Wednesday, August 18, 2010

Liquidity Trap: The Global Collapse of Government Bond Yields

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Government bond yields are dropping throughout the world. The U.S. 2-year, the German 5-year, 10-year and 30-year, and the French 10-year have all hit record lows recently. The Japanese 10-year is back below 1.0% and has fallen as low as 0.90%. The UK 10-year yield has been dropping for months and is only 17 basis points above its Credit Crisis low.

Record or close to record low yields on government bonds indicates enormous buying demand. Bonds hitting record low yields are by definition hitting record high prices. Moreover bond prices are going up when supply has undergone a tremendous expansion to pay for all the economic stimulus programs governments are running. So demand for government bonds has to be increasing faster than the rapidly growing supply if yields are falling. The obvious question is: Who is buying all of these bonds?

If yields were dropping in just one country instead of in almost everywhere, increased demand might be partially explained by countries with big foreign reserves like China buying more government debt. China has been a major purchaser of U.S. treasuries for a long time, but last month it sold about 3% of its holdings. Yet yields on long-term treasuries continued to drop, when they should have gone up. In the U.S., there has been enough buying to not only make up for the loss from China, but to purchase an even larger amount of bonds. There is only one possible source for funding for this demand for government paper in the U.S. and elsewhere on the planet and that is the national central banks and treasury departments.

Essentially, the central banks are 'printing' huge amounts of new money. This money goes into the financial system and gets recycled into purchasing government bonds and also stuck in the banking system as reserves. Most of the newly created money does not go into the real economy. It does allow governments to spend much more money than they could have ordinarily however, but most of this 'stimulus' actually goes for maintaining the status quo (with the objective of preventing further collapse) rather than for anything that would create growth in the future. So the economy stagnates, but holds up as long as the money printing ruse can be maintained. This is a liquidity trap and much of the global economy has already fallen into it based on the interest rate behavior of government bonds.

A liquidity trap is an ugly situation to say the least.  Either a country continues to spend its wealth to support its lifestyle until all of it is dissipated and complete impoverishment occurs or it finds a way to get some of the liquidity into the real economy. The problem is that only small measured amounts of liquidity can be allowed to flow into the economy in any given time period, but this is not the likely scenario. If the central bankers were capable of making this happen, they would have already done it. More likely is that the floodgates will be open and too much liquidity goes into the real economy too quickly. Hyperinflation will then occur and prices could start to skyrocket almost overnight. Japan has faced this situation for the last twenty years, now it looks like all the developed economies are going to be facing it.

Disclosure: No positions.

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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