Saturday, March 10, 2012

Money and Bonds

A government bond that comes due tomorrow will turn into money tomorrow, so it is not very different from money.   In fact, a bond that comes due 30 days from now is still not very different from money.   Most of the time money changes hands slower than once every 30 days.  But a 30 year bond is very different from money.   In this case someone has given up their money to the government for 30 years.  They may be able to sell the bond and get some money now, but not necessarily as much as they paid for the bond.  And if they do sell the bond then there is someone else who has given up money till 30 years from now.   So when the government sells a bond it removes some cash from the economy for that period of time.

Imagine the government's debt was evenly spread out over bonds that came due over the next 30 years.  Then in any one year at most 1/30th of the debt would come due.  This is a far more secure financial position than if all the debt was in 1 year bonds that came due over the next 12 months.   If interest rates go up and all the bonds have to be refinanced over the next 12 months it is as if the government has a variable rate loan where the payments can go up.   If this year the public does not want to buy bonds the government would have to print for 1/30th of the debt in the first case and all of  the debt in the second case, which is far more inflationary.

The Fed is currently trying "operation twist" and now talking about sterilized QE.  Essentially they are buying long term bonds and selling short term bonds.  They claim this is sterilizing their liquidity operation.  But since a short term bond is much more like money than a long term bond it is not fully sterilizing.  If they buy 30 year bonds and sell 3 month bonds then they are really only sterilizing for the next 3 months.   This is 1/4th of a year out of 30, or 1/120th sterilized.   Less than 1% sterilized.  After that all the inflationary pressure may be released.

One of the core ideas of central banking is that they should only buy short term debt that is sure to be paid back.  If they do this then they can always withdraw any money they added earlier.  In this case they always have the ability to prevent inflation.     However, the market price of a 30 year bond could drop in half if the interest rate goes up a few points.  So if the Fed tried to sell a 30 year bond after the interest rates start to go up they might only withdraw half of the money they added.  If the interest rates go up alot they might only be able to withdraw 1/10th of the money they added when they bought the 30 year bond.   If the value of a 3 month bond drops they can just wait out the 3 months and still get the full value back.  But they may not have the option to wait 30 years if inflation starts to pick up.   So buying long term bonds runs the risk of adding money that can not later be withdrawn.    

The government would be safer to move as much debt into 30 year bonds as they can.  Instead the Fed is getting people out of long term bonds and into short term bonds.   This puts the government in a more dangerous position. Moving to short term bonds is part of the setup for hyperinflation

If people have 3 month bonds, then if they decide the dollar is losing value they can get their cash in 3 months and never buy bonds again.  If everyone is in short term bonds then everyone can get out in a short period of time.  In this case the government has to print money like crazy to pay off all the bonds (ok really the Fed will be the only buyer of bonds and they are using new money).  This is the recipe for hyperinflation.

2 comments:

  1. Another post points out that a sterilized QE3 just has to be a lie. If it is sterilized it is not stimulative. If it is stimulative it is not sterilized. So one way or another Bernanke has to be lying.
    http://seekingalpha.com/article/430991-qe-inflation-and-the-case-for-precious-metals

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