Bond market: "Reports of my death have been greatly exaggerated"

If you're like me I'm sure you've been hearing a lot of talk about a bond bubble recently. It's everywhere--on TV, in the news, everywhere. You can't go five minutes without somebody talking about how the bond market is in a bubble and how it's going to burst. That's just for starters, because when they tell you it's going to burst they say that when it does it will make the housing and dot-com bubbles look tame by comparison.

Some of these Cassandras have been shouting their warnings for a long, long time. People like Peter Schiff, Jim Rogers and Marc Faber have been telling us that bonds have nowhere to go but down for years. Meanwhile, the bond market has done nothing but go up. I'm absolutely positive that Rogers, Schiff and Faber wouldn't have any money at all if they followed their own advice. That's why they don't. They've cleverly fashioned lucrative businesses for themselves that keep them far away from the dirty and distasteful chore of having to earn money off their own investment ideas. Rather, they earn money the modern American way: through clever marketing, celebrity, advisory fees, book sales and public appearances. Maybe this is a testament to their business savvy, I don't know, but one thing I do know for sure is that it's certainly a sign of their disingenuousness.

Their message has been finely honed: the United States government is borrowing its way into oblivion and pretty soon there won't be anyone around to buy our debt. We ought to get down on our knees and thank God that all those generous Chinese people buy our bonds because without that we'd be another Zimbabwe. The outrageously flawed analogy to Zimbabwe is one of their favorites and they invoke it often and with great flair! Sometimes they'll even display a real, 100 trillion Zimbabwe note and say that it wouldn't even buy you a 2 cent stick of gum. In the next sentence they'll confidently predict that the dollar is headed for the same fate if the U.S. keeps up this "profligate" spending. You have to admire their showmanship; it's just too bad the comparison to Zimbabwe, Wiemar Germany or Argentina is completely ridiculous.

When I hear people say that the U.S. is broke and that we only exist because of the kindness of the Chinese, I have to ask them a very simple question: What exactly is America borrowing? I mean, seriously, what are we borrowing? Let's be specific here! After all, if you want to solve a problem or understand something complicated you sometimes have to break it down.

So, let me repeat...what are we borrowing?

The answer is, if we're borrowing anything at all (and that's debatable), we're borrowing dollars. Not Chinese yuan or Japanese yen or Euros or Beanie Babies. We're borrowing dollars. Even the "Debt/Doomsday" crowd wouldn't disagree on this one.

Once you accept that dollars are being borrowed, not yuan or yen or Euro, then the next question has to be, where did those dollars come from? Yes, maybe some of those dollars came from China, but where did the Chinese get them from? Ultimately there is only one place where anyone can get dollars from and that is the U.S. Government. The United States is a sovereign currency issuing nation and the monopoly issuer of the dollar. Dollars cannot not be gotten anywhere else; if they are, they're counterfeit.

It follows that in order for anyone to have the dollars to lend us the government had to have spent those dollars into existence in the first place or nobody would have them--period! They can't come from any other place. Moreover, the government must spend more of its dollars than it collects in taxes and fees for the non-government (that's me, you, businesses, states and the rest of the world) to have a surplus of dollars to "lend." There's simply no other way.

It should now be obvious that the money that goes into Treasuries--whether that comes from American citizens or foreigners--is not really a loan at all. A bond is nothing more than a savings account that the government offers to people who hold dollars. That's it. And the money to buy bonds comes from government spending itself (more accurately, deficit spending).

I'd like to bring the Fed into the equation at this point because I started out talking about how this is not a bond bubble and I'll need the Fed to help explain this. (Short sellers, pay attention!)

The Fed's main policy tool is the setting of interest rates. The Fed does this by buying or selling government securities. Yes, those very same bonds, notes and bills that the public holds. When the Fed buys securities it credits the reserve accounts of banks. Reserves are added to the banking system and, voila!, the interest rate goes down. If the Fed wants to raise interest rates it does the opposite: it sells securities and that results in the debiting of reserve accounts and rates go higher.

Throughout this economic crisis the Fed has been bringing interest rates down, in fact, it has brought rates down a lot. The Fed funds rate is currently close to zero and it has been there for quite some time. In order to get the funds rate to zero it has had to be a buyer of securities as per my explanation. Moreover, the Fed recently said that it would start to target longer term rates, so it has begun buying bonds. Remember it is buying bonds from the public. I often hear people say that the Fed is buying bonds from the U.S. Treasury so that the government has the money to spend. That is completely wrong. I explained earlier that the government spends by issuing its own money, which gets spent into the private economy and some of it is held by the public in Treasuries.

The Fed will continue to buy until it reaches the rate of interest that it feels is appropriate and it will maintain that buying as needed to keep the rate there.

This is where the short sellers and bond bubbleheads need to pay very close attention.

The Fed's checkbook is unlimited and it will use that checkbook to any degree necessary to implement its policy. That is why talking about a bubble is simply ludicrous. Bonds are up for one reason: because the Fed continues to guide interest rates lower and it is telling us that they're likely to keep them low for an extended period of time. That means, a lot more bond buying. It also means that no matter how many short sellers there are in the Treasury market no one is going to "break" this market if the Fed does not want it to be broken. Moreover, it doesn't matter if China, Japan, the U.K. the Saudis or anyone else never buys a single bond again; it does not hinder the U.S. Government's ability to spend in its own currency.

In the meantime, interest and principle will be paid the same way it has always been paid, which is by crediting bank accounts electronically. Changing the numbers. Marking them up. That's how it's always been done and that's the way it will continue to be done.

In the end the "bubble" will burst when the Fed tells us it is going to reverse its policy. In other words, when it says it's going to start raising interest rates again. In the meantime, if you've been thinking about going short because of all this talk about a bubble, save yourself some money and go have a beer instead.