Hard Landing / Brace for the Fall of Long-term U.S. Government Bonds

When American government bonds start to fall, Israeli government bonds will fall too, and the profits reaped in the first quarter of 2009 will remain a sweet, yet distant, memory.

"I used to think if there was reincarnation, I'd come back as the President or the Pope," James Carville, high-flying adviser to Bill Clinton, famously quipped. "But now I want to come back as the bond market."

A worthy ambition, if one wants to set the agenda. Throughout modern history, the bond market has ruled fate and fortune. The British Empire, for example, was predicated on the English government's ability to raise money for war on the bond market.

It's just as true in modern society. It was the American bond market that enabled Americans to live beyond their means in the last 20 years. They simply sold pieces of paper, mainly to the Chinese and Japanese, promising to pay them money in the future. In exchange the Americans took cars, televisions and all the other consumer goods they love so much.

One other thing. The bond market is the main long-term savings avenue for people worldwide, including in Israel. Most of our pension savings are in bonds.

Also worldwide, eyes glaze over when bonds come up in discussion, yet last week, the bond market was smack in the center of a planet-wide furor. U.S. Federal Reserve chairman Ben Bernanke announced an unprecedented debt repurchase: $300 billion worth of long-term U.S. government bonds during the next six months. (It will also spend another $750 billion on mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac.)

His announcement took the marketplace by utter surprise and the reaction was not long in coming. The price of 10-year government bonds posted their sharpest gain since 1962, shaving 0.5% from their yield to maturity. Yields behave conversely to price in bonds, so when the price of a bond rises, its yield to maturity falls. Thus yields on these 10-year bills fell to just 2.5%.

"Shock and awe," bond traders called Bernanke's move, borrowing a phrase from America's attack on Iraq in the second Gulf War.

The rationale behind the Fed's shocker is the desire to lower long-term government interest rates, on which the interest rates that companies pay is based. Lower interest rates for corporate America would, in short, relieve the credit crunch that is paralyzing the American economy, and hence, the world's.

This isn't just an American story. Today the financial markets are interlinked, and as prices on American government bonds rose late last week, so did the prices of government bonds in other countries. Here too.

On the face of it, Bernanke's gambit worked. He spoke and long-term interest rates fell even before he'd bought a penny's worth of the bonds. American companies seeking long-term loans in the U.S. will pay 0.5% less. Round 1 to the Fed.

Savers in Israel could also thank Bernanke yesterday morning - the American central banker lowered the interest rate at which the Israeli government borrowed money at the end of last week.

But this is just the start of the game. Investment in government bonds isn't some football game lasting 90 minutes, after which everybody goes home. Bernanke's move merely lays the groundwork for a future retreat in bond prices.

Why? Suppose the Fed's move works and economic growth resumes. Then what will happen? The Fed will stop buying government bonds.

Meanwhile, the panic will abate, share prices will start to recover and suddenly 2.5% yields on bonds will look mighty unappealing. The bond market will return to its historic point of equilibrium, which is yields of 4% to 5%, spelling out major losses for bondholders.

And that, friends, is the optimistic scenario. There is another, more likely one. The U.S. goes broke. Tax revenues drop. Spending to rescue the financial system and to restart the economy mounts by trillions of dollars every few months.

Even now people are starting to talk about the biggest deficit in American history, some 13% of GDP. To finance that, America has to print money, and that is exactly what it's doing.

In a year or two, America will be in the grip of inflation. How bad will it be? Probably like in the 1970s, 10% to 15%, say most economists.

Since most American government bonds aren't linked to inflation, the upshot will be a crash in their value, to prices representing yield levels of around 7% or more.

Don't Bernanke and the Fed chiefs realize this? Sure they do, and without admitting it for a second, they're okay with that, because inflation is ultimately the main way countries offset surplus money and liabilities they've issued.

This story is going to reach us too, dear reader. Israel's government is also running a growing overdraft and our authorities will have to print money or increase bond issues. That will create mounting pressure on their prices. When American government bonds start to fall, Israeli government bonds will fall too, and the profits reaped in the first quarter of 2009 will remain a sweet, yet distant, memory.