Transition Condition

Nothing is planned
By the sea and the sand
--The Who

One phenomenon that is perplexing many who believe in the Big Inflation thesis is the behavior of bond markets--particularly government bond markets. Theory says that yields should go up with inflationary expectations. People should be selling bonds today out of worries that the real value of their bonds will go down as their coupons get paid back in dollars that are lower in value.

That theory has not been working out well in practice. Despite the $trillions created by the Federal Reserve over the past couple of years, and commodity prices screaming higher, long bond yields have not gone to the moon as many inflationistas have forecast.

Perhaps the theory doesn not account well for the dynamics of transitionary periods.

For more than two decades, central  banks have been suppressing interest rates and offering credit on the cheap. This credit has gone into all kinds of risky assets--stocks, commodities, real estate, plants and equipment. Bonds are also a risky asset class although they are often perceived as less risky than other categories. This is particularly true of bonds issued by the US government.

The easy credit spawned a secular boom in leveraged risk taking. Individuals, organizations, and governments have all borrowed at low interest rates and invested in assets deemed to return something more than the cost of carrying the loan. This behavior is also known as the carry trade.

Leverage magnifies returns when prices are going in your direction. A few years back people could buy a $500,000 house with little money down and low interest rate, and flip that house a year or two later for $750,000, generating an enormous return over the cost of carry.

As many have discovered over the past couple of years, leverage magnifies losses as well. When firms like Bears Stearns and Fannie Mae (FNMA) were levered 30:1 or higher in mortgage related derivatives, it did not take much decline in home prices before their assets were less than liabilities, creating conditions of insolvency.

In leveraged systems, falling prices motivate many to close out their carry trades. Risky assets are sold, dollars are bought back, and loans are paid off. We saw, and continue to see, a lot of this since 2007-2008.

But not all carry trades are taken off. Some leveraged investors, rather than totally getting out of risk, merely substitute less risky assets. Thus, rather than using credit to buy stocks, carry traders buy bonds instead. Leverage is still in the system, but it is located in assets classes deemes 'less risky.'

One explanation as to why bond yields have not yet backed up is that much leverage remains in the system. Carry traders are content to earn the spread between nearly 0% borrowing cost from the Fed and ten year T-notes paying 3.1%.

But this is a transitory situation. Huge amounts of leverage cannot last forever. Central banks can seek to force spreads open but over time they must collapse as resources borrowed from the future are paid back (or defaulted upon). Short rates will rise and/or returns on risky assets will fall and the carry trade spread will be crushed--regardless of government intervention to the contrary.

At some point, then, we may witness another counterintuitive situation as markets rebalance. It does not seem out of the realm of possibility that bonds could sell off big-time as more and more leverage leaves the system.

position in SH