The simple answer is that interest rates will be going up in the near future, and this will cause a collapse in the value of bonds, all types of bonds, especially longer term bonds. The credit crisis is not over now, just as it was not over in 1931. When Bernanke announced the implementation of QE2 last November 3rd, the second major round of publicized Fed money printing to buy an additional $600 billion long term Treasury Bonds on the open market, his unstated purpose was to prevent the rise of long term interest rates.
Consumer prices are already rising across the board, despite a contracting economy, so what's all this talk about deflation?
The Fed is quick to point to falling real estate prices. But a drop in real estate will no more cause consumer prices to fall than the real estate boom caused them to rise. Real estate prices are too high, and the economy will never truly recover unless they are allowed to fall. It is interesting that when real estate prices were rising, the Fed did not raise rates to bring them down, but now that they are falling, the central bank feels compelled to lower rates to prop them up. If falling real estate prices threaten deflation, why did the Fed not perceive an inflation threat when real estate prices were rising?
My thinking is that, at the end of the day, all this deflation talk is a red herring. The true purpose of QE 2 is to disguise the decreasing ability of the Treasury to finance its debts. As global demand for dollar-denominated debt falls, the Fed is looking for an excuse to pick up the slack. By announcing QE 2, it can monetize government debt without the markets perceiving a funding problem. If the truth were known, a real panic would ensue. So, the Fed pretends buying treasuries is simply part of its master plan to boost the economy, even though, in reality, it is simply acting as the buyer of last resort.
Which is exactly what the Fed is doing, monetizing the debt. Printing money out of thin air to payoff debts the government cannot afford and killing the dollar in the process.
The following day, on November 4, 2010, Bloomberg Businessweek's Economics editor wrote:
What gives the Fed's plan at least a chance of success is the bank's almost magical ability to create money out of thin air. When the Fed buys a Treasury bond, it pays by simply marking up the balance in the seller's account at the Fed. It's the electronic equivalent of printing money. Bernanke will use this unique money-creation power to scoop up lots of Treasury bonds. By increasing the demand for them, he hopes to increase their price and push down their yields. Then, if all goes according to plan, falling yields on Treasuries will induce investors to move some of their money to other fixed-income securities with higher yields, ranging from corporate bonds to securities backed by mortgages, auto loans, and student loans. Stepped-up demand for those securities would drive down their yields, too, the Fed hopes, lowering interest rates throughout the economy and stimulating growth.
The Fed's new foray into bond purchases has to lower long-term rates to succeed. The $600 billion is less than it has already spent.
The Fed has failed in keeping down long term interest rates which have already risen. And the next time the economy is in desperate need of support, there will undoubtedly be a much larger, multi trillion dollar QE3. Bernanke is a one trick pony. He sees a problem, and just throws more and more money at it, rather than address it with a responsible monetary policy. On November 2, 2010, the day before Bernanke made his announcement that the Fed would begin its “asset purchase plan” (QE2), the ten year treasury bond was yielding 2.59% Three months later on February 8th, 2011, it had reached 3.72%, higher by over 1.1%. It closed March 29th, 2011 at 3.49%
Where does all this freshly printed Fed QE2 money go? To the big banks. The Fed buys these mid and longer dated treasuries from banks, not from individuals. And what do the banks do with the money? They either lend it out (inflationary), or they leave it on deposit with the Fed as excess reserves (delayed inflation).
The zero interest rate policy (ZIRP) of the US Federal Reserve has been disastrous for the economy, and there is no end in sight. It was intended to revive the housing sector with low mortgage rates, but has failed in the attempt.
Tuesday, the Case-Schiller housing index was released which showed that the composite 20 city housing price index fell 3.1% in the past year, and is now “down 31.3% from the peak. The Composite 20 is only 0.7% above the May 2009 post-bubble bottom and will probably be at a new post-bubble low soon.”
So the Fed’s QE1 and QE2 asset purchase (money printing) programs have not accomplished their stated purpose of price stability, either.
ZIRP was supposed to be only a temporary, emergency measure, which has now been made permanent. Increasing this rate would elevate the entire yield curve, exacerbating the chronic and ever increasing current account deficit faced by the federal government, so this is not an option no matter what Bernanke says. With massive deficit spending firmly entrenched in US fiscal policy and no sign of any political will to deal with it seriously, the Fed has no choice but to continue ZIRP ad infinitum until it crashes the system.
Look what this policy has done for Japan over the last twenty years, and you will get a glimpse of the stagflation in our immediate future, and that is only if we are lucky. Unlike the Japanese, the Fed, in concert with our politicians, seems intent on printing money (QE) to infinity as well, as they merrily kick the can down the road to disaster (hyperinflation).
