Copyright 2012 by John T. Reed
In the recent past, I have noted that the law of supply and demand seems to have been suspended, that the difference between TIPs yield and non-TIPS no longer tells the truth about investor inflation expectations and I promised to address this in the future. The future has arrived—in the form of an article by Jason Zweig in the 6/9/12 Wall Street Journal titled “Are bond rates on a road to nowhere?”
Fundamentally, U.S. bond yields should be rising because the riskiness of US bonds in terms of both default and inflation is clearly rising. Our debt-to-GDP ratio is 104% and rising at a rate of 8.5%. 60% is considered the maximum prudent ratio. 90% is the tipping point of trouble and 140% is about where Greece needed bailouts.
Greece got a couple of bailouts because they were too big to fail.
The US will not get bailout because we are too big to bail.
Greece probably won’t get any more bailouts because their way of showing gratitude for the bailouts they already got was to say, “Screw you, If you don’t give us even more bailout, we will default.”
I think the eurozone should foreclose on Greece. Give the Greeks 30 days to get out then sell the country to developers to became a resort and theme park. Nations used to use force against deadbeat nations. Now it’s considered too retro. Since Greece seems to be relying on that new politeness, it appears to be a moral hazard. So end it. If your country’s federal government defaults, it gets placed in receivership.
Back to the persistently low US bond yields. When a country has low bond yields, that is, it can borrow money at very low interest rates, it means the country in question is extremely well-managed from a government fiscal and monetary standpoint.
The U.S. now has one of the lowest bond rates on earth, so we must have a really well-managaed federal government, right?
Ha!
That’s absurd.
It is true of Germany. They recently sold 5-year bonds at a record low interest rate of .41%. They have such a low rate because Germany is well-managed. For example, they have had federal health care insurance since the late 1800s, with no great problems. We started Medicare in 1965 and it has already bankrupted us although because of lax disclosure and pension-funding rules for the federal government, the monstrous unfunded liabilities for health-care expenses is ignored.
So what’s going on?
People make a faulty assumption that all securities market prices are based on hundreds of millions of investors analyzing then buying securities based on their analysis as to which offer the best value.
Double ha!
In fact, much of the market is not really a market at all. It is just human zombies like in that most famous of all TV commercials: the 1984 Apple Superbowl commercial. Like the zombies in the commercial, they buy US bonds, in spite of the S&P downgrade to AA and in spite of the rapidly deteriorating debt-to-GDP ratio because:
• they cannot find a better alternative investment for the volume of money they have and they refuse to do the moral thing: return the money to the investors
• they are required to buy U.S. bonds by company policy, law, reserve-requirement regulations, habit
• they know US bonds are insanely risky and even doomed at this point, but their Main Street investors are too ignorant to understand that so they do what the ignorant investors want rather than educate the investors
• many funds advertise “low risk,” “capital preservation,” and similar things and implicitly or explicitly promise to only put the investors’ funds in things like US bonds
In 1982, 55% of U.S. bonds were owned by individuals and institutional investors. Today, only 23% are. Most of the rest are owned by foreign governments, heavily-regulated banks and pension funds, and the U.S. Federal Reserve. Those guys are NOT the world bond market who buy US bonds because they believe the U.S. government is well runfinancially.
Zweig calls them “price-insensitive buyers.” The many books I read about the Subprime Crisis called them “ratings investors.”
A ratings investor is one who will buy any piece of garbage as long as it has a AAA bond rating. The subprime mortgage—classic garbage—had a high percentage of AAA ratings—basically because the three bond rating agencies (Moody’s, S&P, and Fitch) were corrupt and had a conflict of interest. They got paid by the bond issuers to give AAA ratings and got fired if they did not. They were never punished in any way and still are the main bond raters. The main owner of Moody’s when they were dishonestly and incompetently rating subprime moratgges AAA was Warren Buffett. He, famous for telling investors to make sure they understand the companies in which they invest, excused his involvement by saying he did not even know where the Moody’s offices were. Oh, well, then I guess you’re off the hook, Warren. Go back to singing “I’ve been working on the railroad” and playing your ukelele.
Financial repression is a phrase I discovered when I was researching my book How to Protect Your Life Savings from Hyperinflation & Depression. The first sentence of the Wikipedia article says,
Financial repression is a term used to describe several measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere.
I describe financial repression roughly as the federal government restricting where citizens can put their savings down to only heavily regulated bank accounts and pension funds, then they require those heavily-regulated institutions to buy only U.S. bonds or little more than U.S. bonds through explicit rules, reserve requirements, and ether methods. The government justifies financial repression with arguments like protecting citizens savings and the solvency of institutions. In fact, they are simply using the coercive power of government to force citizens to indirectly buy overpriced (because of high risk not reflected in the interest rate) bonds or they are forcing them to buy bonds so risky that NO level of interest rates would be enough to compensate for their current risk.
Zweig quotes This Time is Different co-author Carmen Reinhart as calling the Dodd-Frank rules requiring derivative traders to post collateral for their leveraged positions “financial repression” in that it creates artificial demand for U.S. bonds. US bonds would be the usual suspects for such collateral. That particular reason alone to buy treasuries will generate $1.4 trillion of purchases on an ongoing basis according to Todd Petzel, chief investment officer at Offit Capital.
