Why the US won't see hyperinflation

May 13, 2009 1:16 AM

The Bulls vs. Bears? The incessant back and forth between equity market longs and shorts is well known to most retail investors via a variety of distribution channels; financial television, the print media, online news. But the really big market battle, one with the potential to impact the entire US economy, happens, as is usual in finance, just out of sight of retail eyes ...

Not seen since the 80's, Bond Vigilantes is a phrase applied to institutional class investors who purchase government treasuries to satisfy their long dated obligations. Cognizant of the risks of inflation, they actively demand compensation in real terms for their investments. In recent weeks they have caused a UK government bond auction to fail, and have driven US bond yields higher.

But even as Bond Vigilantes drive interest rates higher, the US Treasury is actively purchasing securities in the open market. This is, by any measure, an epic battle, one taking place almost sight unseen and one with very high stakes: can Ben Bernanke and the yet unseen US economic recovery tolerate higher bond yields?

Speaking of the power of Bond Vigilantes to compel honesty in government spending, Clinton policy advisor James Carville, was famously quoted: "I used to think if there was reincarnation, I wanted to come back as the president or the Pope or a .400 hitter. But now I want to come back as the bond market. You can intimidate everybody"

posted by Mutant (24 comments total)

US Treasury is actively purchasing securities in the open market

Bernanke's operating the printing presses at the Fed, actually.

Running up a ~$2T deficit is something a Prisoners Dilemma AFAICT. Either enough Eurodollars get recycled into treasuries or the wheels come off and everybody dies in the Great Depression II.

Greenspan held the money supply rather flat in the early 1990s, only to start opening it up in earnest in 1995.

Bondholders want to see muted M3 expansion to keep their coupon and principal from being inflated away, but too few goods produced is equivalent to runaway inflation (inflation is too much money chasing not enough goods) so funding pump-priming and other long-term stimulus spending to keep the wheels turning and industrial capacity utilization up is in the bondholders' interest.

M3 is apparently flat now if the "Shadow Stats" site is to be believed. Money is being destroyed (via debt write-offs) as fast as it is being printed I guess.
posted by toroi at 3:18 AM on May 13 [3 favorites has favorites]

It took the threat of $2 trillion of Treasury issuance to attract the attention of these bond vigilantes enough to raise the 10-year yield all the way up to what is still near the lowest level since 1958? They've got a lot of work to do, to live up to their fearsome reputation.

Bloomberg: "This time around, investors are once again challenging the Fed to buy Treasuries or watch U.S. borrowing costs increase. "

Somehow I suspect that the threat of buying was a lot more effective than actually doing it will prove to be, in supporting the market.
posted by sfenders at 4:48 AM on May 13

I still fail to see who is going to buy the trillions in bonds yet to be issued. Certainly it implies rates will have to rise. Or destroy the dollar's value through quantative easing.
Both options look pretty scary.
posted by bystander at 5:09 AM on May 13

And to answer the thread title, I guess because US sovereign debt is issued in USD, so the dollar can be gutted to shrink the bill.
But that seems a trick you can only play once. Who will loan money in USD to the US Gov if they don't respect the integrity of their currency?
posted by bystander at 5:12 AM on May 13 [2 favorites has favorites]

Mutant, I love your posts - I seldom understand them entirely, but it's always a thrill to try.
posted by jbickers at 5:19 AM on May 13 [6 favorites has favorites]

"Never fight the Fed"
posted by amuseDetachment at 6:25 AM on May 13

I thought this was a post about unconventional sports match-ups between disparate Chicago teams. But this is good too.
posted by shakespeherian at 6:36 AM on May 13 [2 favorites has favorites]

Very interesting. I hope the bond market is successful in raising the cost of borrowing, since it seems like the only remaining check on a cheap-money "jump start" policy that strikes me as having potentially terrible long-term consequences.
posted by Kadin2048 at 7:55 AM on May 13

Silly me, my first reaction to the opening line "The Bulls vs. Bears?" was that this was a discussion of the relative merits of Chicago sports franchises.
posted by Edgewise at 8:10 AM on May 13

Trying to get my head around this - someone please correct me if I'm wrong: Low bond prices are associated with higher yields. The goverment purchasing of securities is trying to get prices up, to lower yields, to reduce the cost of government borrowing?
posted by exogenous at 8:34 AM on May 13

[comment removed - don't bring people into the thread who aren't into the thread.]
posted by jessamyn at 8:47 AM on May 13 [1 favorite has favorites]

exogenous - yes, although the government will claim that purchasing the securities is to increase liquidity (they print and pay cash for the bonds) rather than to support prices.

