As you know, I’ve been calling for a bond market crisis for months now. That crisis has officially begun in Greece, a situation that we addressed at length other articles.This crisis will be spreading in the coming months. Currently it’s focused in countries that cannot print their own currencies (the PIIGS in Europe, particularly Greece).
However, China and Japan are also showing signs of trouble and ultimately the bond crisis will be coming to the US’s shores.
Modern financial theory dictates that sovereign bonds are the most “risk free” assets in the financial system (equity, municipal bond, corporate bonds, and the like are all below sovereign bonds in terms of risk profile).
The reason for this is because it is far more likely for a company to go belly up than a country.
Because banking today operates under a fractional system, banks control the amount of currency in circulation by lending money into the economy and financial system.
These loans can be simple such as mortgages or car loans… or they can be much more complicated such as deriviative hedges (technically these would not be classified as “loans” but because they represent leverage in the system, I’m categorizing them as such).
Bonds, specifically sovereign bonds, are the assets backing all of this.
This is the ultimate backstop for over $700 trillion in derivatives. And a whopping $555 trillion of that trades based on interest rates (bond yields).
With that in mind, the bond bubble has already begun to burst. The fuse was lit by Greece, but it is already spreading. The Federal Reserve is well aware of this situation, which is why it continues to hem and haw about raising rates, despite the fact that we are now six years into the “recovery.”
True, the Fed could raise rates this year, but the fact that it is so concerned about how the markes will react to a measly 0.1% rate hike after SIX YEARS of ZIRP only confirms the scope of the bond bubble.
Moreover, any rate hike that the Fed initiates would likely be largely symbolic as the US is already teetering on the verge of recession (if not already in one). The Fed could raise rates to 0.35% this year, but doing so would only accelerate the US’s economic contraction and trigger a flight of capital into quality sovereign bonds (pushing yields even lower).
In this regard the Fed is truly cornered. If it fails to hike rates it will have no ammo for when the next crisis hits the US. But it if hikes rates now while the economy is so weak (more on this in a moment), it’s likely to kick off or deepen a recession.
Full article: The Fed is Now Cornered (Zero Hedge)