by Dave Kranzler, Investment Research Dynamics:
I saw a thought-provoking retweet on Mark Yusko’s twitter feed and I wanted to clarify the idea conveyed: “When bonds yields nothing, they aren’t much different than currencies.”
This comment is somewhat misleading because bonds are indeed a derivative of currencies. It’s basic financial economics that Mark Yusko learned in the same Robert Leftwich finance course at U of Chicago that I took.
The tweet references sovereign-issued bonds. Sovereign bonds are simply a sovereign’s currency issued to investors who are willing to bear the “time value” risk connected to the sovereign, where “time value risk” is the sum of “credit risk” – the risk of getting repaid – and “opportunity cost” – the foregone cost of spending that capital now or investing it in an alternative asset that might yield more.
Together, in a free market, those two costs equal the interest rate of a sovereign bond. From there, all bonds that are priced off the sovereign bond curve are 2nd order derivatives of a sovereign currency. In that sense all bonds are a derivative of currencies.
Quantitative easing – when a Central Bank prints money and uses that money to buy sovereign bonds for the purpose of controlling interest rates – removes the market’s ability to price “time value risk.” Western sovereign bonds have been driven down to zero – below zero on a real interest rate basis. Western sovereign bonds arethereby simply interchangeable with a country’s currency. There’s almost no difference between holding cash or holding a 30-day T-bill , or even a 2-yr Note, other than the inconvenience and transaction cost of buying and selling the bond.
The point of this is to reflect on the fact that bonds are indeed currencies – currencies with the added feature of time value risk. An investor buying the bond is willing to exchange current spending/consumption in order to lend money to the sovereign issuer. The interest rate is the amount paid to bear the time value risk. The interest earned is paid in more of the sovereign currency.
QE has destroyed the market’s natural function of pricing time value risk into the capital markets which in turn has reduced most bond investments to the equivalent of holding currency in the pocket sans the benefit of compensation for bearing time value risk. This has in turn forced a flood of money of Biblical proportions into the the non-currency assets that are moving higher at the greatest velocity – primarily stocks. Right now primarily tech stocks.
Eventually the QE intervention will fail – it always fails and history has confirmed this fact ad nauseum. When that failure occurs, and I believe that point of failure is closer than most are willing to accept, there will be an asset crash of Biblical proportions.