American hard money advocate, economist, and publisher Franz Pick once called government bonds “Guaranteed Certificates of Confiscation.” In making that statement, he assumed the government would eventually inflate the debt away and thus confiscate the buyers’ purchasing power.
Yet here we are, with U.S. Treasury Bonds holding steady despite seven rate hikes by the U.S. Federal Reserve, huge increases in the supply of bonds, and inflation on the rise. The obvious question is, why?
The reason why government debt keeps increasing and yields are more or less stable isn’t because of the fundamentals of the debt, deficit, or the economy. Instead, it is because the rules of the bond game are written by the banks, for the banks.
In my first book, “Methods of a Wall Street Master,” I introduced “The Gamboni.” Joe is a skilled poker player, but when he sits down at a new game, he has not learned the rules of the house, which include a special set of winning cards called “The Gamboni.” He therefore loses and goes broke. The moral of that story: If you want to win a game, you have to know the rules.
The Backdrop
First, some context. In December 2015, the U.S. Federal Reserve raised the Fed Funds rate from zero to 0.25 percent. This was their first rate hike in seven years.At that time, the yield on the 30-year Treasury Bond was 3 percent. Since then the market has absorbed an additional six rate hikes in the Fed Funds rate, but as of July 3, the yield on the 30-year was still only 2.96 percent. In fact, the highest yield we’ve seen since the initial rate hike has been 3.25 percent on May 14, 2018.
With President Donald Trump and Congress throwing the kitchen sink of goodies into the economy, including huge deficit spending and tax cuts, after 109 months of economic growth, long-term bond yields are lower than they were in December 2015.
Why is this the case, in the face of positive economic data and faster growth and higher inflation? Back in the days of quantitative easing (QE), we could rationalize this phenomenon with zero interest rates and the Fed buying up most of the new supply. Now, the Fed has stopped buying and is not rolling over maturing bonds. The Chinese and the Russians have stopped buying in size.
But if yields are stable, there must be a strong and relentless buyer of Treasury bonds. And given the fundamentals, this buyer, like the Fed, must be a noneconomic buyer who doesn’t care whether yields rise in the future or not.
The Banks and Their House Rules
Now, remember The Gamboni and the house rules, which are different from normal poker rules. The mystery is solved when one understands the rules of the game.- What are the reserve requirements for U.S. government debt owned by a CB?
- What are the mark-to-market rules for government debt owned by a CB?
- Where does a CB get the funds to buy government debt?
- What are the Basel III capital requirements for government debt owned by a CB?
- Zero.
- They are not marked to market.
- It creates the money out of thin air.
- None.
The really interesting part is skirting around mark-to-market accounting, though. Since the banking crisis, banks have been permitted to hold assets in a special account called an HTM account, which stands for held to maturity.
Risk-Free Profit
It’s a complex formula to follow through the different Treasury and Fed accounts, but in effect, government debt is considered risk-free and therefore can be held without reserve or capital requirement, and without mark-to-market risk. That is because it falls under the applicable guidelines that meet the description of the Basel Committee of the Bank for International Settlements (BIS):- assigned a zero percent risk-weight under the Basel II Standardized Approach for credit risk;
- traded in large, deep, and active repo or cash markets characterized by a low level of concentration;
- have a proven record as a reliable source of liquidity in the markets (repo or sale) even during stressed market conditions; and
- not an obligation of a financial institution or any of its affiliated entities.”
In fact, the CBs will be happy the Fed isn’t buying up all the issuance anymore so they can also have a slice of the profit.
Elegant Scheme
You can see how this elegant scheme is similar to a Three-card Monte dealer’s sleight of hand. In this case, the government is the card dealer and makes the rules. This is why the Federal Reserve can sell government debt from its portfolio, the Treasury can issue new debt and pour it into the market, and yields do not go up even if China and other foreign markets fail to join in on the buying.Every 30-year bond gives a CB buyer a profit of 3 percent on money created out of nothing. It’s the Gamboni principle with a powerful government twist.
There are many who believe bonds will go down due to increased supply and yields go up if all other factors remain the same. But they do not understand the rules of free money for commercial banks thanks to the set up of the fractionally reserved banking system.
Perhaps the words of Josiah Stamp, the director of the Bank of England in 1928, are worth revisiting:
“Banking was conceived in iniquity and born in sin. ... Bankers own the Earth. Take it away from them but leave them the power to create money, and, with the flick of a pen, they will create enough money to buy it back again.
“Take this great power away from them and all the great fortunes like mine will disappear and they ought to disappear, for then this would be a better and happier world to live in.
“But, if you want to continue to be a slave of the bankers and pay the cost of your own slavery, then let the bankers continue to create money and control credit.”