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The U.S. Government Bond Bubble
From Expected Returns Blog, which is a blog focused on gold and silver investments.
What follows will read like an indictment on our entire economic system. But underlying my (relatively mild) harangue is an observation that people are ignoring the most obvious bubble out there; that is, the bubble in U.S. government bonds. The following is my attempt to figure out why.
Efficiency Market Theory
Let's face it, markets are inefficient. The efficient market theory, manufactured from the ivory towers of academia, poses perhaps the greatest threat to the stability of our system. Here's why.
False assumptions produce false conclusions. The efficient market theory posits that bubbles aren't recognizable before they pop. The natural consequence of this misguided belief is that government officials will never act to preempt bubbles since they are, by definition, impossible to identify. This is one of the reasons why supposedly "efficient" markets are consistently marked by fat tails, outright panics, and "once in a lifetime" events.
The efficient market theory currently extends to U.S. government debt. In a circular manner, the strength of U.S. bonds is justified by low yields, which is evidence of the strength of U.S. bonds. But take a step back and remember that current yields are a product of government intervention. Stability, especially artificial stability, breeds instability. U.S. bonds are a bubble, and it's pretty damn recognizable at the present time.
Psychology and Cognitive Dissonance
I love incorporating psychology to economics because this dual framework explains the world a whole lot better than pseudo-scientific economic models that are consistently wrong. I'm convinced that one of the biggest barriers to investment success is cognitive dissonance.
To briefly explain, cognitive dissonance is a phenomenon by which people attempt to reconcile two opposing views. When faced with seemingly contradictory facts or opinions, most people will defend their existing framework by explaining away anything that refutes it. To understand why this human tendency is important in the context of a U.S. debt default, we must understand the framework most Americans currently carry.
Most Americans cling to a framework that goes something like this: The U.S. is the biggest economic power the world has ever seen. We are the engine of global growth. We are immune to panics that characterize "less developed" countries. Our debt is rated Triple-A. Therefore, we can never default on our debt.
Any evidence contrary to pre-existing frameworks will be explained away- this is human nature. So when gold goes to record highs, instead of recognizing that it is the free market's indictment of the monetary system, people will say "gold is a bubble." When Greece experiences a debt crises engendered by factors indistinguishable from ours, people say "we're not Greece- we can print our own money." Utter nonsense.
By going short U.S. government bonds, I am basically going short the human tendency to cling to a worldview that provides them the most comfort. Always let historical precedent and facts determine your conclusions, not irrational human tendencies.
Crony Capitalism and Collapse of the Rule of Law
The rule of law is perhaps the most underappreciated aspect of functioning markets. Once the system degenerates into a form of crony capitalism (think: Chrysler bond debacle), you know serious economic shocks lie ahead.
When people realize they can "game" the system, believe me, they will. Economics is all about incentives.
Think about the tragicomedy that is Wall Street. Banks on life support get bailed out from the government to "save" the financial system. But to appease the public, politicians throw in a provision that banks can't hand out bonuses unless they repay TARP. No problem! Banks issue stock and dilute existing shareholders to repay TARP. Then they hand out record bonuses. Follow the path of money and realize your tax dollars are going directly to the pockets of morons who brought down our system. The system is being gamed big-time.
What's the net effect? Investors lose confidence in the entire system and withhold their capital. This especially holds true for government bonds. The system can take only so much corruption before imploding at the seams.
Blindly Trusting Financial "Experts"
To rid you of any delusions that experts know what they are talking about, allow me to briefly walk you through the debacle known as subprime.
Most professionals couldn't see the bubble in housing inflating even though it was staring them in the face. And this was a mere 7 years after the collapse of the Nasdaq! Leading up to the crash of housing, the consensus could not envision a national decline in home prices since their "infallible" economic models used data of home prices over a 60 year period. All quants needed to do was adjust their models back about 15 years to the Great Depression and they would have understood that home prices do indeed fall. Garbage in, garbage out. Models are useless without a proper historical backdrop.
The experts, led by Paul Krugman, are now claiming that the U.S. is not Greece. Some people think this argument is sensible; to me, this is simply evidence of a world gone mad.
The key thing to understand here is correlation. CDO's were priced so richly because it was assumed that different tranches, which respresented a diverse range of mortgages throughout the U.S, were not correlated. This assumption proved to be false because all homes were inflated equally by the same credit bubble and the same fraudulent system.
False assumptions in correlation are prevalent as it pertains to sovereign debt. Somehow we believe the problems in Europe will not find their way to us. Unfortunately, we are experiencing a global sovereign debt crisis. Every single Western government is in debt up to their eyeballs. All bankrupt nations have lent money to each other in a complicated web that can be addressed only through default. Therefore, in the long run, all sovereign debts are correlated.
Failure to Predict Second and Third Order Effects
Perhaps the tendency that underlies policy mistake after policy mistake is the failure to think beyond first order effects. Politicians are especially adept at thinking at a linear level. Let me give you an example.
