Here it comes . . .

The bond market is showing every sign of being on the brink of something very nasty indeed.  You won't find the mainstream media talking about it yet, except in the most indirect of terms;  but the reality is likely to be so severe that they won't be able to get away with that for long.

I'm sure many readers don't fully understand the market for Treasury and other bonds, so before I explain what's going on, let me provide a little background.

The US Treasury issues securities, known as 'bonds', which are sold on the 'bond market' to fund US government operations.  These bonds raise money over and above that derived from taxation, allowing the government to spend more than it 'earns' in tax.  At present something like half of every dollar spent by the US government is raised on this market.  It's reported by Wikipedia that US bond market debt (i.e. the face value of already-sold US bonds, which must be redeemed when they mature) amounted to $35.2 trillion in the second quarter of 2011.

The face value of each bond is not necessarily the price for which it's sold.  This is dependent on two main factors (although other elements such as perceived risk will also affect price).

1. The 'coupon rate' or 'interest rate' of the bond.  This is normally expressed as a sum to be paid each year, in one or more payments, to the owner of the bond.  If a bond with a face value of, say, $1,000 attracts an annual interest rate or 'coupon' of 5%, the owner of the bond will receive a payment or payments to the value of $50 every year until the bond expires, at which time he'll receive its face value of $1,000.  There are also so-called 'zero-coupon bonds', which offer no interest payments as such.  They're sold at a discount to their face value, so that (for example) if an investor buys a bond for $900, with a face value of $1,000, that matures in three years, he'll get back $100 more than he paid for it - the equivalent of $33.33 for each year that he holds it, which equates to an annual interest rate of 3.33% on its face value.  (Yes, that's a simplified calculation, but I'm not going to go into all the decimals and complexities here.)
2. The seller of the bond.  If it's a new-issue bond from the US Treasury, it's offered at face value.  The Treasury usually won't sell it for less (unless it's a zero-coupon bond, of course).  However, if I, a private bond-holder, want to raise money to spend on something else, I can offer for sale some of the US Treasury bonds I already own.  The market will value them based on the interest rate for new US Treasury bonds at the date of sale, compared to the interest rate of the bonds I'm offering.  If the coupon rate of my bonds is better than that of bonds presently available, my bonds may attract a higher price than current US Treasury offerings.  If it's worse, their price may be lower.  Their maturity date will also be a factor, of course.

Current interest rates have a direct and immediate effect on the value of every bond held by investors, whether sovereign (i.e. governments or central banks) or private (i.e. commercial banks and investment firms and private investors).  There's an inverse relationship between interest rates and bond prices;  the higher one goes, the lower the other moves in response.  Let me illustrate by means of an example, using a zero-coupon bond for ease of explanation.

• Let's assume we have a bond that matures (i.e. is paid out) in one year from now.  If its face value is $1,000, and it's currently available for $950, that equates to an effective interest rate of about 5.26%.  That's calculated like this:  (1,000 - 950) / 950 = 50/950 = 0.05263157...
• If a buyer is happy with a 5.26% return on his investment, he'll buy the bond at its offering price of $950.  However, if he can get a higher interest rate (i.e. rate of return) from other investments, he'll want the bond to match or beat those other investments.  He'll therefore offer a lower price for it, one that will bring him the return he wants.  For example, let's say he wants an 8% interest rate equivalent.  Using the calculation shown above, he'll offer to buy the bond for $76 less than its face value, or $924, giving him an 8% return on his investment when the bond matures in a year's time.  If the seller wants to find a buyer for his bond, when that sort of interest rate is available elsewhere, he'll have no option but to price it accordingly.  Therefore, all other things being equal, higher interest rates usually lead to lower bond prices.
• The reverse is also true.  Say the bond's face value remains $1,000, but interest rates available elsewhere suddenly fall to 3%.  Using the same calculation as above, we find that if the bond is sold for $971.50, a buyer will earn 3% on his investment when it matures in a year's time.  At that price, the seller is matching what the buyer can get elsewhere.  Therefore, all other things being equal, lower interest rates usually lead to higher bond prices.

