So, first off my standard disclaimer:
I am an idiot. I do not do this for a living. You must make your own decisions and do not follow me blindly. I’m also an awful speller, so if you get triggered by that, you have come to the wrong blog. Spell check will be used liberally in an attempt to cover up that aspect of my writing =).
The price of money.
For purposes of this argument, I am going to talk about bonds (US Treasuries) vs other forms of assets (fixed rate or market-determined). If I screw up and interject notes or bills, in the end, I am broadly talking about Treasuries so the concept is the same.
To understand anything else about the entire view I hold, I need to explain and expand my views on money.
Money is a triad
We live in an entirely debt-based monetary system. This is true of the entire world post-1971 when Nixon closed the gold window for good.
In a system where debt is the only form of collateral that underpins the value of fiat, currency cannot be created without issuing such debt by an entity with the authority granted to them (by the government regulatory apparatus) via a banking license.
Let me repeat. The issuance of debt is necessary in order to create money. Full Stop. So two legs of this triad are debt and the currency that debt is “priced” in from the private market.
So in such a system, it is impossible to expand the availability of currency without expanding the debt. And if the debt is repaid, it extinguishes that currency from the system, thereby reducing the supply.
The third leg is an abstract concept called duration. Apologies to people who understand bonds at a higher level than I do if I butcher concepts, but I am trying to dumb things down here for the purposes of my own understanding.
Duration is most easily explained (to my own brain) as the time it takes for the bond to mature and your principal to be returned. But in the case of debt, it is the structure and repayment schedule of a bond, which is then measured against other instruments of similar quality at different repayment schedules.
The sooner you get your money back with interest, the less duration risk you have. In many ways, I look at duration risk as the risk of being tied up in a bond vs being able to invest in something else.
The relative value of “risk-free” vs “not-risk-free”
It is generally accepted (by me, if no one else) that if you lower rates, demand for new financing rises. And it is generally accepted that if you raise rates, demand for new financing becomes constrained by people's ability to service that loan and afford the payments.
But what if I lend money out for 2 years at 2% yield, but the market explodes and grows by 8%? I could have put my money in the SPY for that entire time and likely earned more through equity price appreciation vs the interest payments on the bond (the coupon).
So in many ways, this duration window we are looking at is relative to other opportunities. If I can earn WAY more money elsewhere, and I am comfortable with the risks vs just owning the Treasury, I would consider investing in that opportunity instead of buying that boring ass T-Bond. This is the concept of risk vs reward.
But, what if the outlook is not quite so robust for growth?
What if the price of a Treasury is paying something very close to my estimation of other opportunities in risk vs reward terms? Then despite the risk option being slightly more attractive, I may just decide to stick with the Treasury because the spread is not GOOD ENOUGH to warrant the risk.
Thus, even in a very low rate environment, my desire to own a Bond vs another asset may be tilted towards the bond if I am concerned that the risk is too high to warrant owning something else. Sometimes, you are trying to lose less value than the other person, instead of making more. Why? To live to fight another day in hopes that you can find an opportunity in the future that is worth jumping into.
At the end of the day, there are times when it makes no sense to own risk, and there are times when it makes no sense to own bonds. The yield on Treasuries is only relative to the opportunities out in the market to make more money RELATIVE to that risk-free rate.
Supply and Demand and how different risk-taking appetites come together to form a market that prices money “correctly”.
Not all investors have the same goals, risk appetite, or buying and selling patterns. The market is unfathomably complex and because we do not know all of the players and all of the flows all of the time, we are left to guesstimate as to what is going on through a variety of data, narratives, and frameworks designed to discover the “who/what/where/when/why/how” of things.
It is this complexity, and how we attempt to dumb it down so that we can understand it, that forms the disconnect between competing views on finance. I am no exception here. So it is important to remember that if this topic was understood, there would be a consensus and we would have very little volatility in a given market.
But at the heart of the Treasury market (like all other markets), there is a supply and demand dynamic that makes everything work.
The supply of Treasuries is controlled by the US Government thru the Treasury, which is the only one allowed to issue US Government debt.
