Would you Buy a Bond with a Negative Yield?

On Tuesday Oct 25, 2010 a 5-year US Treasury TIPS (Treasury Inflation-Protected Security) bond was sold to the public at a yield below 0%. In other words, the investor is paying the difference between the negative yield and 0% (this happens via the purchase price) for the privilege of getting his or her money back. How could this be, and what are they thinking?

First, there is no way such a yield could occur in normal markets. In this case the manipulation is being carried out as one part of a 2-prong tactic by the US Treasury. The reason we care, is that Treasury these actions get translated throughout world markets. These translations, or effects, involve (a) interest rates charged within various countries and (b) impact the relative value of currencies in relation to the USD.

Let's take as an example the pump price of gasoline at the present time in Ontario. With minor location variations it has already risen above $1/L. There is no scarcity of physical supply. North American and European economies are weak. The summer driving season is at an end. New vehicles get better mileage. So the current demand outlook is not a source of pressure.

Since the US Treasury began suppressing interest rates and at the same time introduced "quantitative easing" (QE1, flooding the banks with cash but ensuring by regulatory changes that bank lending to most individual and business customers cannot be easily expanded) the US dollar has lost about 20% of its relative value when compared to proxies for the US dollar, such things as oil (energy), gold or copper. The basic prices for these things are denominated in US dollars.

A foreign exchange effect occurs when countries with strong positive trade balances with the US see their currencies rise in terms of the US dollar. China's own intervention in currency markets has put a braking effect on its rate of increase. If the RMB were to rise as quickly as the dollar has fallen is seen as a threat to social stability within China.

Canada should be in a pretty good place. Its strength but also its Achilles heel, is its geography, its location on the planet. Our trade patterns have lead to deep integration with American business and consumers. But unfortunately, our export firms get paid primarily in US dollars rather than for example, RMB. It is very difficult to create massive substitute demand, at competitive prices, from elsewhere in the world - especially in the complete absence of any strategic Canadian plan to do so. The National Oil Policy was attacked and tanked years ago.

The public often feels pleased when the Loonie moves toward par. Great to visit Buffalo. But since the US dollar has been sinking at a high rate, the reality is that the Loonie's purchasing power of products or commodities whose values are in process of de-linking from the US, is higher prices here. Welcome to $1.04 gas.

The second phase of quantitative easing, QE2, is about to begin as quietly as possible. What is the end-game of this strategy? Certainly not the same thing as any government public policy statements. The US is far beyond its ability to pay back money it has borrowed from the rest of the world (retire its debt as it matures). This especially true when it needs to restructure its internal and individual state financial problems.

An interest rate increase on debt sold abroad would seriously worsen the problem. Super-low domestic rates forces those dependent on investment income to look elsewhere - invest in stocks or (hopefully) in real estate sufficient to arrest its slide. The proof of this is that many stocks now have yields higher than the bonds of the same companies. Without market manipulation this could never happen.

At this point it becomes clear that the chosen method of reducing US external debt is to export inflation worldwide. The object is to pay external debt obligations (which are not inflation-protected) in electronic dollars of greatly reduced value. If the US dollar were not the principal world reserve currency, the US would be forced to default as in the case of Argentina. Canada cannot simply let its own currency appreciate to the point that the US sources elsewhere.

The Treasury maintains that when the world, and especially the US recovers from its balance sheet and related domestic employment crisis, it will quickly switch gears and rein in the ensuing inflation. Failure to do so would risk hyperinflation.

Easy to say, but no modern major industrial country has ever done it, regardless of the effort.