There are other factors that may affect bond prices.  The underlying trustworthiness of the security (which is precisely what 'security' means in this case) is one of the most important.  A US Treasury bond is backed by the 'full faith and credit of the United States', and has until recently been considered as safe as a bond can possibly be.  (Municipal bonds used to be considered very safe, too, but the Detroit bankruptcy threatens to overturn that assumption.)  Bonds from a third-world country with a record of financial mismanagement and default on its loans would be considered very risky.  To attract buyers, sellers of such bonds will have to offer a much higher rate of interest, offsetting the risk aspect against much greater potential rewards.  (This is how the so-called 'junk bond' market operates.)

Unfortunately, with its five-year-old policy of quantitative easing (QE), the Federal Reserve has diluted the value of the US dollar, making it worth significantly less today than it was at the start of the current financial crisis in 2007/08.  (We analyzed this reality last week.  Seeking Alpha pointed out last year that "fiat currency [i.e. the dollar] has lost about 1/3rd its value via dilution, post bail-out, QE1, and QE2".)  Furthermore, the dollar has weakened significantly against other major world currencies for almost three decades.  We now have 'currency wars' breaking out, where nations such as Japan are seeking to deliberately weaken their currencies relative to others, in order to make their exports cheaper (and thus more attractive to foreign markets).  In response, nations that don't want to be frozen out of those markets are trying to weaken their own currencies as well.  It's a hurly-burly, topsy-turvy situation that holds dire threats to the stability of the world's economic order (such as it is).

In the midst of all this uncertainty, investors want greater security for their money, and the best possible rate of return.  Therefore, bond interest rates are rising sharply, and bond values are dropping equally sharply, on the open market.  The revelation by the Fed that it's considering tightening its previously open-ended QE program has spooked investors.  As CNN put it:

Investors are confused, or simply overreacting, as many try to figure out what the Federal Reserve will do next, says Dean Baker, economist and co-director of the Center for Economic and Policy Research. For several years now, the central bank has kept interest rates super-low by buying up billions of dollars worth of bonds. Ideally this would help the economy grow by encouraging businesses and consumers to borrow and spend more, but Fed Chairman Ben Bernanke on May 22 hinted the Fed could scale back buying soon.

But before the Fed even makes any big bold moves, many investors are acting as if the central bank will stop the money spigot entirely. They've been reducing their exposure to bonds, which has helped push up rates. "I feel like investors are jumping the gun on this," says Baker, adding that it's unlikely the central bank would slow the pace of its bond purchases. Inflation isn't rising, and the job market, while doing better, is creating just enough jobs to keep up with population growth.

There's more at the link.

With fewer outside investors willing to buy bonds at very low interest rates, the Fed itself is buying most of what the US Treasury sells.  Peter Schiff pointed out the dangers of this, and of the shutting off of the QE 'money spigot', as long ago as March:

The Fed is expected to buy nearly 90% of new Treasury bonds in 2013, according to Bloomberg. This is a tremendous subsidy that has kept 10-year Treasury yields below 1.95% on average this year so far. Last year, with 10-year yields averaging 1.8%, the Treasury spent $360 billion on interest payments alone. That represented nearly 10% of all expenditures.

Let's assume a Fed tightening causes these rates to triple - not unreasonable for a government facing over 100% debt-to-GDP. If these rates triple by 2015, and another $2 trillion or so is added to the debt, then interest would make up over 30% of annual federal expenditures. Just interest. Then, there are principal repayments, Medicare/Medicaid, Social Security, the Armed Forces, and all the other entitlements for which the Treasury is responsible. Is Washington going to default on our creditors, our seniors, or our men and women in uniform?

I believe these assumptions are still rosy compared to what might actually happen if the Fed were to withdraw support ... If the Fed were to signal that creditors might face haircuts, then the reaction could be swift to the downside. If rates went above 10%, as they have in Greece, then over half of the federal budget would be committed to interest payments alone.

But that's not all. Higher interest rates would cause the shaky housing market to take another nosedive. Few Americans are in a position to buy a $300K house at 10+% interest. Rather, prices would have to decline to levels affordable for cash buyers and those willing and able to take out high-interest mortgages. That might mean another 50% decline or more, in real terms.

With housing taking a second bath, we can expect the banks not to be far behind. That sector remains bloated and dependent on various subsidies from the Fed. With loan rates higher than their customers can afford, banks would fail at a rate higher than 2007-8. This would trigger another round of bailouts from the Treasury; but without Fed assistance, where will the funds come from?

