Monday, November 12, 2007

Changing Tides I: Interest Rates and Bonds

Astute readers often request guidance on what we regular folk can do to weather the coming financial meltdown.
For instance, here is Suzanne C.:


I read your essay on November 5th Empire of Debt I: The Great Unraveling Begins - very interesting and very enlightening. With all the turmoil going on in the markets, where would you invest money at this point? Things like gold and gas stocks have already gone up so much, but I don't want to stay in cash either. Your suggestions would be most appreciated."

Reader Than H. wrote:

I must tell you that I am gravely concerned at your predictions in your piece, "The Great Unraveling Begins". Is there anything that you can suggest the common man and woman can do to stem what I fear (but agree) will probably be many years of financial pain down the road?

Simply stated, are there any measures you might suggest that the non Wall Street billionaires among us can take to buttress ourselves from any coming economic storm that may be tracking our way? Do you foresee Great Depression like conditions? By your predictions, I am fearing that more and more, not that your piece was the first thing to shed a brutal light on reality, but just a further acknowledgment.

If you have any advice for readers like me, please let me know."

These are profound questions which I will do my best to cover. I am not qualified to offer specific investment advice, nor do I have any desire to do so, so please don't expect to find some simple homily here like "sink every last dime you have in silver." There is no simple answer to investing, for it depends on your personality, financial situation, appetite for risk, time-frame, etc.

But the financial markets do rise and fall much like the tides. If you pause on a beach for only a moment, you can't tell whether the tide is rising or ebbing; an occasional rogue wave might rise higher on the sand, falsely leading you to believe the tide is rising when in fact it is ebbing. Thus we have to take a longer view to see which way the tide is flowing.

In any market these tides are called trends. In an uptrend (Bull Market), you can buy just about any index or fund and make money. The same strategy in a downtrend will result in losses. The most important part of an investment strategy, then, it to get the trend right. If you get that wrong, then it's hard to maintain your purchasing power, i.e. keep up with inflation, never mind actually increasing your purchasing power.

For Instance: As the chart for the Dow Jones Industrials 1966-1979 in When "Buy on the Dips" Becomes a Pampers Moment revealed, your $1,000 invested in the DJIA in 1967 lost 2/3 of its value by 1982 when you account for the period's high inflation.

The DJIA essentially entered a trading range for 14 years, and if you held the index for that time period you lost 2/3 of your purchasing power, even as the index appeared to "hold its own" in nominal dollar terms. (Note I did not adjust for dividends; with those meager returns tossed in, the hapless "buy and hold" investor probably only lost 50% of their money in those 14 years.)

The financial markets appear to be entering a period of great volatility. The best that any of us can do--billionaires included--is get the primary trend right. In other words, there may be more frequent "wild swings" as the market participants try to ascertain if the primary trend is up (Bull) or down (Bear) in all sorts of markets: the dollar, U.S. stocks, emerging markets, gold and silver, commodities, petroleum, interest rates and bonds.

So where should we begin? Let's start with interest rates because if the tide has turned and cheap money is no longer freely available, then you can kiss housing and auto sales good-bye. And all other large consumer purchases, too.

Rising interest rates and the cut-off of "free and easy" borrowing would mean U.S. consumer spending (70% of the U.S. economy and 21% of the global economy) would plummet, rudely shoving the U.S. and the global economy into a deep recession.

Here is one of my favorite charts. If you care about trends, it is highly illuminating.

Please go to www.oftwominds.com/blog.html to view the charts.

Before we dig into the chart above, let's note right away that the U.S. consumer saves less than nothing. Various cheerleaders have attempted to explain away this negative savings rate--the first such period since the Great Depression--by saying that 401K pension contributions aren't counted, and so on.

These are the usual cheerleader prevarications and obfuscations. Other nations in Asia and Europe have household savings rates in the 10% - 20% range--and they don't need fancy footnotes to explain the simple reality: U.S. households save less than nothing, while many other nations' citizens save prodigiously.

So why do we care? Here's why: foreigners have stopped buying U.S. debt. The latest U.S. government statistics reveal that the Chinese actually sold $10 billion in U.S. bonds last month, where for years (see green bars above) they were buying $10 billion or more a month.

What happens when nobody shows up to buy U.S. government and commercial/corporate bonds? The seller has to raise the yield to entice wary buyers. This is how the game worked up until recently. The U.S. ran a huge trade deficit with the rest of the world (roughly $750-$800 billion a year). Foreign governments took all these surplus dollars and bought U.S. Treasuries with the bucks, keeping U.S. interest rates low so the "junkie" (the spendthrift U.S. government and consumer who was borrowing heavily to buy consumer junk and fund an expensive war in Iraq) could continue buying their "cocaine" (consumer goods).

Unfortunately for the non-U.S. lenders, the U.S. has been playing an insidious game called "devalue the dollar." As the dollar has plummeted 37% since 2002, the non-U.S. owners of U.S. bonds have seen the purchasing power of their holdings slashed by 37%.

