If a shift from low volatility to high volatility signals a change for the worse in the macroeconomic outlook, then the collapse in the yield of short term US Treasury securities is a symptom of the current credit crisis, which has infected all the sectors of the credit market save the highest quality credits.
At the same time, the sharp decline in the yield of ten- and 30-year Treasury bonds and the collapse of lower-quality bond prices seem to indicate that a bad deterioration in US and world economic conditions is about to occur. Since, according to Philip Isherwood, equities tend to perform poorly when volatility is high, cash and bonds would seem to be a good alternative. But, stating his case in favour of US equities on CNBC, a US money manager made the comment that “money in cash is also at risk”. This is certainly true for bank deposits, CDs all structured products, and even money market funds, because the return of capital is uncertain. In the case of Treasury securities, “money is also at risk” but for different reasons.
In the case of Treasuries, the return of capital won’t be a problem for now, but I suppose that with a yield of less than 2% on two-year, 3.7% on ten year, and 4.5% on 30-year Treasury securities, the risk is that inflation (not that published by the government, but the cost of living increase for the median household), which is already higher than these yields, will over time completely eat away the purchasing power of the principal, including the interest.
I hope my readers understand the problem of interest rates, which are artificially low and below the rate of inflation. This forces investors, including individuals, institutional investors, and state and private pension funds, into risky investments, which as we have now seen can also lead to widespread losses. In fact, the losses are now so large that they threaten the entire financial system. I estimate that, when all is said and done, the losses experienced by the financial sector and investors brought about by Mr. Greenspan’s and Mr. Bernanke’s irresponsible monetary policies will exceed several trillion US dollars if we add up the combined capital losses on homes, nongovernment bonds, and equities.
Expressed in Euros or gold, the total wealth of the US has already shrunk by at least 40-50% since 2000. I don’t have a high regard for any government (except, possibly, that of Singapore), but the most destructive course a society can embark upon is to appoint academics to positions of responsibility. A problem of artificially low interest rates that is seldom discussed is that many individuals depend on interest income in order to meet their living expenses. Equally, pension funds depend on a certain annual income to meet their present and future liabilities. Moreover, high interest rates provide investors with a cash flow, which can cushion downturns in asset values. Say, an individual or a pension fund owns a balanced portfolio: 50% in equities and 50% in fixed income securities of various maturities. Let’s assume that, in a given year, the stock portfolio declines by 20%. If interest rates average 10% on the fixed income portfolio, the total loss on the portfolio will “only” be around 10%.
Moreover, the cash flow from the fixed income portfolio can be reinvested in equities. But what if the yield on the fixed income portfolio averages only 3%? Obviously, the opportunity to make up for the losses on the stock portfolio by investing the cash flow and averaging down diminishes. And what if the annual cost-of-living increases average 5% or more? In this case, the purchasing power of money will rapidly vanish. Moreover, because of negative real interest rates, consumer price inflation will accelerate, as was the case in the 1970s. At the same time, the “real” spending power of households whose income depends on fixed interest securities will be cut and their standards of living will decline.
My friend David R. Kotok, chairman and chief investment officer of Cumberland Advisors, writes regular insightful comments on the US financial market. Recently he stated: “We still have to deal with dysfunctional credit markets. The Fed must persist in their work of creating liquidity. Only time and transparency will relieve the problem of insolvency. That process is working, too. It takes time and it does and will succeed. Remember, there are no examples of Depression in economic history where stimulus was applied and where the inflation-adjusted interest rate was brought to zero by the central bank. That is the condition in the US today. In sum, stimulus works.”
Well, David, on this one I must disagree with you. I know many economies where monetary and fiscal stimulus was applied and yet they still went into depression. In all these economies, the inflation-adjusted interest rates were not only brought down to zero but, in fact, significantly below zero. The failed experiment by John Law with paper money in France at the beginning of the 18th century ended with a depression, and money printing in Germany between 1918 and 1923 brought about total impoverishment of the German working and middle class. Latin America went through extremely poor economic conditions in the 1980s. (In Argentina, car sales declined by more than 50% between 1980 and 1988.)
However, in all these instances, the depression wasn’t accompanied by nominal price declines but by hyperinflation and collapsing asset prices, GDP, and standards of living in real terms. In fact, I know of two little empires that, as a result of excessive monetary and fiscal stimulus, went bankrupt and ceased to exist: the Roman and Spanish empires.
Admittedly, these empires’ rulers weren’t as smart as our present-day leaders of Western democracies… .
Also, I was pleased to hear that Robert Mugabe (another academic with several degrees from Oxford and an honorary degree bestowed on him by China’s Hu Jintao “for his brilliant contribution to international diplomacy and peace”) has offered Mr. Bernanke a teaching job at the University of Harare. This will provide him with a first-hand opportunity to study the devastating impact of excessive monetary and fiscal stimulus on a society.
