Trader Vic and I will be chatting later this week but in the meantime I wanted to share an article he recently wrote focused on the bond market.

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Franz Pick once called government bonds “Guaranteed Certificates of Confiscation.”  In making that statement, he assumed the government would eventually inflate the debt away.  Yet here we are, with U.S. Treasury Bonds holding steady despite seven rate hikes by the U.S. Federal Reserve and huge increases in supply.  The obvious question is why?

In early February of this year I wrote a piece pondering the question “Has Debt Reached its Tipping Point?”  The answer appears to be no. Again, one has to wonder why?

The reason for both is not due to fundamentals of the debt, deficit, or the economy.  Instead, it is because the rules – which have changed the game – are written by the banks, for the banks.

In my first book, “Methods of a Wall Street Master,” I introduced “The Gamboni.”  Joe is a skilled poker player, but when he sits down at a new game, he has not learned the rules of the house.  He therefore loses and goes broke. The moral of that story was: if you want to win a game, you have to know the rules.

This moral holds true today and is especially applicable to the bond market.

First, some context. In December 2015 the U.S. Federal Reserve raised the Fed Funds rate from zero to 0.25%.  This was their first rate hike in seven years. At that time, the yield on the 30-year Treasury Bond was 3.00%.  Since then the market has absorbed an additional six rate hikes in the Fed Funds rate, but as of July 3rd the yield on the 30-year was still only 2.96%.  In fact, the highest yield we’ve seen since the initial rate hike has been 3.25% on May 14, 2018.

With President Trump throwing the kitchen sink of goodies into the economy, including huge deficit spending and tax cuts, after 109 months of economic growth long-term bond yields are lower than they were in December 2015.  Why is this the case, in the face of positive economic data and faster growth? Obviously, someone is a strong and relentless buyer of these bonds. As it happens, the biggest buyers are Commercial Banks (CB’s). But again, the question is why?  Why are CBs buying so many Treasury Bonds with inflation at a year-over-year headline high of 2.8% since January 2012, and with the current Federal Reserve “dot plot” predicting Fed Funds going to 3.25% by the end of 2019?

Remember the Gamboni.  The mystery is solved when one understands the rules of the game. Here are the questions you need to ask if you want to learn the house rules:

1. What are the reserve requirements for U.S. government debt owned by a CB?
2. What are the mark-to-market rules for government debt owned by a CB?
3. Where does a CB get the funds to buy government debt?
4. What are the Basel 3 capital requirements for government debt owned by a CB?

Believe it or not, the answers to these questions are:

1. Zero.
2. They are not marked to market.
3. It doesn’t need any.
4. None.

Since the banking crisis, banks have been permitted to hold assets in a special account called an HTM Account, which stands for Held to Maturity.  Government debt held in this account is not marked to the market. So even if interest rates rise and the price of the bonds fall, the bank reports no decline in the value of the debt.  But it still gets to collect the interest. Since early 2014, CBs have been routinely shifting greater and greater portions of their government debt into these HTM accounts, avoiding accounting for any mark-to-marked losses entirely.

The official HTM account treatment is as follows: “Debt held to maturity is classified as a long-term investment and it is recorded at the market value (original cost) on the date of acquisition. All changes in market value are ignored for debt held to maturity. Debt held to maturity is shown on the balance sheet at the amortized acquisition cost”.  By contrast Trading Securities and Available for Sale (AFS) Securities are debt and equity securities held principally for selling them in the near term. They are reported at fair value, with unrealized gains and losses included in earnings.

Basel II and III

It’s a complex formula to follow, but in effect government debt is considered risk-free and therefore can be held without reserve or capital requirement, and without mark-to-marked risk.  That is because it falls under the applicable guidelines that meet this description:

“Marketable securities representing claims on (or guaranteed by) sovereigns, central banks, PSEs, the Bank for International Settlements, the International Monetary Fund, the European Central Bank and European Community, or multilateral development banks, and satisfying all of the following conditions:

• assigned a 0% risk-weight under the Basel II Standardized Approach for credit risk;
• traded in large, deep and active repo or cash markets characterized by a low level of concentration;
• have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions; and
• not an obligation of a financial institution or any of its affiliated entities.

where the sovereign has a non-0% risk weight, sovereign or central bank debt securities issued in domestic currencies by the sovereign or central bank in the country in which the liquidity risk is being taken or in the bank’s home country; and where the sovereign has a non-0% risk weight, domestic sovereign or central bank debt securities issued in foreign currencies are eligible up to the amount of the bank’s stressed net cash outflows in that specific foreign currency stemming from the bank’s operations in the jurisdiction where the bank’s liquidity risk is being taken.”

Yes, this is called an arbitrage; it’s Mayer Amschel Rothschild’s dream come true. Since 97% of fiat paper currency is loaned into existence by creating debt by the banks, and then the banks creating loans, the money supply continues to grow.  Not only can CBs create fiat currency from nothing, but they buy U.S. government debt with that money and keep the interest (which adds to the CB capital).

The logic from regulators is that the Government will create money and/or tax the citizens to pay off the holder of the debt at maturity, or simply issue new debt at that time.  So, no risk exists.

You can see how this elegant scheme is similar to three card monte dealer’s sleights of hand.  In this case, the government is the card dealer, and makes the rules. This is why the Federal Reserve can sell government debt from its portfolio, while at the same time new debt is poured into the market, and yields do not go up even if China and other foreign markets fail to join in on the buying.  Every 30-year Bond gives a CB buyer a profit of 3% on money created out of nothing. It’s the Gamboni principle with a powerful government twist.

So those who believe bonds will go down due to increased supply (if all other factors remain the same) do not understand the rules! As far as I can determine, the only major risk to this scheme is an unexpected geo-political event.

Perhaps the words of Josiah Stamp (Director of the Bank of England in 1928) are worth revisiting?

“Banking was conceived in iniquity and born in sin… Bankers own the Earth. Take it away from them but leave them the power to create money, and, with the flick of a pen, they will create enough money to buy it back again… Take this great power away from them and all the great fortunes like mine will disappear and they ought to disappear, for then this would be a better and happier world to live in… But, if you want to continue to be a slave of the bankers and pay the cost of your own slavery, then let the bankers continue to create money and control credit.”