The Coming Government Bond Price Crash

Today, I finished an introductory book on the Austrian School of economic thought. The differences in economic beliefs of the Austrian School compared to the mainstream Keynesian school of thought are quite stark. According to Keynesian economics, when the economy is slowing or has slowed down (recession), the government should use deficit spending and set low interest rates to kick-start the economy again. Ever since 2008, the U.S. federal funds rate has been quite low, and the federal debt has increased significantly. Canada has managed to grow federal debt at a much slower rate, however interest rates in Canada are also quite low.

Because both countries are in relatively large amounts of debt (although to different degrees), both countries have a significant portion of the federal budget devoted to interest payment on that debt. There are three ways a government can obtain income for the purpose of spending: taxes, borrowing, and printing money. Tax increases are quite difficult to implement due to typically fierce opposition. This leaves borrowing, and printing money. Since governments are aware of what can happen if too much money is printed (hyperinflation), printing money may still be used to service debt, but not likely in excess. All that is left is to borrow more money to pay the interest on currently borrowed money. The U.S. debt scare during the summer of 2011 is proof that borrowing will simply continue because it's the only way not to default on interest payments (never mind paying down the principle amount!).

The method through which the government borrows money is to issue government bonds. Individuals and institutions buy these bonds, and receive their principle back plus interest at a later date. As with many other securities, bonds can be bought and sold on the market. Bond prices tend to move opposite of current interest rates at the time. To see why, consider the following. A bond yielding 2% interest is offered on the bond market for a certain price. Interest rates go up, and new bonds being sold yield 3%. Why would anyone buy the 2% bond when they could buy the higher-yielding 3% bond? To attract buyers, the price of the 2% bond must go down. If interest rates were to go down to 1%, the bond yielding 2% is now actually more valuable because it yields more interest. If this is the case, the price for the bond goes up.

As with any market good, bonds are subject to the laws of supply and demand. If there are few bonds being sold (small supply) and lots of people wanting to buy bonds (large demand), prices will tend to go up, and the highest bidders will get to buy the bonds. Conversely, if there are lots of bonds (large supply), and not many people wanting to buy bonds (small demand), prices will tend to go down to try and attract buyers.

At the current moment in time, it is difficult to tell what the demand for bonds is. Some consider bonds a pretty safe investment, and so may want to buy bonds. Others may not want to invest in bonds because they want access to their money right away, or they may not want to do any investing whatsoever due to all the horror stories about the economy not doing well. However, due to the government needing to borrow to service debt, it is safe to assume that the supply of bonds will in the best case stay constant and in the worst case increase.

Given the above statements, it is easy to summarize what will likely happen to bond prices in a chart:

Since it is more likely that the supply of bonds is going to increase, the price of bonds will either stay where it is if there is enough demand for bonds, or the price will fall (either somewhat or significantly). But remember the effect interest rates have on bonds! (Not represented in this chart). If interest rates go up, bond prices tend to go down. Interest rates are already low, and so have nowhere to go but up. So if we factor in that at some point in the future, interest rates will eventually go up, we can conclude that bond prices are in for a plummet at a certain point in time. This point in time will be when there is increased government borrowing and increased interest rates, both of which are almost certain to happen.