So, to a large extent, I agree that “money in cash is also at risk”, because there is the risk either of default or that money’s purchasing power will decline. Also, I am beginning to wonder for how much longer buyers of ten- and 20-year Treasury bonds will accept their low yields, which are now below the cost-of-living increases and below nominal GDP. The poorly delivered, contradictory, and incoherent statements made by Mr. Paulson and Mr. Bernanke at a recent Senate hearing didn’t provide much comfort to holders of US fixed interest securities. Not surprisingly, gold has more than doubled since Bernanke was appointed Fed chairman, while the yield on 30-year US government bonds is higher now than before the January 125 basis points Fed fund rate cuts.
Surely, the Fed can cut the Fed fund rate to zero. But this doesn’t mean that longer-dated bonds will rally. If inflation were to accelerate further, rate cuts would inevitably lead to higher long-term rates and capital losses on long-term bonds – particularly if the dollar weakens further! In other words, the Fed can bring down short-term interest rates, but it has little power over the longterm bond market. I may add that one of the problems of hyperinflating economies is that the long-term fixed rate bond market ceases to exist.
I should like to introduce one more thought. Throughout most of the 1970s interest rates were below the rate of nominal GDP growth and negative in real terms. So, what happened? Inflation accelerated, bond yields soared from 6% in 1970 to above 15% in 1981, and the US dollar tanked. After 1981, we had for most of the following 20 years bond yields that were above both nominal GDP growth and the rate of inflation (positive real interest rates).
What happened? We had a lengthy period of disinflation. Also, because real interest rates were particularly high in the early 1980s, we had a huge US dollar rally between 1980 and 1985. After 2001, we again had interest rates that were below both nominal GDP growth and cost-of-living increases, which led to the unprecedented credit inflation we experienced between 2001 and 2007 and the subsequent historic bust.
Now, let us assume that market participants begin to believe in the nonsense Mr. Bernanke has been coming out with concerning “money printing” and “dropping dollar bills from helicopters” in order to stabilize asset markets and avoid economic downturns. They will begin to realize that he is the messiah of the gold bulls and the arch-enemy of sound money.
What will investors do? They will dump bonds and the US dollar en masse. In this context, it is interesting to note that recently, on very poor economic statistics, bonds didn’t rally but sold off. The Institute for Supply Management’s non-manufacturing index, which is representative of almost 90% of the US economy, fell in January from 54.4% to 41.9%. (A reading of 50 is the dividing line between growth and contraction, and the index has averaged 57.6% since its inception in 1997.) January retail sales – closely scrutinised – were a disaster and confirmed my view that US economic statistics published by the government misinform the public about the true state of the economy.
How can January auto retail sales increase by 0.6% when volume sales were down 6% month-on-month? According to David Rosenberg, in addition to declining sales at department stores (down in three of the last four months), sporting goods and book stores, furniture and building materials stores, sales at electronic stores were down 1% in January on top of a 2.5% slide in December, which represents the worst back-to-back performance since the 1990 recession. According to Rosenberg, the “bottom line is that the cyclical components of retail sales – autos + clothing + furniture + electronics + sporting goods + building materials + department stores – were down 0.1% in January.
By way of comparison, spending on gasoline, food and health care rose 1.1% collectively for the month.”
The poor state of the economy is reflected by the collapse of the ABC News/ Washington Post Consumer Comfort Index and its various components. The personal finance component is now lower than it was in 2002. Also, the University of Michigan index of consumer sentiment collapsed in January to its lowest level since 1992. According to Rosenberg, “consumer sentiment is now at a level that is telling us that we are not on the eve of a recession but are rather already several months into the downturn”.
As I have noted in earlier reports, the US economy is already in recession in real terms, but this fact is obscured by the government’s grossly understating price increases throughout the economy. Despite, in my opinion, horrible economic statistics (in real terms), the Fed needs to be very careful not to disturb bond holders by “printing too much money” (electronically), which – aside from the collapse in lowerquality bonds that had already occurred – would also lead to a rout in long-term government bond prices. At the same time, the US must be increasingly careful about its budget deficits and about bailing out the entire financial sector, which is loaded with crappy paper.
Otherwise, Treasury securities will reach “junk status” sooner than I had expected. But I can very confidently predict that, in the long term, US debt will become “junk”!
So, whereas under a sound monetary regime high-quality bonds would be – like utilities – a candidate to outperform, under a central bank that lacks any monetary discipline they are a rather dangerous investment. But this isn’t to say that, at some point in the current downturn, distressed lower-quality bonds won’t provide a great buying opportunity.
Dr. Marc Faber
for Markets and Money