How “Risk-Free” Bonds Will Trigger Bloodletting in Bonds, Stocks, other Assets

The costs of the largest game of “Greater Fools” in economic history

By Alex M., Founder of Macro Ops:

Rarely do we investors get a market that we know is overvalued and that approaches such clearly defined limits as the bond market now. That is because there is a limit as to how negative bond yields can go. Their expected returns relative to their risks are especially bad. If interest rates rise just a little bit more than is discounted in the curve it will have a big negative effect on bonds and all asset prices, as they are all very sensitive to the discount rate used to calculate the present value of their future cash flows.

That is because with interest rates having declined, the effective durations of all assets have lengthened, so they are more price-sensitive. For example, it would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest are embedded in the pricing of all investment assets, that would send them all much lower.

Those words are from the most successful hedge fund manager of all time — Ray Dalio. When he speaks, we listen.

There is now more than $13 trillion — that’s trillion with a “T” — of global debt that offers investors a guaranteed loss if held to maturity. Investors are now partaking in what can only be described as the largest game of “Greater Fools” in the economic history of man.

Wikipedia defines greater fool theory as when “the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price.”

With over $13 trillion dollars (which is over half of all Western debt) held by bond owners that are assured to get a lower amount in return than their principal, I suppose we can all agree this is prima facie an example of GTF on a Godzilla scale. Here’s the following via the WSJ (bolding is mine):

The pull to par has become a drag: a buy-and-hold investor is guaranteed to lose money, even before taking inflation into account. The only way to make money is to find another buyer willing to pay a higher price—but that implies a bigger loss down the road.

The crucial thing to understand is that these instruments are no longer bonds—at least not in the traditional sense. With no income attached to them, they are simply bets on the price another investor is willing to pay. They will also be more volatile: the long wait for repayment means small changes in yield will have a big effect on current prices.

Dalio said at the top of this passage that “there is a limit as to how negative bond yields can go.” Those limits have been reached, so naturally that now leaves us with only one direction for rates to go… UP.

Sovereign bonds sit at the base of the capital structure. They’re considered risk-free and so they’re the basis for what all other assets (i.e., corporate bonds, high yield, equities etc.) are valued off of.

The financial system works off risk premia spreads, which is the difference in expected risk/return between different assets. We’re not going to talk much more about that here, but if you’re interested, you can read this piece we wrote on the subject. It’s just important to know that when the return on sovereign bonds falls, the risk-premia spread is widened, and riskier assets become more attractive. And the opposite occurs when the return on bonds goes up; the spread contracts and riskier assets become less attractive.

Well when interest rates across the entire western world have hit their lower bound and have only one way they can go, you can see how this becomes an issue for other assets like stocks.

To turn to Dalio again, “that is because with interest rates having declined, the effective durations of all assets have lengthened, so they are more price-sensitive. For example, it would only take a 100 basis point rise Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest rates are embedded in the pricing of all investment assets, that would send them all much lower.”

Goldman Sachs came out with a report not too long ago that showed that holders of US Treasuries would lose over $1 trillion should the Fed raise rates by just one percentage point.

That’s equivalent to 1/18th of our annual GDP that would be wiped off the face of this earth in the event the Fed raises interest rates by a measly 1%.

Oh, and that’s just here in the US where we still enjoy nominally positive real rates, unlike our counterparts over in Europe and Japan, who are sitting well below zero. There, a 1% rise in rates would wreak financial havoc. By Alex M., Macro Ops.

October was merger-mania month with a surge at the end: five of the largest 11 US-focused acquisitions in 2016 were announced in the last few days of October, including two that broke all-time industry records. Something weird is going on. Read…  Is Merger-Mania October the Classic Paroxysm before it All Comes Unglued?

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  27 comments for “How “Risk-Free” Bonds Will Trigger Bloodletting in Bonds, Stocks, other Assets

  1. mvojy says:

    Equities are over-valued and bonds are set for a tumble. Time to diversify in things that will always be in demand- canned soup and toilet paper.

    • Anon says:

      I am long toilet paper and letting my bond portfolio run off. I haven’t bought a bond since the great California muni bond sell off in 2010-11.