Multiply $3 trillion (guesstimate of non-U.S. ownership of U.S. Treasury and commercial debt) by 37% and you get, wow, $1 trillion in losses. Hey, a trillion lost here and a trillion lost there, and pretty soon you're talking real money.

Even as non-U.S. central banks are tiring of this charade, non-U.S. banks, pension funds and insurance companies are tiring of finding their "safe" U.S. mortgage-backed securities, CDOs and SIVs turning out to be worth 70%, 50% or even 0% of their original investment.

The U.S. investment banks have played 3-card monte with every sucker in the world, and now the suckers are drifting away in disgust.

Now take a look at the "long cycle" this chart reveals. Bond yields rise and fall in about 20-23 year cycles. Yields (and thus interest rates on mortgages, auto loans, etc.) topped out around 1982, and then fell until 2003. They have since started to rise.

Various bond pundits are predicting yields/rates will fall. This chart suggests they will be proven disastrously, horribly wrong. Interest rates don't drop for 21 years and the stay flat for another 20 years; historically, they rise.

Let's turn to a chart provided by frequent contributor Harun I. awhile back. Note that the value of any long-term bond rises as the yield drops and falls as the yield rises. Thus the value of the Treasury bonds dropped to all-time lows when interest rates hit 15% in 1981, and they rose all through the 2000-2004 period as interest rates fell.



Without belaboring the point, here's how this works. If you buy a 10-year Treasury (or corporate bond) tomorrow which pays 5%, what happens if interest rates rise to 10%? Who wants a lousy bond paying a lousy 5%? Nobody. The face value of that bond falls by 50%, down to the point that the effective yield is 10%. This is why rising interest rates absolutely devastate the bond market.

In summary: we have glib pundits predicting low or even dropping interest rates forever, but they will be proven terribly wrong. Why? Because the U.S. banks and government have ripped off non-U.S. investors to the tune of trillions in losses, via a sharp devaluation of the dollar and via "marked to model/myth" garbage debt packaged and sold as "safe" investments.

Non-U.S. entities are now net sellers of dollar-denominated debt, and you have to wonder what took them so long. The Big Con suckered them in, and now they are suffering stupendous losses. Do you really agree with the bond cheerleaders that non-U.S. bankers and investors are dumb enough to trust any U.S. security ever again? Maybe in 20 years.

There are potential saviors: U.S. pension and insurance companies. Frequent contributor Albert T. has suggested that these U.S. financial institutions have the assets in hand to buy U.S. Treasuries and corporate bonds as foreign entities sell. He may be proven correct in this; but I have some doubts, based on the inflation rate.

As I have covered ad nauseum here before, actual inflation is running about 6-7% annually, if not more. If you're a fund manager, and you buy a 20-year bond paying 5%, then you're losing 2% a year in real terms. Can you do that and keep your job? I don't see how you can--you're losing money every year. You might buy the bond on a gamble that yields will fall to 4%, but if you're wrong and they double to 10%, you'll take a 50% haircut-- a catastrophic loss for a "safe" investment.

The historical cycle--the tide, if you will--is running against the cheerleaders and optimists. The tide has turned, and interest rates are rising, and will contiue to rise for at least another 15 years.

OK, so the Fed has briefly run yields down; but if nobody buys their lies about low inflation, then who will be stupid enough to guarantee losses for decades to come by buying a low-yield bond or mortgage-backed security or corporate bond? No one.

That's how we get interest rates and yields rising for the next 15 years, folks; the U.S. bankers have conned the world with bogus MBS, CDOs and SIVs, while the Fed and Treasury have shredded non-U.S. holders of U.S. debt with an "incredibly shrinking" dollar.

When nobody steps up to buy the risky debt at 5%, then you have to raise rates regardless of what the U.S. mortgage, commercial paper and credit card lenders are screaming about.

There are a couple of other problems. If U.S. pension funds and other institutional investors lose a few trillion in the current market meltdown, they may not have any free cash to invest in new U.S. debt. There may be few buyers of low-yielding debt. Nobody seems to think this is possible, which is a good reason to think it might.

Ironically, a sharp rise in U.S. interest rates would immediately support the dollar. Buying euros in 2002 when $1 = 1.15 euros was a brilliant idea. Buying euros now when $1 = .69 euros--maybe that's not a sure bet any more.

Bottom line: if you think the tide has turned and interest rates will rise for years to come, then you would not be interested in buying long-term Treasury, mortgage or corporate debt. If you agree with the cheerleaders, that interest rates are sure to fall and stay low for years or even decades to come, then you'd buy long-term debt with abandon.

Here's the truly frightening part of the above chart: note that Harun's projection for the possible head-and-shoulders pattern actually exceeds the 1981 low. THis opens the door, figuratively speaking, to the possibility that rates will rise higher than the 16% peak reached in 1981.

Don't think that's remotely possible? Neither did anyone in 1970. The low interest rates of the 60s were supposed to last forever, too, but they didn't; the tide turned, and the pundits and cheerleaders were too busy congratulating themselves to notice.


Thank you, Dineshkumar P. ($10) for your generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

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