Reinhart wrote a Bloomberg article “Financial repression back to stay” on 3/11/12. You should read it. Here are quotes from it:
A large role for non-market forces in interest-rate determination is a central feature of financial repression.
That means markets for government bonds are increasingly populated by nonmarket players, calling into question the information content of bond prices relative to their underlying risk profile -- a common feature of financially repressed systems.
It is difficult to sort out the exact motivations, but as bank deposits have migrated from the periphery countries in Europe to Germany and Scandinavia, among others, the amount of disclosure, red tape and other requirements that are necessary to make such transfers has been on the rise. Although some of these requirements may be motivated by a government's desire to curb money laundering and tax evasion, the measures also amount, in some cases, to administrative capital controls.
In case it is not obvious, this is an outrage. Your federal government is stealing your money in ways that you will not recognize what they are doing. The main symptom is real negative interest rates. If you subtract the current inflation rate from the rates you are earning on your deposits, and you get a negative number, guess what, that is the U.S. government stealing the interest you would get in a true free market—typcially the inflation rate plus about 3% more. Why would anyone save money where the real interest rate is necative? They should not. They put money into such accounts out of mindless habit.
According to the MIT Billion Price Project, the inflation rate in the U.S. at the end of April 2012 was 2%. If you are earning less than that on your money in a non-risky investment, find a better non-risky investment. Like what? See my book. Stuff like relatively liquid hard assets, e.g., Forever stamps, and hard assets you will use yourself as mentioned elsewhere in this article.
A recent finding about the securities market was that most sellers do not sell because they feel the asset in question was a bad investment, rather, they were selling for liquidity reasons. Stating it less technically, they were selling because they needed the cash. Why? For a divorce, to buy some into some great business opportunity, to take a round-the-world trip, pay a big tax bill, meet a margin call on another investment, etc.
Similarly, not every securities buyer buys what he buys because he analyzed it and came to the conclusion that it was a great investment. Many, as described above, buy because they are forced to or pressured to by others.
Get the hell out of U.S. bonds! I sold all mine and all my stocks.
The risk-reward combination of current US bonds is a colossal joke.
Where should you go with the money? I put mine in bank accounts in foreign countries and paid down my home mortgage somewhat. We have improved our home, increased the amount of books that I have have written that we have in inventory, paid off car loans, stockpiled food and business supplies and home supplies like soap.
Basically, you need to stay liquid enough to avoid having to sell assets at fire sale prices—I get that from some U.S. money market deposit accounts and my foreign bank accounts—and you need to move other money to hard assets like your house, vehicles, business.
Wealthy people sometimes ask me what to do with millions of dollars. Buy an extremely high-priced principal residence and the make sure the high price stems mainly from location, NOT size or finish. Spend on reducing every risk that you face: fire, burglary, flood, inflation, car accident injury, etc. You really need to read my book How to Protect Your Life Savings from Hyperinflation & Depression to get the whole story. It is lengthy and complex. I cannot fit it and the explanations of why into an article. The book has 320 pages and an 8 1/2 x 11 format.
Perhaps the main issue is there is a huge market for a passive, no-brainer, safe investment.
But that does not mean there is a passive, no-brainer, safe investment. There used to be: U.S. bonds, AAA corporate and municipal bonds, some foreign bonds. But those have generally gone away. Sorry.
Pretending that such investments still exist won’t make it so. Children believe in fairy tales. Grown-ups need to analyze using reality facts and logic. Essentially, US bonds’s safety today is like the emperor with the new clothes. I and others are the child who points out that the emperor’s new clothes do not exist.
Here is an email I received abotu this:
I enjoyed your article on why U.S. bond yields have remained low in spite of America's declining creditworthiness. I am a trustee for a small public pension and thought you might enjoy hearing about our reaction to the S&P downgrade.
About 40 percent of our fund's assets are in fixed-income, which is very standard. We also have a policy that requires our fixed-income portfolio to have a certain average credit rating. Again, very standard. So what happened when S&P downgraded U.S. debt? Our policy forced us to buy more. How does that work? It's surprising, but really quite simple. When Treasuries were AAA we needed a certain percent of our portfolio to be Treasuries in order to meet our requirement for overall credit rating. If Treasuries are only AA+, we need more of them to bring the average up.
In our case, we actually took action to essentially suspend this policy. But imagine if we hadn't. Policies like ours are very standard for big pensions. I think this probably explains a lot about why yields on U.S. debt have remained so low. I like the term you used--we're ratings investors.
In Chapter 9 of his book Free to Choose, Milton Friedman discusses inflation and asks, why does this piece of paper (a U.S. dollar) have value? Because everyone else accepts it. Why do they accept it? Because they expect it to continue to be accepted by others. Why do they expect that? Because in their lifetimes, it always has been. Fundamentally, the value of the dollar is based on a myth or fiction. He goes on to say:
"The convention or the fiction is no fragile thing. On the contrary, the value of having a common money is so great that people will stick to the fiction even under extreme provocation... But neither is the fiction indestructible: the phrase 'not worth a Continental' is a reminder of how that fiction was destroyed..."
James Drake
John T. Reed