  2. Evidence that over-capacity is as much of a threat in the financial services sector as in the manufacturing sectors such as ship-building, automotive, cell-phones, or aircraft.

    As the old saw has it “If some’s good — more’s better — and too much is just enough.”

  3. Tom Kauser says:

    DB survives like licks on a tootsie pop?
    System needs everyone to stop licking!

  4. Kam says:

    Stating the trillion dollar losses that are a function of even a small rise in interest rates, is the ugly side of the math; that financial “assets” have inflated solely because Central Banks, by power of law, not markets, distort an otherwise functioning economy, where no one, and no bank is Too Big To Fail.

    Bring back Too Big to Exist.

    • polecat says:

      and ‘mark to market’ ……..

      ……. enough of the mark of the unicorn, I say !

  5. mike says:

    Corner the market on the Monopoly game, Its play money is going to be worth millions!

  6. NotSoSure says:

    I’ve just initiated a long position in SJB, which is short High Yield Index. Knowing my luck, this is probably going to cause the market to rally :)

  7. VK says:

    What’s the problem? FED’s got investors back, just QE those 13T in bonds. Money is just electronic digits now, Yellen can just copy and paste as much zombie money as she wants, the economy is just a bad hallucination at this point. No speculator shall ever face losses anymore! And the FED can never be insolvent as they can just ask the US Gov to issue bonds, that they then QE and request an injection from Treasury to recapitalise their losses. And inflation figures can always be cooked with none the wiser.

    • That $13 trillion is in non-dollar instruments, there is nothing Yellen can do.

      A reason for overpriced bonds is the ECB and BoJ have been (and still are) ‘copying and pasting’ zombie euro- and yen credit to the point where the process has become counterproductive/offers diminished returns.

  8. OutLookingIn says:


    ISM contracts for 3rd month in a row, weakest streak since 2009
    Stock Markets suffer from worst losing streak in 5 years
    ADP emplyment report sinks to weakest since April 2013
    Business investment swings to contraction
    Labor market conditions crash to 2007 level
    Corporate profits falling for 5 consecutive quarters
    Capital goods orders declining nearly every quarter since 2014
    Business conditions have declined to levels last seen in 2014
    Consumer confidence continues to fall dropping to 2014 levels
    Commercial & industrial loan delinquencies spike to 2009 levels
    Russell 2000 small cap index leading indicator is breaking down, now below long term uptrend.
    Gold & silver price holding uptrend

    Recession imminent.

    • Meme Imfurst says:

      You forgot Obamacare…that will make Christmas presents apples and lumps of coal.

      So to help offset that rising costs of everything while incomes draw down, I have a new idea for our great President to consider. The Affordable Airline ACT or AAA for short. It goes like this:

      The cost of airline tickets has skyrocketed, so to speak. And, the benefits have been chipped away one by one…drinks, baggage, pillows, peanuts.

      The new bill to be presented to Congress will fix the problem, the Affordable Airline Act aka AAA.

      Everyone who is not an employee of an airline must sign up for the program. If you own your own plane you can still keep it, restrictions apply.

      There will be Ticket Exchanges – the government-regulated, state-based ticket service with affordable plans set up as part of the act.

      This will be a great program for those who travel for business or pleasure to finally get the service they need at an affordable price and at the same time guarantee the airlines full planes.

      Anyone who opts out will be required to pay a fee of 10% of their unadjusted gross income or $600 if you are on welfare or have no income at all. Children under 16 except for now.

      The plan encourages young people to sign up and avoid the penalty fee, even if you are not going anywhere for many years to come.

      Lets get this done!

    • NotSoSure says:

      What about this?

      Gallup U.S. Job Creation Index, October 2016: “American workers’ reports of hiring activity at their place of employment remained relatively strong in October, with many more saying their employer was adding rather than subtracting jobs” [Econoday]. “For nearly all of Gallup’s JCI trend since August 2008, net hiring in the private sector has far outpaced government net hiring. But the latest poll shows the narrowest gap between net hiring in the two sectors since April 2009, with nongovernment hiring (plus 32) essentially tied with government hiring (plus 31).”

