Aden Forecast: A Breakdown in Bonds?

11/19/2020 5:00 am EST

Focus: BONDS

Mary Anne & Pamela Aden

Co-Editors, The Aden Forecast

The bond market is by far the biggest market in the world. In fact, the global bond market is about three times larger than the world stock markets, explains Mary Anne and Pamela Aden, long-standing economic experts and editor of The Aden Forecast.

Most people don’t realize that bonds are the biggest free market. Even though the Fed is known to move interest rates, and their actions are widely reported, it’s really only manipulating short-term interest rates. Long-term interest rates are another  story.

They are driven by traders and dealers around the world and the Fed has no say  regarding what happens to long-term rates. Yes, they can try to influence them, but the free market calls the shots, and that’s been the case for thousands of years.

Interestingly, the first known bond in history goes back to about 2500 BC in Mesopotamia (now Iraq). In those days, corn was the main  currency and that first bond was backed by grain.

Later, silver became popular because it was more durable. And so it went throughout history. Money or goods were borrowed and lent, and this financed trade, wars and governments.

In the U.S., for instance, Treasury bonds were first issued to finance the American  Revolutionary War. But even well before that, France, Spain, England and the city states all issued bonds in one way  or another.  In comparison, stocks didn’t appear on the scene until 1602, with the first being the Dutch East India Company.

So now we jump to the present. The world is drowning in debt and, therefore, it’s drowning in bonds. But a new twist in the past decade has been super low interest rates. And in many cases, interest rates below zero.

This has never happened before, going back all those centuries. But currently, 25%, or $15 trillion of government global bonds pay a negative interest rate. It’s crazy but it’s happening, and it clearly marks a new era.

To give you an example of what we mean, the U.S. federal budget deficit as a percentage of GDP (economic growth) since the late 1700s. Most noticeable, deficits have pretty much been the norm since the Great Depression, and especially since the 1980s.

The current deficit is the largest ever, aside from the ones during World War I and II. So, it’s currently greater than the deficits during the  Great Depression and the Civil War, which is mind boggling if you think about.

Plus, Fed head Powell recently said the U.S. faces “tragic” risks from doing too little to support the economy. For now, the deficit is already at $3 trillion. That’s more than triple last year’s shortfall.

This makes you question how interest rates can stay so low while debt is soaring. And debt is set to go much higher, while bonds are being created massively to finance all that debt.

One reason why is because the Fed is buying tons of bonds. The other is due to the deflationary drag that’s been hanging overhead for many years now. But that may soon be changing.

Interest rates have been surging higher. That is, long-term rates have been rising strongly since  July and they recently hit an eight-month high. They are doing their own thing, and this makes us wonder, what do long-term rates see that we don’t?

You may remember that long-term interest rates are often a leading indicator. And the fact they’ve been rising firmly while short-term rates stay near zero is something we’re keeping an eye on.

We know the Fed is going to keep short-term rates pretty much where they are in the years just ahead. They’ve said so  many times. And if long-term rates keep rising it could be warning us of inflation ahead. 

Inflation? But wait a minute, the economy is now in a recession, and it could be heading into a depression. This is not an environment that would normally fuel inflation. However, it could fuel stagflation. That is, weak economic growth along with rising prices (inflation).

That would be most unwelcome under the current circumstances, but it does seem to be a  possible outcome, especially considering all of the  money that’s being created, which is the direct  cause of inflation.

And if that’s what rising long-term rates are telling us, then bond prices are going to tumble. As we’ve been pointing out, bond prices have been forming a big top formation all year. They’re now breaking down from this top and the leading indicator is signaling that bond prices could fall a lot further.

That’s why we’ve been recommending that you avoid bonds and simply step aside. The risk isn’t worth it and as debt keeps sky-rocketing, and the supply of money and bonds grows even greater,  bonds will simply become even more unattractive.

That’ll be more so the case if inflation perks up too because inflation is the bond market’s worst enemy. Meanwhile, we can also bet a Biden administration will keep the same monetary policies in force.

In sum, bond prices are now breaking down from their top formation. They’re  poised to fall a lot further and we continue to recommend avoiding bonds. The risk isn’t worth it.

In other words, long-term interest rates are likely going to rise further. Short-term interest rates, however, are near 0% and they’ll probably stay there for a long time to come.

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