Market Collapse Dynamics

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Market Collapse Dynamics

The Dynamics of a Bond Market Collapse

How much could rates rise?

Over the long term, the average real rate of interest on U.S. sovereign debt has been around 2% a year. The latest Producer Price Index (which we believe is more reliable than the Consumer Price Index) shows price inflation is currently 6.8% annually. Add the 2% real return we believe investors expect, and you get 10-year Treasury bonds yielding 8.8%. Currently, those bonds yield only about 3.25%.

This implies a huge collapse of bond prices – a collapse of more than 50%. A collapse of that magnitude would completely wipe out the stock market. It would be a massacre.

No one is expecting any of this. Everyone believes something like this could never happen. Yet this rise in interest rates would only carry us to the average return bond investors have earned over the last several decades. It doesn't even consider the kind of panic selling that would ensue.

In truth, rates might go considerably higher than this for one fundamental reason. If the bond market crashes, investors would begin doubting America's ability to finance its debts, never mind trying to repay them. As rates rise, the cost of maintaining our debts would grow substantially – perhaps doubling.

Keep in mind, the U.S. Treasury currently pays only 1.4% annually to borrow $14 trillion. Yes, 10-year Treasurys currently yield around 3.25%. But because the Treasury has issued so much more short-term debt than long-term debt, U.S. borrowing costs are lower.

No, all of our debts wouldn't "reset" to higher rates overnight. But the losses in the bond market, the losses in the stock market, and the resulting decline in business activity would cause a lot of our creditors to worry about our ability to afford higher interest payments.

Think about it this way. By the end of 2012, our national debt will likely exceed $17 trillion. Let's assume our average interest increases to 4.4% – half the rate we believe investors will eventually demand. That works out to an annual interest expense of almost $750 billion. That's more than we spend on defense or Social Security. Interest expenses would leave the government spending almost 25¢ of every dollar on interest payments.

Does that sound wise or reasonable to you? Given these expenses, some of our creditors would become reluctant to "roll" our debt into the future by offering new loans. This could cause a serious problem for the U.S. Treasury. This is how the dollar dies.

Edited by admin on 11/08/2014 - 06:07


An epic lack of foresight, accuracy and humility over 3 1/2 years ago. Once a pumper, always a pumper!

Eric_2's picture
Joined: 06/14/2011
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Nagging question

Thanks for your posts DPH, they are always informative.

There is one thing that I haven't been able to figure out over the last couple years, and that is this -

Why hasn't the bond market crashed already???

If all of us turdites can see the problem, why doesn't everyone else? Anyone with a pocket calculator can see that the debt can never be repaid. Who in their right mind would buy bonds?

Yes, I know the fed is buying a large portion already. So why does it even matter if anyone else buys bonds since the fed is covering it all?

Thinking out loud here, the only conclusions that I can draw are:

The US dollar is "the best looking horse in the glue factory" and regardless of all our problems we are still better off than most of the rest of the world, thus the economy continues to muddle along.


due to the unbelievably large size of the economy and the unfathomable amounts of money involved, it just takes a long time to collapse. Most other countries and investors are quietly exiting bonds and dollars into comodities, and once enough have exited then it's game over.

I'm guessing it's the latter, so maybe I've answered my own question ;)

Shill's picture
Joined: 06/14/2011
Posts: 3699

One could consider a convertible bond. Or shares of a mutual funds made up of convertible bonds. Some of the recent well-performing convertible mutual funds include $[VCVSX], $[CCVIX], and $[PCONX].

Just tossing that out there for the 401k crowd. Mei  ma shorting bonds with TBT.


And I will strike down upon thee with great vengeance and furious anger those who attempt to poison and destroy my brothers.

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