      • OutLookingIn says:

        Yes. The Gallup JCI survey does deserve some credence of fact. However, both the Gallup and government numbers do not approach the increase in population that has occurred since 2009. Which essentially voids any claim of an increase of the job pool, since many more workers are seeking a dwindling number of new openings.

        Just looked under the hood at the numbers just released by the Commerce Department on Manufacturers Shipments, Inventories, and Orders. This is nothing more than touchy, feely good window dressing prior to the election.
        Factory orders up 0.3% (three tenths of one percent) due to an increase of cars (channel stuffing) and car parts. Hardly an economically robust metric, considering Core Capital Goods demand has fallen 1.3% over the same report period.
        Surveys are just that. Surveys. Along with poor reports that are cherry picked by the MSM for the bright spot only, no matter how weak that is. For hog feed, fed to that portion of the populace that is hopelessly lost in the MSM propaganda fog.

  9. economicminor says:

    I was out and about yesterday and walked thru some stores in our area mall. I was appalled at the prices they wanted for simple clothing and other things. I’m glad I didn’t need anything. The other thing that stood out was the number of empty store fronts.

    Why I mention the above is that all this debt has to be repaid or repudiated or at least restructured but I think restructuring is probably out of the question for most because the lender just isn’t in any position to take the losses. So what happens on Main Street is that costs go up (and the prices asked) even as sales go down and eventually there is no way to cover the overhead.

    So existing businesses are crushed even while new strip malls and new stores are being built (by big retail). None of it makes any fundamental sense to me. It seems they are trying to suck water from a rock or blood from a turnip.

    It is all about timing and I just wonder how long all this can continue. The S&P 500 hasn’t gone anywhere in two years. It would seem to me that it is probably in a long term distribution and that the next move after all this time could be really dramatic.. All we need is a catalyst.

    • Ivy says:

      That mall store pricing situation makes me think that the remaining anxious survivors are marking up prices similar to how stocks climb a wall of worry. The bust comes as day follows night. Stores seem to be in their own price discovery mode out of desperation, hoping that shoppers may spring for some overpriced item, to make the rent and cover expenses. How many of those price discovery stores are short-staffed and running on fumes?

      • Petunia says:

        There is a lot of substitution of inventory to lower cheaper quality as well. I don’t shop much, but try to buy good quality clothing during sales. The stores I like are switching to more synthetic cheaper fabrics and trimmings, a real no no with me.

  10. walter map says:

    “That’s equivalent to 1/18th of our annual GDP that would be wiped off the face of this earth in the event the Fed raises interest rates by a measly 1%.”

    So either NIRP/ZIRP policies stay in place, enabling all manner of financial speculation and big bank profiteering, or the economy goes back to where it was with the last meltdown.

    Think of it as a hostage situation.

    Banksters: “Give us what we want or we crash the economy.”

    The combination of economic and political power in the same hands is a sure recipe for tyranny.

    – Milton Friedman

    When the going gets weird, the weird turn pro. And some of them become banksters.

    • Al says:

      I opt to crash the economy, jail banksters, responsible politicians (do we have so much extra room in jails?!?) and start over…

  11. Tom Kauser says:

    13 trillion in negative yielding bonds means they are all owned up. Investors pushed down rates by BUYING bonds and prices stay high because no one is selling? This condition is over thirty years in the making and once the Fed started owning everything someone had to suffer?
    4000 days of interest rates are going up and yet nobody is selling?
    Our economy suffers from a lack of functioning markets because of hoarding of debt instruments and these guys live it.
    The fed has to eventually sell this paper to these fellas but they want a better deal? So they jawbone john q. To death!

  12. Petunia says:

    I think I’m about to go on a Kitten Lopez style rant…

    First of all, the lowest a bond can go is not an interest rate of zero. It is a price of zero. Bonds can crash into nothingness…

    Then there is the issue of sovereign bonds. I recall Russian bonds defaulting back in the 90’s and taking the entire bond market down. Oh, and the equity markets too. If you think sovereigns don’t default, check that one out.

    Those MIT Nobel prize winners over at Long Term Capital Management, who thought they could hedge any risk were proven wrong, when all the liquidity dried up for their out of the money positions. They made the mistake of thinking they would find buyers in a down market….