The market is freely traded, so the various entities that make up the demand may bid in equal standing on the debt on offer.
The repayment of this debt is guaranteed by the United States and all of the power that the US Government can muster. Our economy, our military, our institutions, and our taxpayers all serve as a backstop to guarantee that debt. We issue the currency that debt is denominated in through licensed intermediaries known as banks (keeping it simple for this article and treating banks and primary dealers as 100% interchangeable), who are responsible for creating the market for US Government Treasuries.
Primary Dealers and their role:
What banks actually do is attempt to correctly “price” the issuance of debt and as such, the correct “price spread” between TODAY’s US Dollars and TOMORROW’s US Dollars.
Aiding them in this effort is a public auction held every month by the Treasury for each tenor (2Y,5Y,10Y, etc). Anyone who has US dollars may come and bid in a competitive blind auction on this debt.
But any debt NOT purchased by the wider marketplace MUST be purchased in full by the Primary dealers. In turn, the Primary Dealers bid on this debt too in a competitive auction, so if they highly desire the debt they may bid at a lower yield. And if they do not wish to own this debt, they may bid at a higher yield to compensate them for the risk they are taking by using up balance sheet space by owning this debt vs the other opportunities available to them.
This is important. If a bank does not want to own Treasuries, it can raise its yield bid at auction to a level that it feels comfortable paying for that Treasury. If NO ONE wants Treasuries, the yield will rise to a level that Primary Dealers feel comfortable owning treasuries vs owning something else on their balance sheet. The pure risk vs risk-free spread.
But if a bank sees nothing out in the wild that is worth the cost of carrying on its balance sheet, it will lower its yield bid for that debt because the system makes holding Treasuries desirable from a risk perspective. See Basel III rules for additional info.
Non-Primary Dealers:
Why would anyone want this debt besides a primary dealer? In short, because governments don’t work with the same rules that you and I do when we try to balance our finances. This debt has a very high probability of being repaid in nominal terms. To elaborate:
It has some degree of scarcity. I will pause here for laughter before explaining.
The US Government via the Treasury is one branch of the Government and does not unilaterally decide how much debt to issue. Congress passes laws that require expenditures that must be borrowed or paid for from taxes. The Treasury is tasked with being the government bookkeeper and goes out to ensure that the laws Congress passes are properly funded.
But Congress ultimately controls every dollar spent by the United States. The treasury makes sure that the government's liabilities are serviced on time. While the US has been deficit spending for a very long time, it does not produce an entirely unlimited supply of debt at any one period of time. The debt has a ceiling by law enforced by Congress, and the Treasury must keep the debt issuance in and around that level.
This debt has interest. And because the United States issues the currency (through licensed primary dealers who independently manage assets and liabilities for profit), it is actually very hard for this debt to default absent politicians intentionally self-sabotaging the country. While the real value of the currency may not remain constant, the nominal value of a Treasury Bond is highly likely to be honored and repaid, if not thru taxes then thru additional borrowing.
The government has set up the system to work in perpetuity, with its only limiting factor on how much it can borrow is the consequences of its own spending in future demand for additional debt issuance relative to other fiat currency systems and hard assets sold into the market place in exchange for fiat currency.
The United States has an abundance of things going for it, despite what recent history may lead you to believe. Compared to every other country in the world, it has the most variety of positive things going for it when it comes to judging if the country as it exists today will be here tomorrow. So it has the lowest counterparty risk (warning: believed rule, but one that is more true than false).
To sum up, while there is a multitude of reasons to buy or sell Treasuries, one of the most important considerations is the relative value between owning them vs owning something else. Everyone approaches this question with their own view, and the combination of participants serves to form a marketplace by which the “market” expresses the consensus view of where the “risk-free” rate is. That is the price of money, in summary, and it is represented as an interest rate paid in exchange for the bond.
But that interest rate is not an absolute value that must answer to inflation or growth alone. It is relative to what the market can bear, and the entirety of financial conditions everywhere influence what that rate actually settles at.
The entire world is relative, not absolute, and this is very important when trying to understand how everything works.
I will cover this point in a follow-up article.