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Thursday, December 17, 2009

The Bond Wall

After the market crash in 2008, the answer to Time magazines person of the year, Ben Bernanke, savior of the world, was to create money and fund insolvent corporations.

Combine this with the US congress spending into the trillions, the US is showing its over-the-top disregard for fiscal responsibility.

So, who cares? When money is "created", the mechanism, as previously covered, the US government must issue treasury bonds. The yield, (interest rate) of these bonds are not dictated by the US government, but is set in the market place. For example, if the government wants to sell 100 billion dollar of US 30 year treasury notes at 0.01%, then can offer them, but it is likely not one person will buy it. So the government would raise the rate until the bonds are purchased.

Higher interest rates have huge ramifications on the US government and the economy. As rates rise, corporate debt rates tend to raise also, as corporate bonds typically need to offer higher yields than US treasuries to "compete" in the bond market. Mortgages are indirectly linked to US treasury yields. For example, if US treasuries had a yield of 30%, it wouldn't be possible to find a bank willing to lend you 400K to buy a house at 5.5%. The bank would be better off buying US 30 year bond notes with much less risk than lending me the money to buy a house.

If mortgage rates rise, say from 5% to 7%, house prices typically fall to keep the same monthly-payment for the buyer to be able to afford the house. Each point can mean upwards of 10% fall in housing prices. For example, 30 year mortgage on 400K at 7% is $2,661 vs 5% is $2147. at 7%, to get a monthly payment of $2147, the house price must drop to 323k.

The competition for cost of debt ripples through the entire economy. I have posted many times, that the real fireworks will be the bond market. The 20008 market crash was an opening act, a prelude to wake people up of more to come.

This ridiculous idea that deficit spending will lead to prosperity, and giving insolvent companies larger credit lines will have no effect on main street is outrageous. As the bond market demands better returns on a higher risk debtor - the us government, the cost of everything in the economy feels the effects through increased cost of debt.


Which leads me to the graph below, the US treasury, 30 year interest rates. As you can see, the trend is up, at about 45 degree angle. Rates are reaching into the range of pre-market crash prices, and threaten to continue into July 2010 to new highs.

Hopefully the man of the year, will have an answer on how the US can produce infinite amount of debt and keep the cost of that debt low. Ben knows the answer, FEAR. If the markets enter a fear state, people will run to bonds, applying downward pressure on rates.

The other option is stop issuing new debt. If the government doesn't issue new debt, it can set the rates to anything it wants. if no one buys, government wouldn't care, and it can then set the price. But the government lives in debt, so it MUST find a buyer, and therefore will increase rates to find buyers.

The wall is coming, I don't know the magic number, but at some point, as rates rise, the Federal Reserve bank will need to choose, the economy or crush the stock markets.

From WebSufinMurfs FinancialBlog2

From WebSufinMurfs FinancialBlog2

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