling to part with their gold at records is a function of the reality that the Western world is completely bankrupt and there is no way out of this without a hyperinflation event or a deflationary collapse that ends in restructuring.

Gold vs. Treasury Bonds

Both gold and treasury bonds have performed very well this year.  I stand where I have stood for a long time on treasury bonds.  I believe it is complete financial suicide to own long-term treasuries.  The reason I want to address this issue again is because they have done so well this year and because some people that I have a tremendous amount of respect for are very bullish on them.  The one strategist whom I respect as much as any other is David Rosenberg.  I read his notes whenever I can and I agree with him on virtually every macroeconomic point.  We both agree there was no recovery and that we remain in a depression.  We both agree that what most market observers miss is that we are essentially in what Neil Howe refers to as the  “Fourth Turning” where social mores and psychology completely change from where they were in the prior epoch.  We agree that the governments fudge the data to make things look good.  We agree on gold and on equities.  The only place we really disagree in a major way is on long-term treasuries.  I will make my case below.

First of all when it comes to treasuries in 2010 the bulls have been right and I have been wrong.  Let’s just get that out of the way.  Now let’s look at this market from a historical perspective.  The secular bull has been going on since 1981 so at 29 years this thing is getting long in the tooth.  This would certainly not be a reason to be negative in itself but it should be seen as a warning sign because when these trends reverse they reverse hard and don’t look back.  In contrast the gold secular bull has been going on since 1999 so close to11 years.  It is not a coincidence in my view that the gold bull started just when the tech bubble was about to crash.  The gold bull was born out of the ashes of the secular bull market in equities.  The end of this bull was so terrifying to the Fed and the government that they did what governments have done since the beginning of time.  They started to devalue the currency and create inflation.  This was done primarily through artificially low interest rates and rampant crooked deals in the housing market and on Wall Street.  However, the key point is none of this would have happened to the extent it did without the Fed’s ultralow rates.

Toward the beginning of the decade Banana Ben Bernanke made his now infamous “helicopter” speech and thus everyone knew what the Fed would do.  Thus was born a period of major inflation (underreported by the government the whole way of course) and a credit and housing bubble of catastrophic proportions.  Then the inevitable collapse that EVERY Austrian-school economist (yet not one of Obama’s economic advisors is an Austrian) predicted occurred and then government in plain view decided to use the crisis to expand its power and dole out favors to its allies.  Notice how under both Bush and Obama the banks and Wall Street were put before everyone else.  “If Wall Street does well Main Street does well” they told us.  I worked on Wall Street for 10 years.  This is the biggest bunch of crap I have ever heard in my life.

Whereas maybe 1% of the population knew what a dollar was and how they are created before the crisis this may be above 10% now.  This is huge.  People were asleep to the system and now they are awake.  It’s extremely simple really.  There is no greater power than the power to create money and credit.  Since power corrupts and absolute power corrupts absolutely then the absolute control over the world’s money (possessed by the U.S. Federal Reserve) represents the ultimate power and thus will ultimately be completely abused by human beings within any system.  This is precisely why a small group of men or women should never, ever in a free society have this power.  We now see how they use it.  They have destroyed the Western world but make sure to bail out their friends in the end.

So what does this have to do with treasuries you ask?  Treasuries are payments in the world’s reserve currency (the U.S. dollar) and are backed by the Federal government.  The U.S. dollar in turn has been backed by two things since we defaulted in 1971, the relative strength of the U.S. economy to the rest of the world and the power of our military.  We have completely lost the former and everyone knows it so all we have is the latter.  Why do you think we are so obsessed that no Middle Eastern nation possesses a nuke?  Is it terrorism?  Not really, this is a secondary concern used to sell military action to the citizenry.  The primary reason is that we must not allow any country in this oil rich region to be able to defend itself against us moving in to defend the dollar.  The dollar is all we have left right now as far as keeping our ponzi scheme economy alive, and key to keeping the dollar as a legitimate means of exchange despite the obvious reality that it is not means having a significant presence in the Middle East to make sure oil is traded in dollars.

To assume that the dollar will not be devalued in a major way versus real everyday assets such as commodities (especially real money that is no government’s liability such as gold) is in my opinion counter to all common sense and is logic that a ten year old can understand but escapes the quants on Wall Street.  I guess the only real difference between my view and someone like Rosenberg’s is the timing of it all.  I have made it very clear that I think this will all be a relatively near-term event (the entire monetary and financial system will be dead within two years and something new where gold plays a major role is created).  I think the food, oil and precious metal price surge that is coming has already started and will accelerate since those in political power will print and print and do everything possible to avoid deflationary collapse.  This is not to say that I think they can avoid deflationary collapse, what it means is that in a fiat money system deflationary collapse can mean hyperinflation.  The entire inflation/deflation debate is in my view asinine.  If the debate is between 4% inflation and deflation then I agree, deflation it is.  The larger point is that deflation and hyperinflation are not mutually exclusive they are two sides of the same coin.

