Wednesday, January 20, 2010

Dynamics of Treasury Bonds, ARMs, and the Federal Reserve

Bonds have face value of say: $1000. Investors bid for the bonds. The more investors there are bidding, the higher the bond price will go (high demand, higher cost). Eg. Say the winning bid is $990. So the yield is $10/$1000, or 1%. That's because at the maturity date, the government will pay you the face value of $1,000.

If there are less investors, the bond price will drop (low demand, lower cost). Eg. Say the winning bid is now $950. So the yield is $50/$1000= 5%.

Basically, high bond price = lower yield, and low bond price = higher yield.

Last year, the US issued $1.5 trillion in debt. 80% are funded by the Federal Reserves! This means that foreigners are not willing to buy the US bonds. This means that the Fed printed money and comes in to buy the bonds, artificially creating demand. So the bond price goes higher, and yield drops.

Now, a lot of things are pegged to bond yields. For eg. the Adjustable Rate Mortgages (ARMs). Low bond yields means lower interest payments on the ARMs - for now. But next time, when bond yields start to rise, the ARMs will follow suit. And then more and more defaults start to happen. I'm referring to the commercial real estate ARMs. You can see this in the graphs that I posted 2 posts before this.

So if the Fed buys the bonds, does this means that the US is owing money to itself, like Japan? Unfortunately, no. The US government owes money to the Fed. The Fed is not the US. The Fed is a private entity, whose purpose is to make profits, and with shareholders made up of an elite group of global bankers. Many of them are not even Americans.

So there you have it. The Fed keeping interest rates at ridiculously low levels. Instead of letting the free market set the natural rate, they come in and manipulate it.

Through their action, they can only delay the pain, the inevitable big collapse. And the more they delay it, the greater the pain will be later.

If you have a US bill right now, you don't have to panic or convert it to another currency. Just frame it up and hang it on your wall, and 10 years down the road, show the worthless bill to your kid. Then your kid will really come to understand the devastating effect of inflation.




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