If there isn't a bailout, the major money-center banks would collapse, crippling Wall Street's reputation as the global financial center. The US dollar's reserve status might then be abandoned once and for all.

Quickly, one can see how the Fed's money-printing is the mask holding this charade together.

Again, more at the link.

It's almost obscene to think that the Fed is going to buy 90% of US treasury bonds.  It's doing so, of course, because that's the only way in which the Treasury can sell bonds at a very low interest rate.  Real investors, who want a return on their investment, are demanding higher interest rates, and therefore won't buy low-interest US bonds.  The Fed's taking their place by 'printing money', in so many words.  This is play money, with nothing backing it in reality;  but it has a very real effect on our economy.  The Fed creates a series of entries in its computers, and sends a string of digits over to the Treasury in exchange for bonds.  That money did not exist before, and all it's doing is allowing the US government to live beyond its means for another month.  However, it dilutes the US money supply (as we've pointed out before, most recently yesterday).  It can't help but have a long-term effect on our economy.

Furthermore, according to Eftguide, via Yahoo! Finance:

The yield on 10-year U.S. Treasuries has surged 66% over the past three months. And bond investors, especially those with jumbo-sized positions, are getting hammered. How much money has the Federal Reserve lost?

At the end of July, the Federal Reserve held $1.98 trillion in U.S. Treasuries. That figure represents just over half of the Fed's $3.6 trillion balance sheet.

. . .

Granted, the [Fed] does not value its massive bond portfolio on a mark-to-market basis. But the surge in interest rates has already erased almost $200 billion in the Federal Reserve's capital. But that's not all.

If interest rates continue to head higher, the value of the Fed's liquid assets that it could sell would decline and further undermine its capital cushion. And if the velocity of rate increases intensifies, the Fed, with only $62 billion in capital, could see its entire capital base completely wiped out.

This could have a serious domino effect. It could paralyze the Fed's ability to defend the dollar's purchasing power, causing Treasury prices to fall further and thereby push interest rates even higher. Just imagine the unimaginable; a weakened and impotent Fed.

More at the link.  Bold underlined print is my emphasis.

The losses referred to are, of course, the current market value of those bonds in the light of increased interest rates.  As the latter rise, the former falls.  The Fed won't necessarily suffer any monetary loss if it holds the bonds to maturity and redeems them at their face value;  but if it has to sell them in order to raise funds to tackle some other financial problem, it may find there are no takers at the price it originally paid for them.  It may have to reduce the price of the bonds (i.e. 'mark them to market') if it's to sell them.  If it does, it will suffer a loss.  Furthermore, as Forbes asked a few months ago, 'Who Will Buy All Those Treasury Bonds When The Fed Stops?'  (If you answered "Nobody", you go to the head of the class.)

The Treasury is already finding that it doesn't have enough money in its coffers to redeem existing bonds as they fall due.  It's therefore refinancing existing debt every month, because it can't pay it.  Here's just one example, which will happen this very month:

August 2013 Quarterly Refunding Statement of Assistant Secretary Rutherford

WASHINGTON – The U.S. Department of the Treasury is offering $72 billion of Treasury securities to refund approximately $69.6 billion of Treasury notes maturing on August 15, 2013.  This will raise approximately $2.4 billion of new cash.

In other words, the Treasury has to sell new debt in order to pay off old debt.  Effectively, the US government is using two agencies to fund its spending by having them pay each other.  The Treasury sells bonds, which the Fed buys with make-believe money, giving that money to the Treasury for the US government to spend.  When the bill falls due, to pay it the Treasury sells more bonds, which the Fed buys with more make-believe money, whereupon the Treasury uses the proceeds to redeem the previous bonds, whilst simultaneously selling even more bonds (again, to the Fed) to fund ongoing government over-expenditure.  The cycle goes on, and on, and on . . .

Insane, isn't it?  It's exactly like a private consumer (i.e. you or I) using one credit card to pay off another.  We know that if we get that deeply into debt, we're in real trouble;  but that doesn't seem to bother the Treasury, or the Fed.  Does that give you confidence in our fiscal leaders, or their political masters?  Uh-huh . . . I thought not.

It's a confused (and confusing) situation right now, but warning lights are flashing all over the place.  Keep a sharp eye on the bond market.  Things are beginning to unravel at an ever-increasing pace.

Peter