Investment Roadmap: Bonds

Bonds have done very well since 1982.  They always do after the sharp recession that ends an inflationary period.  At some time in 20 to 30 years we will once again have a Great Inflation like we did from 1965 - 1982, and you should remember to buy bonds at the end of it and ride them for years.  I will be long gone I suppose, but maybe this one piece of advice will stick and you can make a killing in middle age.  Interest rates come down after inflation, and bonds go up and up.  But has that now ended?

At a simple level, it is hard to see rates drop any farther.  Short term rates are essentially at zero, and the long bond (30 yr Treasury) got to as low as 2.5% last December.  At that time, the bullish sentiment for bonds was at 99%!  Imagine that, at such a low interest rates.  I suppose this is to be expected after the 25 year run up in bonds (with a fall in rates) from 1982, but at that very moment The Herd was stampeding off a cliff - the long band has since gone back up over 4%, an absolutely huge move (60%) in less than six months.  That 1% bearish group would have made a killing if they had shorted. 

Worse, the US has to fund an horrific deficit, and it stretches out for years.  In less than 2 years Obama is likely to lap Bush: add more to the deficit than Bush did in 8 years.  Worse, the CBO estimate is that the deficit will narrow a bit, then widen with no end in sight.  How do we fund this?  A lot of our former financiers (China, Japan, Europe) are on the ropes and suspicious of the US Dollar.  If they are reluctant to lend, rates will have to go up to attract them in.

You have read how they have no choice but to fund us, but that was then and this is now.  During the Greenspan Bubble, China among others ran huge trade surpluses with the US, and Dollars flooded in.  Hence they had to place those holdings somewhere, and most went back into US government bonds.  Also, the world trades oil in Dollars, and countries need a large lump of the greenback to manage the oil trade.  When oil shot up from $10/bbl in 1999, and $16/bl in 2001, to $147/bbl in 2008, a lot of Dollars got sucked up to handle those trades.  Now that oil is back around $50, a much smaller lump is required. 

The problem these erstwhile Dollar buyers face is not how to get more, but how to dump what they have!  They have reserves that are overfunded in Dollars.  And they fear that the massive Stimulus, persistent deficits and astonishingly-large steps by the Federal Reserve to provide liquidity to the banks will cheapen the Dollar.  Hence their massive holdings may drop in value.  Better to lighten up.  And they have been, big time - check out this chart. 

Thus, Bernanke has a problem: how does the Fed fund the massive future deficits - $2T in the next nine months for example - and keep interest rates low?  If interest rates rise, the huge and growing interest payments will widen a gap in the future budgets that is already estimated to be around 5 GDP points.  It is almost unfathomable how the US can fund chronic deficits at 5+ GDP points without severe economic consequences. 

Bernanke's solution is to replicate a failed approach from 1959: Operation Twist.  Back then, we had 10-yr bond rates of around 2.5%, and the Fed feared they were about to rise towards 3%.  We were still paying off a huge deficit from WWII, and were very sensitive about overall interest payments.  We were then where we will likely find ourselves in the 2020s - having to pay off a horrific deficit.  So the Fed decided to directly intervene in Treasury Auctions, paying above market for bonds (which has the effect of driving rates lower).  They did so until around 1965, when interest rates had risen towards 6%.  Their 2.5% target was a long lost memory!  They gave up, but the damage was done: Operation Twist helped cause the Great Inflation from 1966-1982. 

What happened?  Direct purchasing is a way of flooding the economy with money.  It is literally printing money.  Normally the Fed buys Treasuries from the Treasury Dept, providing the US Government with cash; and then sells the bonds into the open market, sucking cash out of the market.  The overall effect is to sterilize the creation of money, other than the small vig the Fed gets to keep.  if the Fed fears inflation and wants to lower the money supply, it sells Treasuries into the open market, bringing money back home.  (It has other levers as well to pull.)  But when it buys Treasuries back, it literally puts cash into the bank accounts of the sellers.  It is creating money.

On Mar18 this year, Bernanke announced with great fanfare a plan to buy Treasuries and other government bonds, to keep rates low.  His commitment would be $1.2T, of which $300B were Treasuries.  The 10-year Treasury rate dropped from 3% to 2.5% immediately.  Wow!  Would Bernanke be able to work financial alchemy?  Well, no.  Since then rates have gone back up to 3.17%, 66 bps higher, and higher than they were when he made the announcement.  The 30-year bond dropped to 3.34% on the day of the announcement, but it too is back up, at 4.12%, and seems destined to rise higher, to at least 4.6%. 