Bill Gross, the PIMCO bond king, recently announced that his flagship bond fund, Pimco Total Return Fund, had liquidated 100% of its US Treasury bond holdings by the end of February, down from 12% of the total in January. It is a highly significant signal when a major player like Bill Gross completely abandons what is supposed to be the world’s safest investment. Here is what he was probably looking at:
[Click to enlarge]
This is a recent look at the last two decades of the 20 year Treasury Bond yield courtesy of the Federal Reserve. The Fed Funds rate was already pegged at 0% to .25% ever since December 2008, and apparently the Fed has no intention of EVER raising this rate at which its banker buddies can borrow money overnight any time that they want. Looking at this chart, we see that the 20 year bond yield bottomed out at 3% in late 2008, the culmination of a multiyear trend that began in 1981. If you draw another black line connecting the lows in 1996, 1998, 2003, and 2008, you would get a channel defining the multi decade downward trend in interest rates.
The 20 year treasury bond yield can’t possibly continue its decline indefinitely and approach zero, because in reality, no one in their right mind would tie up their money at less than 1% or 2% interest for a period of twenty years. Instead, they would switch to shorter term US bonds paying a bit less, leave it all in cash, or invest in sovereign bonds paying a decent yield, Australian, for instance. So the question becomes, “when does it bottom out and begin climbing?” Today, the twenty year yield is right at the top of the channel, and looks likely to break out above it. If this happens, it would be impossible for a large player like Bill Gross to exit his huge bond position in time to avoid major losses as the rest of the world simultaneously starts flooding the market with US Treasuries.
Now imagine a line starting from the December 2008 low connecting to the 2010 low and continuing upward. That defines the bottom of the new channel Bill Gross saw, and that is why he dumped tens of billions of US Treasuries over the last few months. Not to mention the fact that Bill Gross, unlike the average individual investor, has access to interest rate default swaps, a type of derivative used to insure against losses from rising interest rates. He could have purchased these to insure his US Treasury bond position instead of abandoning it, but chose to cut and run.
There must have been heavy establishment pressure on Bill not to dump Treasuries, but above all, he needs to protect his business reputation in the face of obvious peril involved in holding treasuries while interest rates surge. There’s really nowhere else for them to go but up. And the pressure must also be heavy on Japan not to sell US Treasuries, even though they desperately need a source of money to rebuild after the quake/tsunami, and by all rights they should be able to liquidate their savings to do so. Even if Japan merely ceases purchasing US Treasuries, it will have a major negative effect on bond prices/interest rates in the US. They are currently one of the largest buyers of US Treasuries together with the Federal Reserve and the Chinese.
The Chinese are major holders of US treasuries, currently holding over $1 trillion dollars worth, and that is not including hundreds of billions worth of US agencies. Over the last few years the Chinese have been shifting into shorter duration bonds which don’t pay much of a yield, but will allow them to recover their principal with just a short wait once they abandon US treasuries (cease purchasing). If they tried dumping treasuries on the open market instead, it would immediately depress the price causing their huge reserve holdings to lose value. By patiently shifting into shorter durations, they eliminate the need to sell, and can just wait a short time to collect full value as they mature.
Here is a nice chart of the longest duration US Treasury bonds, which clearly shows the changing interest rate trend. Bill Gross, the Chinese, and many other insiders are positioning themselves ahead of this changing trend. Will you join them in selling bonds to protect your portfolio?
If you have any holdings in a mid or long term bond fund such as iShares Lehman 20+ Year Treasury Bond Fund (NYSEARCA:TLT), or Vanguard Long-Term Bond ETF (NYSEARCA:BLV), or Vanguard Long-Term Government Bond ETF (NASDAQ:VGLT), or Vanguard Long-Term Corporate Bond ETF (NASDAQ:VCLT), I would strongly recommend selling them today. This goes for all mid and long term bonds, and bond funds. That current income won’t do you any good if you take a 50% to 75% loss on the principal and need to sell it for spending money at some time in the future. At current rates of interest, you are being undercompensated for the risk.
What is a bond? It is a debt obligation, an I.O.U., pure and simple. It may be secured (by a company’s assets, for example) or unsecured (such as a government bond). If a company defaults or declares bankruptcy, the bondholder would have to go to court to get partial or complete compensation. If a government defaults, you have no real recourse. It can be argued that governments should behave responsibly and use bonds only to finance expansion, or other special projects, but it could just as easily be argued that governments should live within their means and never borrow money except in times of emergency (war, natural disaster).
