American hard money advocate, economist, and publisher Franz Pick once called government bonds “Guaranteed Certificates of Confiscation.” In making that statement, he assumed the government would eventually inflate the debt away and thus confiscate the buyers’ purchasing power.
Yet here we are, with U.S. Treasury Bonds holding steady despite seven rate hikes by the U.S. Federal Reserve, huge increases in the supply of bonds, and inflation on the rise. The obvious question is, why?
The reason why government debt keeps increasing and yields are more or less stable isn’t because of the fundamentals of the debt, deficit, or the economy. Instead, it is because the rules of the bond 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, which include a special set of winning cards called “The Gamboni.” He therefore loses and goes broke. The moral of that story: 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 percent. This was their first rate hike in seven years.
At that time, the yield on the 30-year Treasury Bond was 3 percent. Since then the market has absorbed an additional six rate hikes in the Fed Funds rate, but as of July 3, the yield on the 30-year was still only 2.96 percent. In fact, the highest yield we’ve seen since the initial rate hike has been 3.25 percent on May 14, 2018.
With President Donald Trump and Congress 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 and higher inflation? Back in the days of quantitative easing (QE), we could rationalize this phenomenon with zero interest rates and the Fed buying up most of the new supply. Now, the Fed has stopped buying and is not rolling over maturing bonds. The Chinese and the Russians have stopped buying in size.
But if yields are stable, there must be a strong and relentless buyer of Treasury bonds. And given the fundamentals, this buyer, like the Fed, must be a noneconomic buyer who doesn’t care whether yields rise in the future or not.
As it happens, the biggest buyers of Treasury debt are commercial banks (CBs). Just when the Fed started tapering its purchases in December 2013 and left some issuance for private players to absorb, their Treasury and agency holdings started to skyrocket, from $1.8 trillion to $2.55 trillion, as of July 2018.
In the meantime, the Fed has only reduced its balance sheet by $210 billion since the beginning of 2015, between Treasurys and mortgage-backed securities. Between 2015 and now, the Treasury and agency holdings of private banks went up by almost $500 billion, making up for Fed or any foreign selling.
But again, the question is, why? Why are CBs buying so many Treasury bonds with year-over-year inflation at 2.8 percent, the highest since January 2012, and with the current Federal Reserve “dot plot” predicting the Fed Funds rate going to 3.25 percent by the end of 2019? All those factors point to losses on Treasury bonds and banks at least try to stay profitable, although that goal sometimes fails spectacularly, as we have seen in 2008.
The Banks and Their House Rules
Now, remember The Gamboni and the house rules, which are different from normal poker rules. 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:
- What are the reserve requirements for U.S. government debt owned by a CB?
- What are the mark-to-market rules for government debt owned by a CB?
- Where does a CB get the funds to buy government debt?
- What are the Basel III capital requirements for government debt owned by a CB?
Believe it or not, the answers to these questions are
- They are not marked to market.
- It creates the money out of thin air.
Since there are no reserve requirements for the government bonds or the matching Treasury deposits at the CBs, the rising Federal funds rate doesn’t affect them. The same goes for the risk-weighted assets for the Basel III capital ratio calculation. The risk weighting is zero, so in theory, banks could expand their balance sheet by infinitely buying government bonds and still not have to put up additional capital.
The really interesting part is skirting around mark-to-market accounting, though. 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 prices of the bonds fall, the bank reports no decline in the value of the debt, which means no negative effect on quarterly earnings. 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-market losses entirely.
It’s a complex formula to follow through the different Treasury and Fed accounts, but in effect, government debt is considered risk-free and therefore can be held without reserve or capital requirement, and without mark-to-market risk. That is because it falls under the applicable guidelines that meet the description of the Basel Committee of the Bank for International Settlements (BIS):
“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 zero percent 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.”
This would be Mayer Amschel Rothschild’s—the original European arbitrageur’s—wildest dreams come true. Since 97 percent of fiat currency is loaned into existence by commercial banks creating loans through the fractional reserve banking process, the money supply continues to grow. Not only can CBs create fiat currency from nothing, but they can buy U.S. government debt with that money and keep the interest to make a risk-free profit, which even adds to the CBs’ capital.
In fact, the CBs will be happy the Fed isn’t buying up all the issuance anymore so they can also have a slice of the profit.
At maturity, the government will print money or tax the citizens to pay off the holder of the debt, or simply issue new debt, so no risk exists for the CB.
You can see how this elegant scheme is similar to a Three-card Monte dealer’s sleight 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, the Treasury can issue new debt and pour it 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 percent on money created out of nothing. It’s the Gamboni principle with a powerful government twist.
There are many who believe bonds will go down due to increased supply and yields go up if all other factors remain the same. But they do not understand the rules of free money for commercial banks thanks to the set up of the fractionally reserved banking system.
Perhaps the words of Josiah Stamp, the 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.”
Victor Sperandeo is a member of the Trader Magazine Trader Hall of Fame and the author of “Trader Vic: Methods of a Wall Street Master.”