I
think that the bond market has generally reversed itself already and
is consolidating prior to an actual signal that establishes a new
trend line. This will take a lot of time approaching a couple of
years. What is driving it though is investor sentiment which can not
accept meaningless returns forever.
What
they have been accepting is inflated physicals world wide. This had
no yield either, but it also does not have an expiry date. Think
about that. All a bond can offer is a trivial yield and your money
back after at most twenty years. The purchasing power of that money
in twenty years is natually much less, particularly with the feds
behavior factored in.
Thus
buying over priced real estate makes perfect sense in terms of a
fifty year time span. The result is that all those pools of hot
money are simply been used to park land assets in particular for long
time spans. This is not bad news for the economy because it is
moving huge amounts of capital into better hands and into a more
productive role in the economy.
The
unusual thing is that private money is now doing this because it has
to. What I am saying though is that all that blind money out there
is becoming more intelligent and demanding to be treated better just
when all the easy investments are about to generally contract. This
is global and it is huge. Making it completely simple, the oil
industry is about to expire almost completely. That represents about
an eight of the global economy and it will represent an eight loss of
the direct costs underlying the global economy as well. I can say
this with authority because I can do this today.
The
offset will continue to be pricy uneconomic real estate.
Henry Bonner
Jim Grant: We’re
in an Era of ‘Central Bank Worship’Sprott's Thoughts
Friday, October 3,
2014
Jim Grant is the
publisher and editor of Grant’s Interest Rate Observer, a
bi-monthly newsletter that he founded in 1983, around the time when
bonds were considered some of the worst investments – when they
yielded 13 to 15 percent.
Rick Rule, Chairman of
Sprott US Holdings Inc., often quotes Jim Grant’s description of
government bonds as ‘return-free risk.’ (Rick sees US Treasuries
as the ‘anti-gold’).
Mr. Grant took my
questions on interest rates and the bond market – including Bill
Gross’ recent departure from PIMCO – via phone from his Manhattan
office.
Mr. Grant, you argue
that companies whose share prices are rising should be becoming more
efficient – hence driving down the costs of consumer goods and
services.
The Fed is succeeding
in keeping both stock market prices and consumer goods prices moving
higher – which look like contradictory goals. Do you think this
situation is sustainable going forward?
Many years ago,
falling prices were a sign of improved efficiency and expanding
wealth, and of widening consumer choice. Thanks to the spread of
electricity and other such wonders in the final quarter of the
19th century, prices dwindled year by year at a rate of 1.5% to
2% per year. People didn’t call it deflation – they
called it progress. Similarly, in the 1920’s there were advances in
production techniques. The prices didn’t decline and didn’t rise.
They were stable. Looking back on the 20’s from the vantage point
of the 30’s, many people wondered why prices had not fallen. They
concluded that it was because the central banks were emitting too
much credit, and that credit had served to inflate asset values. It
had also pushed the world into a very imbalanced credit and monetary
situation towards the close of the 20’s.
Fast forward many
generations and here we are today with a world-wide labor market
linked through digital technology. We are the beneficiaries of
Moore’s law. Nearly every day we see new, wonderful,
labor-enhancing machinery coming into the workplace – including new
software. And yet, prices don’t fall. They tend to rise,
albeit by 1% or 2% per year. Central banks seem to want more than
that. You do wonder – I wonder – what would be wrong
with what Wall Mart calls ‘everyday low and lower prices.’ People
seem to rather relish that – certainly when shopping on the
weekends. Central banks want no part of it. So, I see that as a
contradiction. What central banking policy has done is to
inflate consumer prices that, if the laws of supply and demand were
properly functioning, would have tended to fall. At the
same time, central bank policy has tended to inflate the prices of
stocks, bonds, and income-producing real-estate. Why it is that these
immense emissions of new credit by the central banks have not been
inflationary? Well, it seems to me that they have been inflationary,
because prices are rising not falling.
Do you think that the
situation will continue going forward – rising consumer prices
along with rising stock prices?
What I don’t know
about the future, we don’t have the time to go into. I dare say
that stock prices will not continue to rise uninterrupted at the same
pace. That’s not a very interesting prediction, but the stock
market is certainly a cyclical thing. Stock prices will pull back in
the fullness of time, whether it starts 5 minutes, 5 months, or 5
years from now. I think it’s fair to observe that today’s
ultra-low interest rates flatter stock market valuations. Stock
prices are partly valued based on a discounted flow of dividend
income. To the extent that the discount rate you use to
value that stream of dividend income, which depends on interest
rates, is artificially low, stock prices are artificially high. I
think that the burden of proof is on anyone who would assert that we
are in a new age of persistently and steadily rising stock prices.
