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Sunday, April 12, 2009

Bonds is where the action is

Everyone is focused on equities. How their 401K is now a 201K, which may become a 101K. Also people have been focusing on bonuses to AIG executives, or GM executive expenses.

What REALLY matters is this nations debt spending. AIG exec bonuses are "seconds of interest" that the nation pay on its debt. GM executive or Labor union costs don't even register compared to the national debt.

As the government attempts to "stimulate" by spending at a record pace, there is a cost. Interest rates.

When the US government deficit spends, it doesn't just "print money" (yet). The US government issues US Treasury Notes (bonds) to finance it's debt. The interest the government has to pay adds to the debt. So the US government wants to issue US debt as cheaply as possible.

But there is a slight problem. Our creditors...the rest of the WORLD.... may want higher interest rates for throwing money at an obviously out of control spend-a-holic, the US government. If higher interest rates take hold, it will curtail the ability for the government to spend, and make credit (borrowing) more expensive, and in general, choke the economy as it tries to get its footing.

So what is the government to do? Since regaining control of the US finances is "crazy talk", the government has to create an environment where people WANT US Bonds more than a better return.

That has been happening with fear and stock market prices dropping. When fear/panic takes hold, or equities fall, money is moved into US Treasuries as a "Safety play". When people buy US Treasuries for safety sake, there isn't that much quibbling over 2.75% interest vs 3.4% for a 10 year note. People take what they can get.

What happens when the market does well, and the fear is taken out? Well the US government faces pressure to "compete" for better returns with other investments. Further the US creditors may demand higher return, out of fear that the world's largest debtor nation may someday fault on it's massive credit bill.

OK, so why does this matter? Well, the actions we have seen in the last 6 months, and the next year or so has this battle playing in the background and pulling the strings on what happens to US equities. The stock market has been rising, and so has US treasury interest rates. At some point, the US government may need to push the "create fear button" to get interest rates down.

If interest rates rise, as people refinance their debt, the costs go up. As costs go up, more people "Fail". As the spiral progresses, the system has greater failures.

Below is a graph of the US Treasury 10 year note, on 4/6/09, it's return was 2.95%. The TNX traded about 29.50 to reflect the interest rate change.

I have blogged on this before, lets hope there isn't a dislocation in the US Treasury sales, where interest rates jump higher due to lack of interest in US bonds. Such events can send shock waves of fear.

Today its Stock prices, 401k, tomorrow its currency valuations, interest rates, and cost of borrowing.

There is NO FREE lunch, as the government tries to manipulate the marketplace for a desired outcome, it will continue to find when one thing goes up, another goes down. The game is efficient, and cost will be realized in the system.

Matt Bors

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