Imagine you are the governor of California and your state is bankrupt (doesn't take much imagination). Say you want to raise your revenue by $100 million dollars. The easy solution is to tax the arbitrarily defined "rich." Suppose your definition of "rich" is anyone with an income of over $1 million. Assume that the revenue derived from this demographic at current tax rates is $50 million. Simple arithmetic will dictate that you double your tax rate and your problems are solved.
Perhaps people don't believe this could possibly be the fantasy world our politicians live in. But this is essentially what the state of Maryland did. Millionaires promptly went "missing."
Our leaders fail to see potential second and third order effects of debt monetization; the subsidizing of the auto, housing, and financial industry; and the ad hoc disregard of the rule of law. If these trends continue, I am 100% sure capital will flee America. We need to start thinking beyond propping up failed corporations and running up our national debt; this course is unsustainable.
Linear World, Dynamic World
Let's go back to the subprime debacle for a second. Credit default swaps, which were an effective short against housing, only started to crater in mid 2007- even after it was obvious that the models pricing CDO's were seriously flawed. Market makers (Government Sachs) briefly manipulated bond prices to buy time as they faded their clients and ran for the exits. Once people understood the toxicity of CDO's, we saw an all-out stampede as bond prices crashed dynamically,
Does this sound familiar? Is our government not manipulating markets and delaying the inevitable by monetizing debt? Short of saying it outright, our government can't make it any clearer that trouble lies ahead. Seriously, what do you expect? Imagine Bernanke going on national TV and saying the following:
"I would like to inform the American people that we are bankrupt. We have been hoping to maintain confidence in our system by artificially suppressing rates by buying up bonds with money we printed from nothing. We hope that by keeping rates low, we can create another illusory speculative boom and kick the debt can down the road for another administration to take the blame for. I have no clue what I'm doing- after all, I'm the one who thought subprime was "contained."
Yea right. Our leaders are going to spend like drunken sailors until the entire house of cards comes crumbling down. I'm telling you, the evidence is staring you in the face. Gold is your only insurance.
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It was kind of GW to build them for Obama.
That my friend is global "hyper-uncertitude".
"hyper-uncertitude" is the only thing I am certain of.
Gold is the answer to the US Gov't Bond Bubble. Period.
If I were anyone dealing with TRSY bills, notes, bonds right now, I would advise you to flip the 4wk and 13wk bills right now and do not touch anything else. Keep your money flowing back to you in short intervals like this, so you will be able to take advantage of the longer term issues once their yields explode when "hyperinflation" finally grabs full hold of this ponzi economy.
Don't get hooked into long term treasuries right now with such crappy rates. No matter what scam street says or does.
It almost seems too good to be true, rates at 4 3/4 for 30 years, I almost feel like going all in realestate wise (a proxy for shorting TSY), only thing that holds me back is that when/if rates rise the values will be tanked, unless of course hyperinflation takes hold first. What a conundrum.
Well written. One of the most interesting aspects is that the main assertion is now becomming common, and acceptable, to assert that the nation is bankrupt.
Must mean reality is getting harder to hide.
But "the nation is bankrupt" is mitigated by unlimited freedom to print "money" ...which buys unlimited mercenaries...who protect the printers...who think they are "the nation".
One can agree with all the points is the piece, baby, without assuming the entire Financial System MUST "implode at the seems". These articles are all a version of front-running: "concerned, sincere, repected" author shorts UST and loads up on GLD... then spends all his time sitting on his ass in his jamies churning out Apocalypse Propaganda.
I've traded the volatility in the Financial Sector daily for 15 years... so bring on the volatility... but do not draw long-term conclusions until we see the post-November politcal landscape. Remember: the Gulf Spill will likely still be spewing "Texas Tea" in November, baby.
I think you misinterpret the author's statement.
Not GLD, gold, as in bullion coins and ingots. There is a difference. One is a paper derivative and potentially a fractional reserve fraud as the holdings are inadequately auditted and suspect in the minds of many here at ZH. The other is the actual tangible.
Really? I actually think November will be mostly irrelevant.
Yes, of course, there will be an election landslide against the party in power. However, the new party won't fix this mess. We *need* national default. And, we'll get it. (We can merely fiddle with how that default takes place.)
I understand you like volatility -- and I understand some people really can thrive in it. However, at present, I fear you are merely betting you are able to guess what finger is over which button, and when it will press. You might be nimble, but IMHO all the rules are suspect (they will change faster than you will be nimble).
But, my hat's off to you -- have fun while you can.
An illusion has to be paid for in both money and credibility. It becomes costlier as time goes by.
Also, hearing gold being tossed around as a currency and not a commodity. Everybody keep it up!
What's the difference between a bubble bond and a bubble blonde? Are the diminishing returns the same?