So let’s say I am correct and the dollar is being devalued already in a major way as we speak versus the real everyday goods people are forced to buy and that this will accelerate rapidly from here.  With a 2.57% yield on a 10 year treasury if the basket of goods purchased in a given year starts to accelerate beyond 3% there is a huge problem for the owner of treasuries.  You will need to rely on continued appreciation in principal just to keep up.  Of course this can happen but the higher the bonds go the tougher the math becomes.  Furthermore, why not just buy gold?  One asset is being manipulated higher by the Fed through its purchases (treasuries) and one is feared by central banks the world over that are constantly attempting to arrest its rise (gold).  As more and more people and investors grow distrustful of their own governments, more and more people will want to bet on its ultimate default one way or the other.  This means of the buying of gold not treasuries.

The 0% BLT Economy

This all brings me to the 0% BLT economy.  This is actually a phrase a friend said to me the other day and I thought it summed it up perfectly. He said pretty soon a BLT sandwich will cost $12 but at least interest rates will be 0%.  Maybe Geithner will provide 0% financing on trips to McDonalds with loans that can then be securitized by Wall Street and sold to some pension fund manager that uses leverage to enhance its yield all with a government guarantee!  In a similar vein, I would like to point out the charts for October Cattle and October Lean Hogs.  They are soaring.  Is anyone talking about this?  How about this tidbit:

Wal-Mart Stores (WMT), which for years has touted its prowess at lowering prices, has been doing the opposite as it tries to bolster its bottom line amid stagnating sales.

A JPMorgan Chase (JPM) study of a Walmart Supercenter in Virginia found that the world’s largest retailer has raised prices by nearly 6% on average over the past six weeks, according to the New York Post. Reuters says it was the biggest sequential increase since JPMorgan started the study in January 2009.

Some Prices Hiked Over 60%

Some of the price hikes were considerably larger. For instance, the price of a 32-ounce bottle of Windex household cleaner jumped 50%, a 12-ounce box of Quaker Oats instant grits climbed 65% and a 50-ounce container of Tide detergent rose by more than 50%. A spokesperson for the Bentonville, Ark., company could not immediately be reached for comment.

Or how about this one from Bloomberg this morning:

Aug. 19 (Bloomberg) — The one-dollar dinner from ConAgra Foods Inc., a staple for Americans throughout the recession, is under threat from rising commodity costs.
ConAgra, which gets almost 3 percent of sales from products such as Zesty Smothered Meat Patty Banquet dinners, will have to raise prices or skimp on ingredients to maintain margins, said James Amoroso, a food industry consultant. That will provide an opportunity for Nestle SA, which has lost share to the Omaha, Nebraska-based company, analysts said.
“It becomes a straightjacket because a $1 meal can’t be sold for $1.20,” said Amoroso, who is based in Walchwil, Switzerland. “The only way that manufacturers can cope with that is to significantly cheapen the offering. But if you say it’s spaghetti bolognaise and you’re just selling red spaghetti, consumers will notice.”

Eric Schmidt of GOOG Makes the Most Foolish Statement of the Year for a CEO

Someone sent me the quote from the top of this email earlier today and I almost fell out of my chair.  If I was a GOOG shareholder I would be up in arms (I have no position long or short by the way as of this writing).  He is quoted as saying:

We’re trying to figure out what the future of search is. One idea is that more and more searches are done on your behalf without you needing to type.  I actually think most people don’t want Google to answer their questions. They want Google to tell them what they should be doing next.

Listen buddy, I don’t know what the future of search is but I am certain that you have just proven how completely disconnected you are from the Zeitgeist sweeping the United States at the moment.  What Americans today want more than anything else is for the Federal government to STOP telling them what to do.  You think they want GOOG to tell them what to do?  Ridiculous.  And just last month it came out that “The investment arms of the CIA and Google are both backing a company that monitors the web in real time — and says it uses that information to predict the future.”  Google is partnering with the CIA to predict the future and now they want to tell us what to do.  I am really getting sick of this company.  Full article on GOOG and the CIA is in the attached Wired article.  http://www.wired.com/dangerroom/2010/07/exclusive-google-cia/

And this company’s motto is “Don’t be Evil.”  Double speak if I have ever seen it.