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[Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), has edited the article below for length and clarity – see Editor’s Note at the bottom of the page. This paragraph must be included in any article re-posting to avoid copyright infringement.]
For those who think bonds are a safe place to be, you might want to reconsider. In addition to rising sovereign risk (yes, for the US as well as other countries), there is interest rate risk. Interest rate risk is what you assume when you buy a bond and do not intend to hold it to maturity. If interest rates rise, then the value of your bond falls. Bonds can produce capital gains/losses, just like stocks.
What is the probability of interest rates rising. If history is a guide, the possibility is pretty good. Here is a graph of 10-year Treasury bond rates:
(H/T to Reader GC for sending chart)
The only comparable period in this 200 plus years to our current level of interest rates was the latter part of the Great Depression. During that period, deflationary pressures kept interest rates low.
Economists have a simple rule of thumb regarding interest rates:
- They have a hypothetical risk-free rate which they assume to be 3%. This rate cannot be seen, although is assumed to be the rate paid on short-term government securities (which used to be considered as having a zero percent chance of default).
- In a non-inflationary world, Treasuries would presumably pay 3%.
- In an inflationary world, Treasuries would presumably pay this 3% plus a premium equal to the expected inflation rate over the course of the bond. Thus, if you anticipated a 3% inflation rate, you would be willing to buy Treasuries that paid a return of 6%.
In the Great Depression, the inflation rate was negative (i.e., deflation). 3% minus some number explains why interest rates were so low then. There is no market rationale for interest rates being so low [now]. They are because of the Fed’s “operation twist” whereby they (last year) bought 61% of new Treasuries. That cannot go on much longer.
There are two things to worry about:
- If you own 10-year Treasuries and interest rates rise to a more normal level, you will incur a capital loss if you dispose of the bonds prior to maturity.
- If interest rates rise, government interest expense will double or triple from the amounts being paid today. That potentially triggers a debt death spiral, where government has to borrow more than otherwise expected. It also raises the credit risk and could ratchet interest rates up again. Greece’s short-term interest rates approached 100%, months ago. Spain and Portugal ratcheted up into the twenties. The same thing can (and eventually will) happen here unless deficits are dramatically reduced.
The distortion in interest rates is only one of the distortions embedded in our economy. For years the Fed and government have been propping up the economy with low interest rates and fiscal policies designed to stimulate. As a result, the price distortions and capital misallocations are large. They are also unsustainable. All of this will eventually overwhelm the government’s attempt to pretend and extend and end up in another Great Depression.
[Editor’s Note: The above article may have been edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.]
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