In this new year, we should look at the state of the bond market as Donald Trump ascends to the presidency. Some have said that the bond market bubble is about to burst. Some say China will sell a massive hoard of bonds as a trade war is initiated by the Donald. But I am not sure that would help China in a time where it needs bonds to appreciate in value.

The market for bonds has kept up even with massive bond auctions after the Great Recession. Revenue fell massively. Federal revenue fell again this year after recovering since 2008. But this decrease is small change compared to what happened in the Great Recession.

So, what are the issues in attempting to determine the bubble/no bubble status of long treasury bonds? Here and here are a few:

1. China could sell bonds in large quantities, since it holds over 1 trillion dollars of US government debt. Supply of long bonds could greatly outpace demand for those same bonds, at least for a time. Would China ever seek to destroy a major trading partner? It is unlikely. 

2. Demand for long bonds has been massive. As David Beckworth, economist, has said, the demand for bonds has been massive because of a safe asset shortage. The Great Recession decreased private safe assets, as they were no longer considered so safe. Excess demand for public safe assets has increased since the crash. Treasuries, repos, agencies and new commercial paper have replaced the failed private MBSes as money supply in the shadow banking money markets. They function like money. They are often used as collateral, for making loans and deals.

Shortages of these financial assets cause fewer deals and loans to be made. The study of repo fails has been center of research by Talkmarkets' Jeffrey P. Snider.

Beckworth shows us a study done by MIT,  Harvard and U.C. Berkeley by economists Caballero, Farhi and Gourinchas, which shows that central banks cannot push natural rates (r*) too far negative. The article is titled Safe Assets and Aggregate Demand. The failure of central banks to push rates lower results in an interest rate gap emerging, which will cause output to fall below its potential. This impact on aggregate demand has slowed the normal business cycle. By the way, the economists say that physical assets are simply not safe assets.

Slow growth is the by product of negative natural rates. Certainly it is causing upheaval in Europe. And an upheaval of sorts in the US with the election of POTUS Trump, is forcing the Fed to try to raise rates under conditions in which revenue is dropping for the US Treasury. This raising of rates appears to be a potential drag on growth, but so is letting the natural rate drop below zero. It seems that Fed is boxed in.

3.  Yields are increasing worldwide for long bonds and have accelerated the increase since the election of Donald Trump. Beckworth is admittedly puzzled by this increase. It could be a replay of the tantrum of 2013, but revenues were increasing for the US Treasury then. Now there is a decline and a few more bonds will become available.Yields are not as high as in 2013, which was a false alarm. But, they are going up everywhere in the world at the same time.

This has made many who believe that the bond market is a bubble to set out panic warnings. There is some fear that is likely driving bond investors towards shorter duration treasury notes.

4. Some have said that the bond market is no different than other markets that are manipulated. When it comes to physical assets, speculators have hoarded contracts, causing price fluctuations of the underlying commodity even if the commodity itself was in abundance. This way price can be manipulated. Could this same behavior be applied to bond markets? Could this be the reason why bonds are all rising in yield at the same time?

Or is the rise attributed to tightening by the central banks in preparation for a slowdown, or even to facilitate a slowdown? It is all manipulation, and perhaps both are true.

If tightening is in preparation for a slowdown, long bonds become important for safety. I believe the central banks do not have a problem with popping bubbles in a controlled fashion in every market, except the bond market.

If the bond market were to theoretically go bust, with massive yields the result, all bubbles everywhere would pop, as the money underpinning those bubbles is in the form of bonds, mostly.

I cannot see the central banks ever allowing that to happen. We would go beyond a recession to a Great Depression.

Just talking crazy can have a manipulative affect on markets. Besides central bank tightening, futures manipulation, and Greenspan tantrums, fear of a Great Depression and default is a strategy of the incoming Trump administration to nudge interest rates higher. After all, Donald Trump threatened default:

“I’m the king of debt. I’m great with debt. Nobody knows debt better than me,” Trump told Norah O’Donnell in an interview that aired on “CBS This Morning.” “I’ve made a fortune by using debt, and if things don’t work out I renegotiate the debt. I mean, that’s a smart thing, not a stupid thing.” “How do you renegotiate the debt?” O’Donnell followed up. “You go back and you say, hey guess what, the economy crashed,” Trump replied. “I’m going to give you back half.” (Politico)

 And Steven Bannon made this incredible statement:

“With negative interest rates throughout the world, it’s the greatest opportunity to rebuild everything” Bannon said. “Shipyards, ironworks, get them all jacked up. We’re just going to throw it up against the wall and see if it sticks. It will be as exciting as the 1930s, greater than the Reagan revolution.” (The Washington Post)

The 1930's was a time of abject poverty and decline of wealth worldwide. Either Bannon thinks he can build out of a real Great Depression, which is delusional, or he is frightening people with the possibility of massive economic decline and possible default But the USA did not default. Bannon is likely using talk of an economic cataclysm to push rates up.

A recession is always better than a depression, I always say. Bonds and cash and maybe gold, (but gold is a physical asset not as safe as the other two), are the way to go going forward in a diversified portfolio. I take Trump's words and Bannon's words with a grain of salt, as they are talking up interest rates within limits. A recession is expected, but we must avoid worse.  

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I wish everyone a happy new year. In a tumultuous end of 2016, the nations of Russia, China, and Israel have been in the news. Regardless of whatever position you take with regard to these nations politically, pro or con, I hope all of my readers would fight for tolerance towards all Russian people, all Chinese people and all Jewish people residing in the USA and abroad. Tolerance is the backbone of stability of this great nation. The USA is an experiment that works. The weakness in the nation often revolves around the doctrines of supremacy of race. All races and ethnic groups deserve respect, because it is, quite simply, the American Way. 

Those who wish that tolerance be subjugated need to be careful for what they wish for. Germany prior to World War 2 did what all colonists have done throughout, created harsh conditions and genocidal conditions for the occupied people.  

But the great difference between the old Germany and other western nations that behaved wrongly, is that the other nations, Australia, the US and the UK eventually came to terms with the existence of diverse people within their borders. Germany didn't do that, until after WW2. The possible rejection of peoples is what leads or at least adds to instability and desperate measures often resulting in horrible evil and atrocities. 

We don't want to repeat the German experience by rejecting any people whose origins lie middle east or anywhere else. It is easy for leaders to come to power who forget who we are and what we stand for. We need to fight any tendencies to allow leaders of our nation to go down that dark path, in favor of the American Way, which has not been perfectly executed, but is far greater than the alternative.   

Economic prosperity hinges on diversity. If diversity did not exist in Las Vegas, where I live, the casinos would go bust, the city would go bust. Las Vegas is just one example of the need to keep on course towards prosperity and tolerance for ourselves, our children, and our grandchildren.