On the subject of bond
markets, you’ve said: “does it not seem incongruous to chase
low-yielding fixed-income securities denominated in a currency that
the central bank is vowing to inflate?” Why do you think that
investors go into bonds despite the Fed’s intention to devalue them
over time?
Well, I can’t
explain it. I can try to piece together what might be driving people
to do that, but, to me, it’s a mystery. One thing to bear in mind
is that bond prices have been rising and yields have been
falling since fall of 1981. That’s a long time and
there’s something in financial markets that we might call ‘muscle
memory.’ Long-running trends tend to gather force, just as a rock
rolling down a hill tends to pick up speed. There’s something about
the persistence and age of this bull market that leads more people to
think that it will continue. That said, fixed-income investors are
intelligent and reasoning people. That can’t be the entire
explanation. I see that in Europe money market interest rates are
trending below zero. You have to search long and hard over the globe
to find government securities in developed countries yielding more
than 2%. In Ireland, some short-term securities are yielding less
than 0%. Why would people buy them? I simply don’t know – I can’t
fathom it --, but they certainly are, hand over fist.
You’ve also said
that Treasury investors may ‘repent at their leisure’ for buying
US Securities, and that corporate investors will one day wish they
had not invested so heavily in corporate bonds. Do you see a bear
market coming imminently for bonds?
Yes – starting about
2002…
Henry, now, that’s
meant to be a laugh line.
I have wholly been way
out of step with the bond market for a long time, and everything that
I say with regards to the future of interest rates deserves to be
written in something like invisible ink. You know, in a work entitled
‘Security Analysis,’ a work about value investing written by
Benjamin Graham and David Dodd, this approximate phrase appears:
“bond selection is a negative art.” Well, what Graham and Dodd
meant by that is that, because the buyer of a bond at par can do no
better than getting his money back and earning some interest along
the way, the prospect for gain is inherently limited. Risk ought to
be at the front of the mind of the creditor. There are no 2 or
3-baggers in investment-grade bond investing. You have to be mindful
of what can go wrong, and it seems that the world over, thanks to
these policies by central banks, bond investors are not looking at
risk, or feel they can’t afford to look at risk. Rather, they are
grasping at the few straws of yield that remain and I think that
posterity will look back at this with wonder.
“Think of it” –
I’m now putting words in posterity’s mouth. “Think of it,
people were buying as if the supply were limited. They were buying
government securities, which yielded practically nothing. They were
buying bonds denominated in currencies that the central banks
explicitly vowed to depreciate. Why did they do that?”
So, I think posterity
will ask that question. Certainly I am asking that question now, and
I can’t come up with a really persuasive answer.
What would a bear
market in bonds look like? Would it be accompanied by a bear market
in the stocks?
Well, we have a pretty
good historical record of what a bear market in bonds would look
like. We had one in modern history, from 1946 to 1981. We had 25
years’ worth of persistently – if not steadily – rising
interest rates, and falling bond prices. It began with only around a
quarter of a percent on long-dates US Treasuries, and ended with
about 15% on long-dated US Treasuries. That’s one historical
beacon. I think that the difference today might be that the movement
up in yield, and down in price, might be more violent than it was
during the first ten years of the bear market beginning in about
1946. Then, it took about ten years for yields to advance even 100
basis points, if I remember correctly. One difference today is the
nature of the bond market. It is increasingly illiquid and it is a
market in which investors – many investors – have the right to
enter a sales ticket, and to expect their money within a day. So I’m
not sure what a bear market would look like, but I think that it
would be characterized at first by a lot of people rushing through a
very narrow gate. I think problems with illiquidity would surface in
the corporate debt markets. One of the unintended
consequences of the financial reforms that followed the sorrows of
2007 to 2009 is that dealers who used to hold a lot of corporate debt
in inventories no longer do so. If interest rates began to
rise and people wanted out, I think that the corporate debt market
would encounter a lot of ‘air pockets’ and a lot of very
discontinuous action to the downside.
Is it possible for the
Fed to ‘lose control’ of the bond market and yields?
Absolutely, it could.
The Fed does not control events for the most part. Events certainly
will end up controlling the Fed. To answer your question – yeah. I
think the Fed can and will lose control of the bond market.
So no matter how many
bonds the Fed buys, it eventually won’t be enough to keep yields
low?
Well, let’s try to
imagine a case where the Fed proposed to buy every single bond in
existence. To do that, it would undertake to print more money than we
– even us hardened veterans of the QE era – could imagine. If the
Fed undertook to print the money necessary to buy all the bonds on
offer, it would spook at least the more thoughtful investors, who
would see that the Fed would certainly be undertaking a truly radical
program of inflation.
It seems like the Fed
is doing almost exactly that today – and we’re still waiting to
see the adverse effects.