Given that the credit markets are no longer frozen due to a lack of cash liquidity, while even the creditworthy have to pay a high premium, that it is inevitable the longer rates rise.

Good post, thanks mutant.
posted by fistynuts at 10:34 AM on May 13

Neat post. Certainly, nobody the bond market lacks the media glamor given to the equity market, presumably because it lacks the overnight-millionaire lottery aspect.

I wasn't aware you could short bonds, but in retrospect I suppose there's no reason youu couldn't. But isn't TIPS designed for investors wary of inflation?
posted by pwnguin at 12:12 PM on May 13

nobody
posted by pwnguin at 12:15 PM on May 13

I still fail to see who is going to buy the trillions in bonds yet to be issued.

People who are frightened of losing it all in equities or commodities at a guess. Large funds that are dedicated to gummint debt. Widows and orphans. Those without appetite for risk.

Not that gummint lately is encouraging on that topic. Consider the recent events with GM where holders of Senior Debt were put down by the president himself as "speculators" (evil was implied) when all they wanted was the guarantee of first out once the poo hit the fan. Which is why one buys senior debt. And one does like to think that rule of law will guarantee your purchase.

Of course the government apparantly can do as it likes, and add insult to injury as it likes, and there are even people who find the action invigorating - Snakehead presumably among them - but the end effect is to make investors shy, which is not a good thing if you want to re-ignite a cooling economy.

Or am I missing something? Economics frequently dizzying to Indigo.
posted by IndigoJones at 2:46 PM on May 13

exogenus - It's not just about government borrowing though. Many long fixed rate loans are indexed to the longer treasury yields (your variable rate stuff will typically be fixed to LIBOR). If the 10 and 30 year bonds start to climb we see rates for loans indexed to these yields to rise.

The last thing you want in a recession is for borrowing costs to rise before the economy can take it. You need consumption to start going back to normal. You need the economy to be producing stuff and people buying it. If the producers can't start production (through attractive low rates you can use to finance it) you won't have anything in the economy to buy little alone worrying about who's going to buy it.

This is the equivalent of threatening the economic equivalent of nuclear war. Basically they'll open the flood gates and send so much money into t-bonds that pension fund managers heads will explode in a comical fashion. Typically you can't do this without massive amounts of inflation but during the risk of a deflationary spiral, a nearly flat M3 saying the money supply is holding steady through writeoffs in the finance industry you've got a shot to do it without demolishing the dollar.

The bond markets know this. They can't not buy bonds though. There's nowhere else they can possibly safely stick the amount of money that they deal with except in AAA bonds (i.e. US treasuries).

So the bond markets have had their bluff called and it'll be interesting to see what happens from here.

Or at least that's how I've come to comprehend this stuff.
posted by Talez at 3:12 PM on May 13 [1 favorite has favorites]

Thanks for the explanations.

By the way (this is a bit of a tangent), I recommend the book Fiasco by Frank Partnoy for a look at derivatives trading in the late 1990s (the book seems to have a couple of different subtitles). The level of cluelessness among institutional investors is amazing.
posted by exogenous at 3:31 PM on May 13

Not that gummint lately is encouraging on that topic. Consider the recent events with GM where holders of Senior Debt were put down by the president himself as "speculators" (evil was implied) when all they wanted was the guarantee of first out once the poo hit the fan. Which is why one buys senior debt. And one does like to think that rule of law will guarantee your purchase.

Of course the government apparantly can do as it likes, and add insult to injury as it likes, and there are even people who find the action invigorating - Snakehead presumably among them - but the end effect is to make investors shy, which is not a good thing if you want to re-ignite a cooling economy.

Or am I missing something? Economics frequently dizzying to Indigo.

GM's market cap is currently (as of last trade) is 738.7 million dollars. To put this in perspective Apple could buy GM in cash and still have 85% of their balance left. Now, any idiot with half a working brain can see that all of GM's assets are going to be worth faaaaaaaaaaaaaaaaar more than that amount should GM go bankrupt and the company get carved up and sold.

