This past week the U.S. Treasury needed to borrow $118 billion to finance the monster deficits that the U.S. Government is racking up in the short-term. Financial market experts were watching this financing closely to see how investors would react to the passage of the healthcare reform legislation and to the U.S. Government’s recent spending binge. The U.S. Treasury tried to raise funds three separate times offering different types of bonds to investors yielding interest rates they hoped would entice investors.
The U.S. Treasury’s plans went awry because “bond vigilantes” (unhappy bond investors) were unwilling to accept the interest rates the U.S. Treasury initially tried to offer them. Bond vigilantes wanted much higher interest rates to compensate for the increased inflation and currency risk that came after the passage of the costly health care reform legislation. As a result, interest rates for U.S. Government bonds rose significantly this week. For instance, the 10 Year Treasury bond rose from 3.69% at the start of the week to as high as 3.90% on Thursday before falling to 3.85% on Friday.
I doubt this week’s borrowing fiasco will just be a one-time event. The U.S. Treasury is likely going to need to continue raising $100 billion plus each week for the foreseeable future as the U.S. Government continues to engage in reckless deficit spending. In addition, there are indications that China, the U.S.’s biggest creditor, is losing its appetite for U.S. Government debt. The past couple of months China has been a net seller of U.S. Government debt. The growing supply of U.S. Government debt in the marketplace along with the weakening demand for U.S. Government debt is a recipe for higher interest rates in the long-term.
Rising interest rates are toxic for the U.S. economy and the financial system. Mortgages rates typically follow the movement of the 10 Year Treasury bond rate. The higher the interest rate bond investors demand for 10 Year Treasury bonds the higher mortgage rates typically will be. The last thing the weak U.S. housing market needs is higher mortgage rates because that curtails demand by making it more expensive for people to borrow money and by making it more costly for those who have adjustable rate mortgages to keep their property. In addition, higher interest rates make it more expensive for businesses to borrow, which leads to less economic activity.
Many people do not realize that they can lose money by investing in bonds. The value of a bond is primarily tied to five factors:
- Principal: The principal is the amount of money the bond investor initially invests. The principal is returned to the investor when the time of the bond is up. For a 10 Year Treasury bond, the investor receives the principal back at the end of the 10th Year. The principal (or face value) of a 10 Year U.S. Treasury bond is $1000.
- Interest Rate (Coupon) Payment: While the bond investor waits to receive the return of their principal they are compensated for waiting. The size of the interest rate payment depends on the interest rate at the time they purchased the bond (and the number of times that interest rate is compounded in a year).
- Number of Payments. Some types of U.S. Government debt pays the investor only once a year while other types pay the investor twice a year. The 10 Year Treasury bond pays two interest rate payments each year (thus the interest rate is compounded semi-annually).
- Maturity: This is the life of the bond. Obviously, the life of a 10 Year Treasury bond is 10 years. This means that there will be 20 interest rate payments during the life of the bond.
- Current Interest Rate: This is the interest rate that bond investors can currently get in the marketplace. Interest rates change so it is unlikely that interest rates will remain at the same levels that the bond investor got when they initially purchased the bond. This is the only factor that changes after a bond investor buys a bond, so it’s the most important factor affecting the value of a bond after the bond investor buys it.
As an example to illustrate how you can lose money investing in bonds, let’s use what happened with the 10 Year Treasury bond this week. Let’s say you bought the bond when it was yielding 3.69% on Monday. At that time the bond was worth $1000 in the marketplace because interest rates had not changed yet.
Now let’s say you wanted to sell that bond on Thursday after the U.S. Treasury had difficulty raising money. There is no way you are going to get back the $1000 you originally invested in the bond when you sell it because your bond is only paying 3.69% interest. An investor is going to shun your offer because they can invest that same $1000 to buy a bond that is paying them 3.90% interest. The only way you will be able to entice the investor to buy your bond is to lower your offer so that they are compensated for getting back a lower interest rate.
After using an online bond value calculator you find that the value of your bond in the marketplace fell to roughly $983 on Thursday. This means that you must sell your bond for only $983 to make a buyer indifferent between buying your bond and a bond yielding 3.90%. Congratulations! You just lost $17 on your $1000 “safe” investment in three days because interest rates on a 10 Year Treasury bond rose from 3.69% to 3.90%.
Keep an eye on the financial markets and the economy as you monitor what’s going on in the Mideast, in the political arena, and in the spiritual battlefield that is Earth. There are serious economic and financial repercussions coming from all the reckless spending governments worldwide have engaged over the past several years. The bond market is going to be a market to watch very closely because bond vigilantes may eventually take matters into their own hands and punish governments worldwide for all the debts they piled up. If/when that happens there is going to be a lot more economic and financial pain.
For more about the pain higher interest rates can cause, including the dangers of rapidly rising interest rates, see Chapter 11 of my book Prophecy Proof Insights of the Next World War.