Well, yes indeed. I
think this is a time where people will look back on us and see it as
a period of practically central bank worship. The central bankers –
Draghi, Yellen, Bernanke – have become almost celebrities in
America. People have invested unreasonable hopes in what these
central banks can know, and what they can do. I think that, sooner or
later, the investing public will become disillusioned of these ideas.
What are ‘safe haven
assets’ if you believe that a bear market in bonds is inevitable?
Well, if we believe
that financial markets are cyclical, then bear markets are inevitable
-- just as bull markets are inevitable. I wish I could tell you when
these will happen – I can’t. I think that the nature of a safe
haven will depend on the type of bear market and the reason for that
bear market. You can imagine a bear market in bonds where the reason
was an unscripted burst of prosperity. Let’s say that the
indestructible American economy, for whatever reason, got back its
mojo, and the Fed seemed to be way behind the curve. Interest rates
would go up for the wholesome reason that things were looking better.
At that point, you could make a very good case for common stocks.
If the bond market
sold off because of a sudden and unscripted loss of confidence in the
currency, that would be a different matter altogether. I think that
‘safety’ is not inherent to any asset – rather, ‘safety’ is
a function in large part of valuation. Towards the tail end of the
great bond bear market of 1946 to 1981, people were fed up with
fixed-income securities. They only seemed to go down in price
–investors were always disappointed. They slapped various labels of
scorn on the entire asset class. That was when people first called
them ‘certificates of confiscation’ – and that was when they
yielded 13%, 14%, or 15%. They certainly were not certificates of
confiscation as events revealed. Today, when bonds yield a great deal
less than 13, 14, or 15%, most investors regard them as intrinsically
safe assets. Well, they are not intrinsically safe. They are popular
– that’s a very different matter.
At Grant’s, we try
to look for assets that are castoff, unpopular, out-of-favor, and
value-laden. We have been looking at common stocks in, for example,
Argentina and Russia. These are places that would appear to be
inherently unsafe. We’ve of course been looking at gold and gold
mining shares for a long time too. What gold, Argentina, and Russia
have in common is that people are, by and large, going from them
rather than towards them. If you asked the average person on the
street whether securities relating to those three areas were safe or
unsafe, I think that 99 out of 100 would say ‘unsafe.’ There is a
great deal to be said for the ultimate safety that low valuations
afford. That’s how we approach the situation. A little bit less
exotically, we’ve been looking at business development companies
generating attractive cash flows in this time of ‘yield famine.’
‘Safety’ is a tricky and paradoxical concept. The safe assets are
often the ones that people regard as hopelessly risky.
One more question –
Bill Gross recently announced his departure from PIMCO. Is this a
trivial event, or a sign of something more fundamental happening in
the bond market?
I don’t know how to
read it. Maybe after 40-odd years in the same place, Bill Gross
deserved a change of scenery? I think he has enough money to retire –
I dare say he could scrape by on a billion or so. He seems to want to
continue to work – that’s laudable. Insofar as his exit having a
deeper meaning, it may be to underscore the new illiquidity of the
bond market. On news of his exit, a lot of different classes of
fixed-income securities sold off, and I wouldn’t have expected
Treasuries and mortgages to move the way they did. We at Grant’s
think that the illiquidity of fixed-income securities might be one of
the important themes of the coming autumn for the bond market.
By ‘illiquidity,’
you mean that investors are unable to buy and sell bonds easily?
It’s not difficult
to buy them.
So it’s difficult to
sell them.
Correct. What you want
is a ‘greater optimist’ and it’s not clear that a ‘greater
optimist’ will be available when you want to get out.
P.S.: Want to receive
more interviews like this one? Subscribe to our regular
e-letter, Sprott’s Thoughts. It’s free. Also tune in to our
free webinar on October 7th, featuring Eric Sprott, John Embry, and
Rick Rule in a gold-focused round-table discussion: “Gold – Where
do we go from here?” Register here.
James Grant
founded Grant's Interest Rate Observer in 1983 following a
stint at Barron's, where he originated the "Current Yield"
column.
His books include works of financial history, finance and biography. They are: “Bernard M. Baruch: The Adventures of a Wall Street Legend” (Simon & Schuster, 1983); “Money of the Mind: Borrowing and Lending from the Civil War to Michael Milken” (Farrar, Straus & Giroux, 1992); “Minding Mr. Market” (Farrar, Straus & Giroux, 1993); “The Trouble with Prosperity” (Times Books, 1996); “John Adams: Party of One” (Farrar, Straus & Giroux, 2005); “Mr. Market Miscalculates” (Axios Press, 2008); and “Mr. Speaker! The Life and Times of Thomas B. Reed, the Man Who Broke the Filibuster” (Simon & Schuster, 2011).
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