    And now everything is different, why?

    • Wolf Richter says:

      Let’s clear up some things here.

      The PRICE of a bond going to zero = bankruptcy with 0% recovery = total annihilation of capital.

      This by definition is not possible with sovereign bonds issued in the currency of the country because the country will print more money to redeem the bonds at face value (perhaps crushing the currency in the process). But face value is maintained. The US and Japan are example of this.

      Eurozone countries issue bonds in a currency that they cannot print on their own, so they’re dependent on the good will of the ECB to print money and buy their bonds, which it doesn’t always do, see Greece.

      Many countries with rapidly depreciating currencies (Argentina, Mexico, etc.) issue bonds in foreign currency ($,€,¥, etc) because they can borrow a lot more cheaply that way. But they cannot print these foreign currencies, and so they can – and do – default on these foreign currency bonds. But countries cannot seek bankruptcy protection, so in the end some kind of deal (including bailout) is worked out. See Greece, Argentina, and Mexico.

      The YIELD of a bond going to zero (or negative) = bond BUBBLE = the opposite of the PRICE going to zero… and that’s where things are these days, and that’s what the article described … a gigantic bond bubble and what happens when yields begin to rise just a little bit.

      • walter map says:

        At this point one could produce the proof that pegging ones currency to a foreign currency could make a disaster out of trying to run an independent fiscal policy, but with so many other ongoing disasters that sort of disaster would be lost in the noise, so I shall forego producing such a proof.

        All one really needs to know is that bonds really, really suck these days.

      • I personally would like to see the US government ‘print money’ and use it to start breaking up the banking cartel. The government still has authorization to issue something like $360 million in US Notes (which are not in circulation). A first step would be to authorize a larger issue, something like $800 billion per year.

        Of course, the government ‘printing’ its own money is repudiation by other means. It would throw the banking cartel into chaos; if the government can change the rules (that favor the cartel) in the middle of the (looting) game, what else can the government do? They might even go so far as to jail bankers.

        The bankers would retaliate by freezing credit; ATMs would shut down and grocery stores would be emptied out in a matter of hours. Gas pumps would not spew forth precious gasoline. Drivers would become outraged, a revolution would break out! “Who do you think you are?” growl the bankers to the government, “we rule not you.” The government would surrender!

        That’s kinda what happened in Greece and the Greek government never even considered producing fiat euros. Just shows you how unimaginative Varoufakis & Co. were.

        When the central banks make loans (‘buy’ bonds) they themselves borrow the funds from commercial lenders they are compelled at some point bail out: why? By (re)lending they are in effect ‘laundering’ the banks’ lack of good collateral => the loans are effectively unsecured => the entire finance system not just commercial banks becomes insolvent … the US and Japan are examples of this.

        : )

      • Petunia says:


        Your explanation of paying off sovereign bonds with worthless hyper inflated money may be legal, but it is the equivalent of a default nevertheless.

        All those bonds sold on thin or negative spreads have to be purchased in huge volume to make any money. Even if everything goes their way, they will all be trying to exit at the same time, and will there be liquidity out there to absorb them. I don’t think so.

        As far as sovereign defaults that are reorganized, the original investors always take a beating, so a default of sorts in any case.

        In all these cases the economies of entire countries are affected. While these bond traders are playing master of the universe, real people are losing money, losing jobs, and losing control over their property. I think of it as pseudo investing or make work programs for Wall St.

  13. Ishkabibble says:

    In the near future, we at the living end of human existence are going to be the ones to finally discover if a certain widely-accepted “given”

    is not only true, but, after the living Elite’s post-’09, “flying by the seat of their pants” ongoing political / economic experiments inevitably result in either another “financial crisis” or WW3, just exactly WHAT will we and the people of the future accept as an alternative to outright barter, if any “thing”?

  14. ambrose bierce says:

    same argument as negative rates, what if the rate of deflation exceeds the surcharge from holding a negative rate bond. a bond loses 2% the stock market loses 20%, who wins? in outright deflation you could lose half your portfolio and still be a winner.

Comments are closed.