Bond Market Power

The reasons behind James Carville’s quote stating that if he would want to be reincarnated as the Bond Market as appose to a political figure or religious leader (Ferguson, N, 2008) is clear, the Bond market since its inception over 800 years ago has been the most influential financial instrument throughout history. Its longevity and power far surpasses any leader. It affects the outcome of wars, the success and failures of even the largest economies and also touches the lives of individual people.
The below paper will discuss the history and origins of such a Debt Instrument, its rise in America inspiring James Carville’s quote. Also how the Bond Market works, its components and its power over economies throughout history using examples to support this. Concluding this analysis with the Bond Market in Ireland and how it has been greatly affected by the current economic climate. Origins and Early History of the Bond Market:
Nations, races and religions have been at war since the dawn of time and has seen many wars; there have been countless debates as to what ultimately plays the most important role in winning a war. Many people would argue that it is the size of an army, some would say it is the General at the forefront of a battlefield, others would denote it to technological advances in weaponry. These arguments all have one factor in common, they all need to be funded by money; money to pay soldiers, to reward Generals and to pay for arms. The amount of money which a town, country or kingdom has to fund a war is what determines victory.

Niall Ferguson outlines the historic origins of the Bond Market very informatively in ”The Ascent of Money” tracing the use of Bonds, to as far back as the early 14th century in Italy. Throughout the 14th and 15th Century, Italian cities were at war with one and other. Florence, Pisa and Siena being the main cities at war with each other among others. As concluded above, it is money which is the most influential strategy or weapon to be victorious against the other cities and in the case of Florence we see that by funding their wars they landed their town into major debt.
How could Florence pay back this debt? Imposing tax increases would lead to upheaval, they therefore came up with the revolutionary idea of a commonly coined term: “Government IOU’s” (Ferguson, N 2008); the wealthier citizens would lend the Government money over an agreed period of time receiving regular interest payments on said loan. The ideal factor in this agreement is that these IOUS’s could be sold to other citizens prior to their maturity making them a liquid asset. This debt instrument saw the birth of the Bond Market. By the early 14th Century, two thirds of households were the Florentine Governments prime lenders in financing their “Mountain of Debt”. (Ferguson, N 2008).
While it seems like a win-win situation for both investors and the Government a critical point arose, if a Government kept going to war and kept issuing Bonds to pay for such wars, how could an investor be guaranteed the investment would be returned. It is this point which highlights the link between the Bond Market and is power over economies. Governments undertaking this idea grew throughout the 16th and 17th century, some using towns as intermediaries; France with Paris hotel de ville, Spain utilizing Genoas Casa di San Girgio and Antwerp’s beurs. (Ferguson, N, 2008)
But it is the 18th Century and the British consol which paints the most relevant picture as to the rise of the Bond Market and the extent of its power, both from the perspective of winning battles and to be capitalized as a rewarding investment; The Battle of Waterloo being the best example of this. Nathan Rothschild was the most prominent figure at that time in the UK financial world and due to this and his reputation of being a successful Gold smuggler, he was given the task by the British Government of using funds from the issuance of Bonds to purchase amounts of gold to finance the Duke of Wellingtons battles. Rothschild was commissioned to deliver £600,000 worth of Gold but instead collected £2 million worth of bullion reserves.
It is when the war was announced over and won by the British in 1815 that Rothschild had a problem of having an overly excessive gold reserve from his gold piling mission. He then, in a clear way of capitalizing on the Bond Markets in such a historic way, made one of the best investment decisions of his life. Post being informed of the Duke of Wellingtons victory, Rothschild purchased the British Bonds before the market had an opportunity to react, expecting the price to rise with increased stability of the Government due to the victory at Waterloo. Rothschild purchased the British Consol initially on 20 July 1815 and then again in subsequent years until selling at a peak in late 1817 at an increase of 40%.
It is this display of financial valour and a clear inter connection between Government economies and the Bond Market which saw its rise to power in the global financial world. (Ferguson, N 2008). Linking the above to America and ultimately James Carville’s quote, we can begin with the oldest impact of the Bond Market on American History, the American Civil War. The South approached the Rothschilds to back them as they did Britain in Waterloo but the Rothschild decided to opt out, this resonated throughout the entire European quarter which led to the an ingenious idea by the Confederacy to offer “cotton backed bonds” to the Europeans which basically guaranteed the bonds with Cotton making them a less risky initiative.
Because the south monopolised the global cotton supply, they could influence prices thus making the cotton backed bonds more expensive leading to the increase in Bond price and ultimately funding for the Civil War. This is why it is said that the fall of New Orleans (cotton producer of the south) in April 1862 was the true definitive moment in the American Civil War, as a result the Bond prices fell astronomically and hence the financial backing for the Confederacy, the end of the war being 1865 with the North claiming victory. (Ferguson, N 2008). Bond Market America 1900’s – 1990’s Clinton Administration: In terms of the US Treasury Bond Market, it began as part funding for World War I.
The war was financed through a rise in taxes and through the sale of war bonds, called “Liberty Bonds”. Over $21 billion dollars of debt were raised in maturities that came due after the war. Budget surpluses were not enough to cover the debt and so converted into T-bills, notes and bonds. These amounts were paid down regularly until borrowings were increased during the Great Depression of 1929. Foreign governments became holders of United States debt as they began to have surpluses in the balance of trade.