Bernanke may have felt he had no choice - he had to fill in for those foreign buyers who had left the market (indeed, they may be net sellers not buyers, compounding his dilemma). 

Unlike Bernanke, you have a choice.  Stay out of bonds except the short term ones as a place to park money.

But wait you will cry! What about muni's and corporate bonds?  Well, if you had gone in during the crisis last Sept and Oct, you could have made a killing. Fear drove wide spreads between Treasuries at one end and corporates or munis at the other. As the spreads closed, the rates dropped for those others, and the bonds rose quite a bit in value.  That is once again 20:20 hindsight; you can be a (virtual) millionaire if you play fantasy investing! 

Since then, spreads for lower quality issues have NOT narrowed. Look at this chart - they are actually WORSE than they were during the Lehman fiasco last Sept.  The difference between the top munis and the dreck is 92 basis points, the widest it has been for 26 years.  Junk bond spreads vs. quality corporates are huge.  The banking markets are not normalizing.  Indeed, the more the administration runs stress tests and demonizes bankers, the longer this fiasco will continue.  You can learn more from this great post at Zerohedge, from which I borrowed the last two charts. 

Bottom line: where the Fed directly intervened to assume risk, spreads have narrowed (eg. LIBOR). Where it has stayed out, spreads have widened.  Don't be fooled by manipulation.  The Fed is creating a perception of normalcy where none exists.  Risk to an investor is high, especially as the Fed keeps meddling in unpredictable ways. 

Comments

[john walker]

Yelnick,

Isn't there a contradiction between your bond and currency outlooks? In the Currency post, you wrote that "the bet to make right now is deflation". If so, bond prices could easily rise, since deflation raises the real interest rate on any fixed coupon.

For bond prices to fall during a period of combined deflation and a contracting economy would be historically unprecedented (counter-examples most welcome).

[yelnick]

john walker, historical analogies an be tricky. From 1873 to 1896 we had a long but mild deflation, but the economy expanded (quite a lot actually) rather than contracted. Bond prices rose, but the analogy is imperfect to today. From 1837 to 1842 we had severe deflation and a huge contraction, and that is more like today; but we had just gotten rid of the central bank, so lacked a Fed to try to drive rates down. Again, an imperfect analogy to today.

From 1929 to 1932, we had a horrific deflation, and bond prices rose. After that it is hard to generalize, as we went off gold, but paradoxically gold flowed back into the US as a safe haven, so the money supply expanded. We didn't need to raise rates to attract investment.

From 2007 to 2009 we have dropped rates, and deflation has arrived, and so far bond prices have risen. My contention is that they will now fall as rates will go up in order to finance huge deficits. Interesting is that from 1929 to 1931 the Fed dropped rates from 6% to 1.5% very quickly, almost a mirror of our last two years. Then in 1931 the Fed raised rates to 3.5% to stem the outflow of gold, somewhat analogous to having to raise rates to attract foreign buyers of Treasuries today. Bonds fell. But in late 1931 Austria defaulted, then England defaulted, and we had a huge baking crisis worldwide. This prompted the Fed to start dropping rates again, back down to 1.5% in 1932.

One of the most influential diagnoses of the Great Depression was Milton Friedman's Monetary History of the United States, which argued that the Fed failed to flood the market with money. In retrospect, it is much less clear today that he was right. The Fed dropped rates as fast as Bernanke has, but was overwhelmed not by a contraction of money in a narrow sense, but by a huge write-down of debt. For example, by 1933 most nations were defaulting on their foreign debts, most notably Germany, which repudiated the WWI war reparations, and England, which tried to get out of debt owed the US. Hard to see how the Fed could have put enough fingers in the dike to hold back that flood.

My argument is that the Fed has already driven rates down to really low levels, and it is hard to see how it can keep them there. With deflation, real rates are destined to rise, but nominal bond value should drop.

[KRG]

Yelnick:

I think you have raised a very pertinent doubt on the continuation of the Bond rally. The sheer amounts of deficit financing required world over could easily steepen the yield curves with the short end subdued by the liquidity and long end stressed by the largesse of the debt burden. This fits in with the logic of weaker USD in the last downleg
The steepening of Yield curve can thus resolve the contradiction pointed out by JW