There was a time two decades ago when the bond traders served as a fake gold standard. No longer.
The gold coin standard restrains central bank and commercial bank inflation. If they inflate, there is a run on the banks. Depositors withdraw gold coins. This forces the banks to stop inflating. The bankers hate this. So do politicians. So, they undermined the gold coin standard. In 1933, Roosevelt unilaterally declared it illegal for Americans to own gold.
A gold standard existed for the Treasury. Foreign governments and central banks could buy gold from the Treasury for $35 an ounce. Nixon unilaterally ended that on August 15, 1971.
After that, bond investors held the hammer. If the government ran a huge deficit, and the Federal Reserve was inflating, bond traders sold bonds, driving up interest rates. That was what forced Clinton to run surpluses at the end (not counting the Social Security deficit). He could not ram through his spending plans in his first term. The “bond vigilantes” could de-rail his programs. No longer.
Here is a summary.
No longer can investors’ bond-selling campaigns pressure officials into politically unpopular tax increases or spending cuts, measures that both Clinton and his predecessor, George H.W. Bush, were forced to adopt to improve the fiscal balance and support bond prices.
The institution that has disarmed the investors: the Federal Reserve.
The central bank’s giant purchases in the Treasury market and near-zero interest rates have supported bond prices and marginalized private-activist bond investors. Just ask the biggest bond investor of them all: Bill Gross, founder and co-chief investment officer at Pacific Investment Management Co., whose bets against the Treasury market went so bad last year that his flagship Total Return Fund had its first annual outflow of investor money.
In the euro zone, they still have clout. That is because the European Central Bank has hesitated to imitate Bernanke’s FED. Not in the USA.
Even with a record U.S. fiscal deficit, Treasury bond yields–which define the rates the U.S. government must pay to borrow in capital markets–are trading near historic lows, allowing the government significant maneuvering room.
The benchmark 10-year note’s yield stayed below 2% Wednesday at 1.94%. While it has risen from 1.672% in September, the lowest since the 1940s, few bond bears dare to call a jump in the yield to above 3% any time soon. Prior to the subprime crisis, the yield traded well above 5%.
That is partly due to the “flight to safety” that Treasurys have enjoyed as investors escape exposure to the euro-zone debt crisis, but it is also because of the Fed’s yield-suppressing actions, which are aimed at encouraging investors to take risks and bolster the economic recovery, and are made possible by a benign inflation environment.
We know the background.
During and the financial crisis of 2008-2009, the U.S. central bank slashed interest rates virtually to zero and initiated a $1.75 trillion program to buy Treasurys and mortgage bonds. This was followed by another $600 billion bout of Treasury buying that began in 2010 and, in October last year, by “Operation Twist,” a program to sell shorter-dated notes and buy longer-dated Treasurys aiming to keep long-term borrowing costs for U.S. consumers and businesses low.
The FED has inflated the monetary base as never before. What has kept hyperinflation from occuring is the unwillingness of businesses to borrow and the fear of commercial bankers to lend. The banks turned most of the money back to the FED for a tiny 0.25% or less on the money. These are called excess reserves.
If the banks ever start lending what they are legally allowed to lend, there will be hyperinflation. This is the sword of Damocles hanging over the U.S. economy. If fear ever recedes, prices will double. Gold will soar. Silver will soar. To stop this, the FED will either have to sell assets or stop inflating. The Great Default by the U.S. government would follow.