Falling Interest Rates and Duration Mismatch

Since 1982, US Treasurys have been in a bull market. This is Exhibit A: the yield on the 10-year Treasury bond (the yield and the market price of the bond are inversely related, like a teeter-totter).

This statement should not be controversial. But outside Austrian circles, most people don’t understand that this structural decline is engineered by the Federal Reserve. But speculators—and would-be “vigilantes”—know that the Fed often practices their so-called “open market operations” to buy bonds. Why get caught in front of that steamroller, when it’s so easy and so fun to ride it instead?

Note: this does not imply any particular “insider knowledge”. A long-term bull market is very forgiving, and it hardly matters when you buy in—especially in an asset that pays a dividend, and which will not default. That said, it should not be surprising whenever the best professionals who are risking their own money are up against salaried bureaucrats in a game of cat-and-mouse, the former will always win (especially when the latter may be hoping for a more lucrative job in a few years).

Zero Hedge has run a series of articles exposing a scandal that the Fed meets regularly with the big financial players who buy Treasury bonds and discloses bond purchases to them in advance. They have also published lists of specific bonds that will be purchased, and their success rate in guessing is well over 80%.

Since falling interest rates mean a rising bond price, it is great fun for bond speculators! They get “free” capital gains. Oh, wait.

Is there such a thing as free money?

No, actually the money comes from the capital account of the bond issuer. The speculator carries the bond on the asset side of his balance sheet. The issuer carries it on the liabilities side. No matter whether the issuer marks the liability to market, or not, the loss is taken. It is very real.

The loss of capital can be seen in every case where a company borrows money to expand its production. Then the Fed pushes the rate of interest lower. Then a competitor can borrow more money for the same monthly payment, and outcompete them with a lower cost structure. This same dynamic applies to hotels, restaurants, and every other business that tries to attract customers. Businesses that borrowed more recently have fancier buildings than those who borrowed earlier, at a higher interest rate.

Corporate executives have a choice. The right thing to do is accurately assess the useful life of the tool, hotel, or whatever they are going to buy with the money. And sell a bond with the same duration. The bond is repaid with some of the revenues generated by the asset.

But this is suicide in a long-term structural falling interest rate environment, as I showed above.

Companies have another alternative. They can borrow short-term money and rely on the markets to be able to roll the debt each time it comes due. This avoids the problem of falling interest rates, because each time they roll the debt, they get the benefit of the new, lower interest rate (and the rate on short-term borrowing is ultra-low anyways).

But they create another problem for themselves. If, for whatever reason, the bid on short-term bonds falls, the company cannot roll its debt. And it then must face a crisis that can force it to seek creditor protection.

The falling interest rate structure creates a no-win choice between losing capital vs. duration mismatch and the certainty that sooner or later the company could be wiped out. Duration mismatch works no better for industrial companies than for financials.

The only solution to this problem is a proper gold standard. Under gold, the rate of interest stays within a very small range, and thus borrowers can plan long range without having to choose the tiger or the tiger.