Crash Course on the Bond Market
Government Treasuries for Dummies
This post was inspired by a text conversation with a friend. It’s intended for those of you that want a 5th grade reading level explanation of what’s going on with the treasury markets and interest rates.
Feel free to share it as well if you need to explain it to a friend but can’t quite put it into language they can readily understand.
If you are new please read my FAQ.
Table of Contents
The Cost of Borrowing
Money Printing and QE
Interest Rates
Inflation
The Mathematical Conclusion
1. The Cost of Borrowing
Supply and Demand determines the cost of borrowing money. Most every government is actively borrowing money every week; this is what government treasuries, bonds, bills, and notes are.
When you are borrowing in a free market, the interest rate fluctuates based on supply and demand. When more money is in the system than there is demand to borrow it, interest rates go down. When governments want to borrow more money than is available, interest rates go up until more money enters the system.
2. Money Printing and QE
So you can already see the problem. Governments want to borrow a lot of money, but they don’t want to pay high interest on what they’ve borrowed. The US Government for instance has $30.5 Trillion of bonded debt outstanding at the moment. A 5% interest rate would have them paying $1.5 Trillion a year in interest payments alone. So in order to keep the interest rates down on government bonds, The US government had the federal reserve print money to create an artificial money supply and then buy bonds so that there was an increase of the amount of money in the system which pushed interest rates down.
Above is a chart of the market rate of interest for a 1 year US government bond.
Starting in 2009 you can see the start of money printing driving the interest rate low
And you can see where we tried to reverse this process in 2018 and interest rates began rising.
You can also see where we started printing money again in the middle of 2019 and interest rates went back down
And you can see a sharp increase in money printing in March 2020 that pushed interest rates to near 0%.
You can also see the incredibly steep rate that interest rates have risen since we tried again to slow down and stop money printing in November 2021 to today.
The government prints money to increase the supply of money available to borrow in order to keep lending rates low for itself, because it can’t afford to pay a free market interest rate.
This is not just an American problem. Governments all over the world have been doing the same thing. They print money and lend it to themselves. This process is officially called “Quantitative Easing.”
3. Interest Rates
The interest rates the government pays for treasuries impact all other interest rates across the markets. Your home loan, a car loan, a student loan, a business loan, etc. Banks consider lending to the government to essentially be risk free because they expect the US government will never default on a promise to pay. Banks view all other forms of lending to have some risk to them, and so banks charge a premium on lending to you that is always above how much the government pays for them to simply lend to the government. So if the government is paying 1% on a treasury bond, you might pay 3.5% on a home loan if you have good credit. If the government is now paying 4% on a treasury bond, your home loan is now 6.5% if you have good credit. The 2.5% spread is what the bank calls a “risk premium.”
When the government prints money to lend to itself, it can’t directly give the money to itself. So the Federal Reserve goes to what’s essentially a “used bond market” and only buys bonds from third parties that have purchased bonds from the US treasury already. This avoids the conflict of interest of having the government pay itself directly. But the banks know that the Federal Reserve is doing this, so when the government is printing money, the banks all fight to bid for treasury bonds from the US Treasury, because they know they can turn around and sell them to the Federal Reserve for a profit. It’s easy money. Essentially these large financial institutions get a cut of the freshly printed money, and the Federal Reserve gets to pretend they aren’t just loaning money to the treasury directly.
4. Inflation
The artificial money supply that is created does not just stay in the treasury bond market. It instead spreads out into the wider financial markets as it flows through the large financial institutions that act as middlemen. As the money supply in the broader markets increases, it devalues the existing savings of citizens and decreases the purchasing power of the money they make at work.
It’s been about 2 years since the major return to money printing of March 2020 began, and citizens in the US and worldwide are experiencing cost increases of 20-30% in many western nations, while some less developed nations have seen prices increase by many multiples due to money printing.
Governments worldwide are now promising to fight inflation by reversing the money printing of the past 2 years. But most world governments do not have the ability to do this because they owe too much money or are currently spending in a significant deficit. If they were to allow interest rates to keep rising these governments would run into a situation where they could not afford the interest payments on their debt with their current tax income. The US, the EU, and Japan are some examples of such monetary systems where the tax base could not cover interest payments if the net interest rates these governments paid were to get to 5 or 6%. But in order to fight inflation, interest rates would likely need to be at 10 or 20%, which is simply not possible due to how much outstanding debt these countries have.
5. The Mathematical Conclusion
Since these countries have not stopped deficit spending, the only choices that remain are for these countries to default on their debt when interest rates get too high, or for them to return to money printing so that they do not default on their bond obligations. It is not possible for a country with $30.5 trillion in bonded debt, that is running a yearly deficit of $2.5 trillion to pay a high enough interest rate on that debt for inflation to be fought.
All borrowing has a cost. Governments thought they could avoid paying this cost. They were wrong and it is going to blow up in their faces. This is why I have mostly divested from the Dollar, and typically recommend people create plans to do so. Do not take your life savings and invest tomorrow, that’s foolish. But do plan for an inevitable return to money printing if you live in an insolvent country. There is no other mathematical option besides money printing or debt default.
Thank you for this concise and easy to understand explanation!
Appreciate all the time and effort that you put into your posts to help educate people. I am self admittedly not well versed in financial topics, but am trying to learn