The senior debt holders know this as well.

Now, GM is a rather large company. Not only do they have a large workforce but they also have a pension plan that needs to be supported. Should GM go under a large swath of that workforce would be cut, tens or even hundreds of thousands more would be unemployed in companies that provide products and services for GM and thousands of retirees would be left effectively destitute without their regular income, insurance and other benefits they were also promised upon working at GM.

There is no way GM is going to be able to meet its debt obligations which leaves two options.

1) Everyone writes a bit (read: a lot) off and GM can try to restructure, save itself, jobs, pension holders and generally try to keep the house of cards up long enough to give it a concrete foundation and some double brick walls.

2) The company goes bankrupt and they start carving the company up and watch the said shit hit the fan.

Scenario 1 would mean senior debt holders cop a write down but still get paid something while the company would try to weather a period where people just aren't buying new cars.

Scenario 2 lets senior debt holders be paid in full (after all they're first in line and GM assets would be worth hundreds of billions). It'll also cause untold human suffering throughout the US and the rest of world.

The president, funnily enough, is on the side of the people who are about to be thrown out with the garbage if bankruptcy were to be declared.

Now. Getting your money back through bankruptcy can take years. For a small investor whether you're getting paid or not in the future (which is still up in the air) it's not a good idea to be holding GM debt right now and it's showing. There are speculators that are jumping in while yields on GM notes have soared (GM 7.25 notes are trading at well over 40% yields at the moment) knowing that all this senior debt is either going to have to be met with them scoring insane yields or they're going to get their money back eventually (and before every other unsecured creditor in the bankruptcy food chain). The only way they could possibly lose out is if the government was to offer a decent amount of equity in GM to bond holders which could convince the pension plan holders (which hold most of GM's debt) to take a deal. Despite the fact that GM is up shit creek these bond holders still think they're getting a better deal with bankruptcy (which with the current offer would be true eventually).

While there are people who have and still are holding GM debt for a stable, long term return (pension funds) more and more speculators are jumping in to try and stop any acceptance of a debt-for-equity plan (which is going to require 90% approval and pension plans only have 50-60% IIRC) get a piece of this very delicious bankruptcy pie. They're like vultures circling a dying man waiting to savage the corpse and I can see why Obama is so fucking pissed.
posted by Talez at 5:05 PM on May 13 [2 favorites has favorites]

There's nowhere else they can possibly safely stick the amount of money that they deal with except in AAA bonds (i.e. US treasuries).

Some people think that AAA != US treasuries, anymore.
posted by A dead Quaker at 9:41 PM on May 13

Sorry, I'm a software engineer. != means "is not equal to", to those of us who talk to computers.
posted by A dead Quaker at 9:43 PM on May 13

The latest round of the battle between Bernanke and bond vigilantes.

This week has seen a massive sell off in benchmark US Treasuries, pushing mortgage yields well above five percent.

Clearly a twenty four year bull market in bonds has come to an end, and interest rates have no where to go but up.
posted by Mutant at 9:31 AM on May 29

This may be blissful ignorance on my part, but with my fixed rate mortgage and student loan obligations set to consume fixed monthly payments for the next 20+ years, I wouldn't mind a bit of inflation.
posted by exogenous at 9:50 AM on May 29

Clearly a twenty four year bull market in bonds has come to an end, and interest rates have no where to go but up.
Assuming that the Fed wants the dollar to retain some integrity.
They can always beat the vigilantes with more quantitative easing, printing money, at the expense of the exchange rates.
Of course, this drives up costs of imports to the US, which may explain some of oil and other commodities recent run up.
The US can have low interest rates and unlimited government deficits if they keep printing, but the inflation will be a problem.
And that is the problem for those like exogenous, your debt gets devalued over time, but your house that was worth $300k, and could be traded for 300oz of gold today, can only be traded for 150oz in a future where the dollar falls to keep rates low at the expense of inflation.
Of course, you won't want gold, but you may want gasoline and macbooks.
posted by bystander at 10:55 PM on May 31 [1 favorite has favorites]

And its even more of an issue if you live on a cash pension.
posted by bystander at 10:56 PM on May 31