As the Government deficit rose during World War II and accelerated during the Vietnam war, the debt markets and the rise of debt related trading instruments has dominated financial markets. In the early 1980s, bond yields rose substantially due to increases in commodity prices, labor wage increases and expanding deficits. Bond prices anticipate rising amounts of future debt and thus yields rise. (www.ehow.com).
U.S. interest rates beginning in 1900-2010:
(observationsandnotes.blogspot.com) The graph above shows U.S. interest rates beginning in 1900. From 1953 onward, the rates are 10-year U.S. Treasury Note rates, plotted monthly; prior to 1953, they’re the less granular. This can support the previous paragraph’s historical perspective in the ascent of the US Bond Market, in that we see how the interest rates drop from the depression and how it slowly began to rise post the Vietnam War in the late 60’s early 70’s.( observationsandnotes.blogspot.com).
Placing the James Carville quote into perspective and in line with the time at which it was stated, during the Clinton administration. We can see according to some the destruction of the Bond Market happen in the US in 1994 entirely caused by the policies of said Administration. In 1993 President Clinton began with a plan to kick push the economy. His view was that all he needed to push the economy was lower interest rates. Short-term interest rates can fall for many reasons; public expectations change, increased savings increase, the market or as Adam Smith coined the “Invisible Hand” drives down interest rates as a signal for more investment. (Smith, A 1991).
The same can happen artificially as the central bank expands credit and intentionally causes increased money supply within the economy, the central bank creates distortions in the capital structure, including stocks and bonds, while an increase in private savings allows steady economic growth. The Clinton administration, pushed the Federal reserve to lower short-term interest rates. Making money cheap and plentiful to pump up spending. But there is a fine line between plenty of money and plenty of devalued money. One is higher prices or in other words Inflation, lowers the purchasing power of money, which forces the Fed, sooner or later, to raise the interest rates back to a higher level.
The usual consequence is an economic slowdown or even recession. A by-product may be a lower exchange rate internationally. But the actual consequence in the time of the Clinton administration was the bond market collapse. (Pongracic, I, 1995) So far we have tracked the history of the Bond Market from its origins in Italy to its rise within the US economy, but what is the Bond Market technically and how can we analyze the Bond Market and break it down to see how it operates within the financial system in today’s terms? The Bond Market and How it works:
When dissecting the bond market and its relevance and importance in today’s terms we do not associate it too much to the funding of wars or the financing of battles, as we did with Waterloo, The American Civil War and Vietnam, we view it like Nathan Rothschild did, as an investment tool. Stocks historically produce higher rates of return than other investments but at the same time carry with a substantial amount of risk, also noting that it is at the Board of Directors discretion to pay out dividends on common stocks.
The alternative being Bonds on the other hand have a maturity date at which time the Bond is redeemed at the issuing price. US Treasury Bonds interest and redemption payments are backed by the U.S Treasury thus rendering them “risk free” . (Faerber, Esme, 1993) The word ”BOND” means contract, agreement, or guarantee. An investor who purchases a bond is lending money to the issuer , and the bond represents the issuer’s contractual promise to pay the interest and repay the principle according to specified terms. The issuers themselves can be the National Government, Lower Levels of Government , Corporations and Securitisation Vehicles. (Levinson, M, 2000).
Bonds are traded on both the Primary and Secondary Capital Markets along with Stocks and Mortgages, they are first introduced as initial public offerings or IPO’s on the primary market and then can be traded or sold on the secondary market before maturity. The Par, face or maturity value of the Bond is the amount the issuer must pay at maturity. The coupon rate is the rate of interest paid on the bond. If the repayment of Bond are not met, the holder can claim on the assets of the issuer, (in the above Civil War example, the South’s cotton). Long term bonds traded in the capital market include long term government notes and bonds, municipal bonds and corporate bonds. When dealing in Corporate Bonds,
Default risk is an important factor of Bonds, as it is the main factor which influences a Bonds Interest Rate. This can be explained to be the risk that the issuer will not be able to meet interest payments and pay the principle back to the investor. If the possibility of default increases because the corporation is suffering losses the default risk will increase and their expected return on these bonds will decrease. Due to this importance, it is the credit rating agencies which assess the risk of default of Companies and Governments alike and rate them according to likeliness of default. (Mishkin, F.S, 2006)
When buying and selling bonds, investors can utilize brokerage firms as they do with other investments and in the case of U.S Treasury Bonds can purchase them directly, it is when successfully realising where its best to buy and sell bonds which leads the investor in gaining from both differences in bond pricing and in commission costs.
The Irish Economy & its Bond Market a midst the crisis: As displayed above, the main way for countries to raise fund when required are theough the Bond Markets. They are also a a key indicator as to the economic position of that country. This is because the more concerns the markets have about a nations financial stability, the more expensive it is for that government to issue its Bonds and raise money. A midst the Irish Financial Crisis and the troubles of Irelands Banks, mainly due to the blanket guarantee annoiunced by the Irish Finance Minister John Lenihan, Ireland have found it so much more costly to attract interest in their bonds this year.
This is due to the Government accepting responsibility for Commercial Bank’s risky Loan Books, considering these loans will more than likely be defaulted so is the risk that the Irish Government will default on their soveirgn debt. Due to the above, the market prices of Irish Bonds have fallen in recent months, pushing up the yields. The yield on a 10-year Irish bond reached about 9% at one point. That is very high. The UK government – in spite of all its financial difficulties – can borrow for 10 years at just over 3%. (bbc.co.uk).

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