May 10, 2015
The Globe and Mail
Don Coxe: It’s time to rethink the supposedly safe bond market before it’s too late

Worried about stocks?

Maybe you should be worrying about bonds.

Since the crash forced central bankers to put the global economy on life support, the supply of publicly traded debt has been increasing faster than the numbers of Black Death victims during the 1340s.

That bond yields have been declining while supplies have been soaring is largely due to buying by central banks, with help from private investors worried about the stock market, particularly retirees.

The Fed has quadrupled its balance sheet, and the European Central Bank is committed to buying €1.6-trillion ($2.2-trillion) in bonds from its member nations. The ECB is making those purchases even as bond yields for many of its member countries fall below zero. The U.S. national debt has doubled since the crash, and countries across much of the world have been levering up in similar fashion.

Those low rates were meant to stimulate economic growth, but they have, to date, done more to boost prices of stocks and homes than GDPs. Corporate America is selling bonds at record rates to buy back its shares – but not to spend on growing its businesses.

As the Bank of Canada has been lamenting month after month, lower and lower mortgage rates mean higher and higher home prices, and rising home prices mean even more borrowing as the central bank is forced to cut its rate in response to a slowing economy and plunging oil prices. In the U.S., the supply of junk bonds keeps climbing as retail investors rush to buy product that has a yield that used to be restricted to Treasury bonds, but is more than double today’s rates on Treasurys.

Last autumn, there were two “flash crashes” in the U.S. bond market that would have triggered stock market crashes if they had lasted even hours longer. According to JPMorgan Chase & Co.’s CEO, Jamie Dimon, those sudden bond plunges were so huge that they should only happen every three billion years. (That shows Wall Street still uses the same elegant – and preposterous – risk-modelling techniques that helped trigger the crash of 2008. There weren’t even dinosaurs three billion years ago – let alone banks and bonds.)

We have been arguing that the bond market has become riskier than the S&P 500 – which is certainly overvalued. Why?

In past crashes, the Fed and other big central banks moved swiftly to lower rates. But with the Fed’s rate at virtually zero for overnight loans and the ECB’s at negative yields, it is unclear how successful the rescuers will be when the Big One arrives. (Both the Bank of England and the Bank for International Settlements flatly assert a Big One is coming … some time.)

Thanks to the 2,000 pages of Dodd-Frank passed when the Democrats still ran Congress, U.S. banks are now subject to so much regulatory scrutiny and red tape that only big banks can afford the lawyers, lobbyists and accountants required to continue to participate in warehousing and trading non-Treasury bonds. The result: Many of the thousands of small and medium-sized banks, whose combined operations have long helped provide liquidity for the corporate bond market, have been merging or closing.

For the first time since Alexander Hamilton’s day, almost no entrepreneurs want to set up new banks. Only one new bank has been incorporated in six years: the Amish Bank of Bird-in-Hand that has a special service Hamilton would have applauded: a window for transactions with customers in horse-drawn buggies.

The horses and buggies will survive, but the bugs in the U.S. and euro zone banking systems might some day mate to spawn a global financial pandemic.

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