A Mother of a Low Hanging Fruit

I am always amazed by the popular slogans. I wonder if the “low hanging fruit” slogan is still in use. “Green sprouting” is the latest craze but the low hanging fruit which I will be discussing will not excite the green sprouting crowd.

First a basic economic rule. The price of a fixed rate bond is inversely related to the interest rate. Thus the price of a fixed rate bond goes up when interest rates fall but the price decreases when interest rates rise. Nothing spectacular but for the reality of interest rate calculations of time value of money and a massive oversupply of government debt. A bubble market always finds its nemesis in the law of supply and demand.


Component One: An explosion in supply of Central Government debt (Over supply).

USA Central Government debt growth is now in an exponential curve. The Japanese experience was similar for about 15 years but they had a Current Account Surplus to generate a cash flow to finance the expansion of their Central Government debt. The USA does not have that luxury.


USA



It is also clear that the Japanese expansion in Central Government debt has stopped and levelled off at about 4 times the amount prevailing at the start of the Japanese crisis. It is of interest that this phenomenon coincides with a mild decreasing trend in the absolute level of USA Treasuries held by Japan (See Major Foreign Holders of Treasuries in Component Six). An inability to fund more Japan national debt coincides with an inability by Japan to fund more USA debt.


Japan


The projections by the British Government follow a similar patter. Unprecedented expansion of the Public Sector Debt. It must be very disconcerting to have experienced their first failed bond auction at such an early stage in their planned expansion of Public Debt. Perhaps some price (interest rate) competition with other national governments may help to sell more UK Public Debt. That will not necessarily be in the spirit of international co-operation on maintaining low interest rates but then again the UK government answers to the UK taxpayer.




United Kingdom





The race to increase Government spending is on. Will price competition only rear its head when the forces of supply and demand deny a government access to the funding markets? Which nation will place national interest first and be the first to break ranks?


Component Two: Historic low interest Rates

The inverse relationship between the price of bonds and the interest rate translates into very expensive Government Debt at a time when they all have plans to expand government debt exponentially. Extreme demand for debt at near zero interest rate levels must surely be another economic absurdity. Can it be possible that they actually believe that they can happily print any shortfall at the Central Bank without destroying their ability to attract any investors to their bond auctions? Better yet, can the printing press be a substitute for bond investors?



USA



The prevailing Target Rate in the USA is Zero to 0.25% (see also the chart in Component Four). The Japanese equivalent is 0.10%, the European Central Bank equivalent is at 0.25% and the UK equivalent is 0.50%. These rates are all in that interest limbo state called the zero bound. The question still to be answered is can they fund their public debt expansion plans at these absurd interest rates?


Component Three: Divergence in long term yields.

The failing bond auctions were not the only signal from the market. The market does not like the heady mix of expensive pricing and an explosive over supply and is reasserting a term premium. Oops, here is a green sprout for higher interest rates. There is no guarantee that interest rates will not rise in spite of depressionary conditions when Central Governments suck every last saved global penny into their debt expansion plans.


USA





Component Four: The interest burden is rising.

Actual interest costs are rising in spite of historic low interest rates due to the exponential growth in supply of Central Government debt. Observe also the interest rate trap. Can Central Governments afford any rise in interest rates? Do taxpayers have the spare cash to service higher interest costs should interest rates rise? That pesky law of supply and demand which eventually got the housing bubble will also get this supply, demand and interest rate structural distortion.

Long term interest rates just do not want to co-operate with Governor Bernanke’s promise to “keep interest rates lower for longer” a long standing proposed strategy of his. Does he have the power to hold long term interest rates down with the printing press or will the market call his bluff. The now well established divergence in the 30 year treasury rate and the acceleration of the trend to diverge since the beginning of 2009 indicate that the market is calling his bluff. I suspect the market will win in the stare down just as the debt bubble eventually had to succumb to market forces.



USA


USA






Component Five: Lambs to the slaughter.

Private Investors have grown their Central Government Debt portfolio at an unprecedented rate. Who will they sell to when the market asserts the law of supply and demand to re-price these bonds? Even more compelling is the potential losses baked into this cake of historic exposure to treasuries when interest rates start to rise. Can the Global Economic Crisis absorb a Global Bond Crisis?

USA





Component Six: Reliance on foreign funding flows to fund treasury purchases.

Japan’s Foreign Trade flows can no longer support new purchases of US Central Government Debt and China seems to be heading in the same direction. Can the rest of the world keep up purchases of US Central Government Debt? What happens when countries in distress have to cash in their holdings of USA Central Government Debt? Who will buy the securities from them?


USA

Data Source: Department of the Treasury/Federal Reserve Board
Note: Series revisions in each year in May/June from 2002 onwards and Jan 08 data omitted between the current and historical series data.


Component Seven: Diminishing international trade and falling Global Foreign Exchange Reserves.

We can already observe signs of distress in Global Official Foreign Exchange Reserves. The IMF’s data on Official Foreign Exchange Reserves is signalling that total global reserves are falling and have been falling for two quarters. Again, a well established trend. Perhaps it would not be wise to rely on foreigners to buy into the explosive growth in Central Government Debt.




Let’s add up the Seven Components:

1. Over Supply of Central Government Debt - Prices must fall.
2. Historic low interest rates. The probability of interest rates rising is much higher than the probability for a further fall.
3. Divergence in long term yields points to rising interest rates and distressed bond auctions confirms this trend.
4. The actual interest amount payable is already rising sharply even though yields are still low and sticky. This poses an incredible risk of funding distress should investors fail to keep absorbing the explosive growth in Central Government Debt. Central Bank purchases of own Central Government Debt cannot take the place of investor money, or will they risk hyperinflation? The failed bond auctions indicate that this activity is probably already capped.
5. Who will buy from “Private Investors” their holdings of Central Government Treasuries and save them from further losses?
6. Relying of “Foreign Holders” to accelerate their purchases of US treasuries at a time when trade flows are falling and each nation has to deal with their own national economic distress would be perilous.
7. Who will buy USA debt from distressed countries when they cash in their reserves?


My cat gets convulsions in its jaw and makes agitated mewing sounds at the sight of a bird which he thinks it is within striking distance. Bond traders are also snapping their jaws and salivating away when looking upon the evidence of the bubble in Government debt. Let no-one shout “fire” in this crowded theatre for bond investors may get trampled as they run for the exits.

Watch for the next billionaire in the making when this mother of a low hanging fruit is plucked.



Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
17 April 2009


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .