The Painful Price of Subsidized Money

Bond yields have been generally declining, and the market as a whole is set up for them to continue the trend.

Not bad, right?

Wrong.

It's extremely dangerous - to all investors - because it can't go on forever. It's not a question of if this might happen, it's a question of when.

Fortunately, there's one antidote to this poisonous path. But first, you need to see the path we're on and its dire consequences.

Bonds are integral to the entire financial system and the economy as a whole. At some point sooner rather than later, bond yields will start rapidly increasing - and the bond market will become a Death Star, devastating the global economy.

Since 2008, and to a large extent since 1995, the bond market has been subsidized by the Federal Reserve, which has consistently printed more money than the economy demands - with broad money supply rising by over 8% a year since 1995, compared to a nominal GDP rise of less than 5%.

That subsidy has been hugely increased since last September, with the Fed buying $85 billion monthly of long-term Treasury and mortgage agency bonds.

Distorted Path

When something is heavily subsidized, its price gets out of whack.

And that's what has happened to the bond market, where 10-year Treasury yields have been at or below the rate of inflation for several years - and now even 10-year TIPS (Treasury Inflation Protected Securities), which are essentially inflation-linked bonds, have a negative yield.

The U.S. economy is now four full years from the bottom of the last recession. Based on the last 100-plus years of history, 10-year yields should now be about 2% above the rate of inflation.

At some point, the Treasury bond market will correct itself, and T-bond yields will revert to that level - meaning about a 5% nominal yield on the 10-year Treasury bond. It probably won't happen this year, but I'd be pretty surprised if it hasn't happened by the end of 2014.

The recent modest run-up in 10-year Treasury yields from 1.5% to 2.1% has caused considerable hiccups in markets -- for example producing about a 20% drop in the price of mortgage REIT stocks, even as the market as a whole has been rising. A run-up to 5% yields will have much bigger effects:

• Most mortgage REITs will go bust. Their mortgages currently yield no more than 4% and they fund themselves in the overnight market. Since they are leveraged as much as 10 to 1 in some cases, the loss of value in the mortgages will put them underwater, with liabilities greater than their assets. At that point, even if the Fed forces short-term rates to stay low, they will not be able to access the short-term "repo" market for the funding they need. There's about $500 billion or more of these companies, so their bankruptcy will make waves.

• Housing itself will be in trouble. With home mortgage rates of 6-7% once more, fewer buyers will be able to afford homes. Home values will reverse their recent rise and lurch downwards. That will panic the market, and cause a general tightening of lending standards, which will produce a downward spiral as in 2006-09.

• The banks will be forced to "mark to market" their gigantic Treasury bond and mortgage bond portfolios, wiping out much of their capital, and leading the regulators to force them into emergency share issues to prop themselves up. That will crash their share prices, and cause corporate lending to dry up.

• The leveraged buyout market will crash, because higher interest rates will make the calculations on which the LBOs are based stop working - not enough interest cover. That will cause a rash of defaults among private equity fund debt - all the debt that has been happily rolled over in the last couple of years. Values of corporate assets will crash.

• Stock markets worldwide will crash, as leveraged players such as hedge funds are forced into distress sales, while emerging markets suffer a liquidity crunch as they did in 2008. Emerging markets with poor cash flow, such as Brazil, will default on their debt.

And Then What?

Needless to say, the economic recession following a bond market re-pricing will be long and painful. And since bond markets won't be receptive to new debt, monetary and fiscal "stimulus" such as was used in 2009-10 won't be available (even in the early 1980s, when the U.S. Treasury was truly AAA, there were some failed T-bond auctions).

That's a good thing for our long-run solvency and living standards, but in the short run it will make the recession even deeper and more painful.

Since the 1980s, the bond markets have financed a long run of spending beyond our means. That's about to change.

And when it does, bonds will indeed become Darth Vader's Death Star, capable of destroying the world economy with a single beam. And it's most unlikely that the current global economic brain trust will find their secret vulnerability...if they have one.

For my portfolio, only gold remains a possible antidote. In my newsletter Permanent Wealth Investor, I go into more detail on which gold investments will benefit the most, as well as other sectors that will thrive as the Death Star approaches. What's more, I'll keep you in the loop on when to sell as well as what to buy.

You can learn more about Permanent Wealth Investor by clicking here.

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