Retirees have traditionally bought bonds for a safe income stream to fund their monthly retirement expenses. They relied on the monthly payments of a debtor for this income stream rather than the income stream of a profitable company (dividends). As the debtor goes further and further into debt, the likelihood of default on those payments increases, and puts the security of the bondholder’s retirement at risk. If the debtor is the United States federal government, then they can print all the money they need to continue making the monthly interest payments, (although this is technically a form of default), since it comes out of the retirees’ pockets eventually in the form of inflated prices on the goods and services that they require to survive and enjoy life.
If the debtor is a city, county, state as with municipal bonds, then the likelihood of default becomes a reality, and the interest rate should be far higher to compensate for this added risk. Municipalities can’t print their way out of debt like the federal government can. Most people never even worry about the risk of default on munis, but with the federal government already insolvent with no realistic hope of ever paying off the national debt, or even balancing the federal budget through tax increases and spending cuts alone, it is clear that they will never be able to bail out all the states and cities as they continue to overspend themselves into insolvency. If they did bail out all the failing municipalities, the resulting inflation caused by the additional money printing required would rocket the country toward hyperinflation.
Corporate bonds have all the risks of municipals and many, many more: loss of market share, squeezed margins from price inflation of commodities and other production inputs, mismanagement, bankruptcy, obsolescence of their products caused by advances in technology, etc. There were once thriving companies producing typewriters, buggy whips, and buttonhooks. I’m sure that many retirees were holding their bonds at the time they went under.
No investment is without risk. Dividends can be cut, or eliminated entirely. But one might consider it wiser to own a share of the continuing income stream of a profitable company, rather than the debt obligation of a company (or government) that can’t even function without borrowing the money to operate. The real estate bubble and the market crash of 2008 were cause by the over extension of credit by the Federal Reserve, and the inability of businesses and consumers to pay back all the debt. This is not a good time to place the security of your future retirement on someone else’s ability to repay their debt.
This is why I cannot, in good conscience, recommend that anyone, no matter how old, buy bonds of any type in their retirement portfolio. This may have traditionally been a good source of retirement income, but we are talking about the next few years now, not the past. The bubble is about to burst.
Disclaimer: I am not a professional financial planner. I am a macroeconomist with an interest in retirement planning and helping people preserve their life savings from the ravages of mismanaged government policy and corporatism. I believe that following the obvious macroeconomic trends will make you more money than focusing on individual investments and sectors. Today in 2011, the most important trends to follow are the multi year price imbalance in the precious metals market, peak oil, the continual devaluation of the dollar and all fiat currencies, world population growth, baby boomer demographics, the continual decline in the housing market, and the insolvency of the banking/financial/insurance sector. To keep things simple, the goal is to limit the portfolios to no more than ten to twenty individual holdings. Mutual funds, ETFs, ETNs and derivatives of any kind are to be avoided, although physical precious metals funds are necessary to substitute for physical bullion holdings.
Excessive diversification for the sake of diversification may limit your losses but will also limit your gains. Concentration is obviously good if concentrated in the correct areas. Traditional retirement allocations have included both stocks and bonds based on past performance that bonds would often perform opposite to stocks. In the coming few years, I believe that the bond bubble will burst, and stocks will also perform poorly. A portfolio of precious metals, certain commodities, and carefully chosen stocks will outperform. I’m currently avoiding all retailers, bankers and homebuilders based on the current economic conditions.
I would advise any investor at this time to have at least 50% of their investment capital in physical silver and gold bullion to protect against the coming currency collapse. You would need to achieve incredibly high, unrealistic investment returns to compensate for the fact that the US dollar is losing 50% of its purchasing power every 10 years. But since most people are too complacent or find other objections to investing in physical bullion, my model portfolios are designed for use in self directed retirement accounts by those who won’t follow my good advice to purchase physical bullion. All are designed as long term buy and holds with a minimum time horizon of five years. Portfolios should be examined once or twice a year to insure that all holdings are still compatible with current macroeconomic trends, and have not cut dividends. I’m not interested in the many short term trading strategies using these same trends that may produce higher returns, as these are time consuming to actively manage, and assume more risk. I’m interested in helping the individual investor who prefers to manage his own assets, while getting superior total return without wasting money on a professional who gets paid no matter how poor the results. Do not use this model portfolio as investment advice. Your own portfolio should be customized for your individual situation. Always consult a financial professional, but avoid the 98% of financial professionals that don't think for themselves, and don't have a thorough knowledge of the fundamentals and long term trends in the precious metals markets, peak oil, and other macroeconomic trends
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.