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How a Liquidity Trap Affects You - Part Two |
by John Jagerson
A liquidity trap created by artificial intervention, like the one currently at play in the U.S., presents a lot of risks and potentially a few opportunities. Knowing where those risks and opportunities are can be a real benefit to retail investors active in the bond market. You can see the first article in this series here.
The current liquidity trap in the U.S. has been partially created by the Federal Reserve engaging in quantitative easing to stimulate the economy. Find out more about quantitative easing here. They do this by buying U.S. debt from banks in exchange for cash. Increasing the supply of cash in the hands of the banks is supposed to make capital cheaper for banks and businesses but so far demand for borrowing and a willingness to lend has not emerged as desired.
The buying pressure by the Fed combined with a broader flight into "safety" or government debt has driven demand through the roof. As demand for bonds increases, prices rise. At this point there is a real probability that we have merely exchanged an asset bubble in real estate, commodities and equities for one in bond prices. Prices have risen so far, the yield on 90 bonds is nearly zero and the 10 year yield is hovering at all time lows near 2%. Both of these are well below expected inflation rates over the debt's term. To understand more about how yields and bond prices work, click here.
A sudden rise in selling pressure can pop just about any bubble and the more inflated it is the more extreme the correction may be. The current plans for deficit spending and stimulus in the U.S. will be paid for with new debt issues from the Treasury which could shift the balance between sellers and buyers enough to cause such a correction. The selling pressure from the Treasury could easily coincide with a decline in demand for U.S. debt, especially if the intended effect of the stimulus (growth) is realized.
If sellers enter an overbought market with additional supply may fall and could fall precipitously. Falling bond prices is a risk that bond holders should be aware of and prepared for. It is also an opportunity for speculators to benefit. For example, a trader could short bonds or bond ETFs or buy call options on yields. The 10 year note yield index (TNX) is optionable and long term calls could be an interesting opportunity for adventurous traders. I will cover this specific example in more detail in the video accompanying this article. In the trading example I will be talking about buying calls on an index. If you need some help understanding how to trade options on an index, click here.
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