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Bond yields have been generally declining, and the market as a whole is set up for them to continue the trend.
Not bad, right?
Wrong.
It's extremely dangerous - to all investors - because it can't go on forever. It's not a question of if this might happen, it's a question of when.
Fortunately, there's one antidote to this poisonous path. But first, you need to see the path we're on and its dire consequences.
Bonds are integral to the entire financial system and the economy as a whole. At some point sooner rather than later, bond yields will start rapidly increasing - and the bond market will become a Death Star, devastating the global economy.
Since 2008, and to a large extent since 1995, the bond market has been subsidized by the Federal Reserve, which has consistently printed more money than the economy demands - with broad money supply rising by over 8% a year since 1995, compared to a nominal GDP rise of less than 5%.
That subsidy has been hugely increased since last September, with the Fed buying $85 billion monthly of long-term Treasury and mortgage agency bonds.
Distorted Path
When something is heavily subsidized, its price gets out of whack.
And that's what has happened to the bond market, where 10-year Treasury yields have been at or below the rate of inflation for several years - and now even 10-year TIPS (Treasury Inflation Protected Securities), which are essentially inflation-linked bonds, have a negative yield.
The U.S. economy is now four full years from the bottom of the last recession. Based on the last 100-plus years of history, 10-year yields should now be about 2% above the rate of inflation.
At some point, the Treasury bond market will correct itself, and T-bond yields will revert to that level - meaning about a 5% nominal yield on the 10-year Treasury bond. It probably won't happen this year, but I'd be pretty surprised if it hasn't happened by the end of 2014.
The recent modest run-up in 10-year Treasury yields from 1.5% to 2.1% has caused considerable hiccups in markets -- for example producing about a 20% drop in the price of mortgage REIT stocks, even as the market as a whole has been rising. A run-up to 5% yields will have much bigger effects:
- Most mortgage REITs will go bust. Their mortgages currently yield no more than 4% and they fund themselves in the overnight market. Since they are leveraged as much as 10 to 1 in some cases, the loss of value in the mortgages will put them underwater, with liabilities greater than their assets. At that point, even if the Fed forces short-term rates to stay low, they will not be able to access the short-term "repo" market for the funding they need. There's about $500 billion or more of these companies, so their bankruptcy will make waves.
- Housing itself will be in trouble. With home mortgage rates of 6-7% once more, fewer buyers will be able to afford homes. Home values will reverse their recent rise and lurch downwards. That will panic the market, and cause a general tightening of lending standards, which will produce a downward spiral as in 2006-09.
- The banks will be forced to "mark to market" their gigantic Treasury bond and mortgage bond portfolios, wiping out much of their capital, and leading the regulators to force them into emergency share issues to prop themselves up. That will crash their share prices, and cause corporate lending to dry up.
- The leveraged buyout market will crash, because higher interest rates will make the calculations on which the LBOs are based stop working - not enough interest cover. That will cause a rash of defaults among private equity fund debt - all the debt that has been happily rolled over in the last couple of years. Values of corporate assets will crash.
- Stock markets worldwide will crash, as leveraged players such as hedge funds are forced into distress sales, while emerging markets suffer a liquidity crunch as they did in 2008. Emerging markets with poor cash flow, such as Brazil, will default on their debt.
And Then What?
Needless to say, the economic recession following a bond market re-pricing will be long and painful. And since bond markets won't be receptive to new debt, monetary and fiscal "stimulus" such as was used in 2009-10 won't be available (even in the early 1980s, when the U.S. Treasury was truly AAA, there were some failed T-bond auctions).
That's a good thing for our long-run solvency and living standards, but in the short run it will make the recession even deeper and more painful.
Since the 1980s, the bond markets have financed a long run of spending beyond our means. That's about to change.
And when it does, bonds will indeed become Darth Vader's Death Star, capable of destroying the world economy with a single beam. And it's most unlikely that the current global economic brain trust will find their secret vulnerability...if they have one.
For my portfolio, only gold remains a possible antidote. In my newsletter Permanent Wealth Investor, I go into more detail on which gold investments will benefit the most, as well as other sectors that will thrive as the Death Star approaches. What's more, I'll keep you in the loop on when to sell as well as what to buy.
You can learn more about Permanent Wealth Investor by clicking here.
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Great article Martin, and this is something investors should really bear in mind given recent moves in the gold price.
Gold remains a key defensive asset, regardless of whether you hold an Austrian view, bearish view of the financial system (like I do). Gold goes up a bit, down a bit, up a lot, down a lot… but never to zero. It's still a great asset to use as the foundations to your portfolio, especially if it's in physical form, out of the banking system. This article covers this all from a slightly different angle: http://therealasset.co.uk/gold-manipulation-fuss/
Thanks for the read, it made my Friday lunch!
Mr. Hutchinson,
Thank you for laying it out so concisely, simply, and clearly, explaining everything that will happen.
But what do you think will be the trajectory of the dollar? Will we have inflation or deflation? Or, is that completely dependent on what the Federal Reserve ends up doing in response to the debacle it created?
It's hard for people to grasp that interest rate increases from 0% to .25%, for example, can have such a destructive effect. But many fail to grasp something like that is a 25% increase in the cost of money, which is huge. When the market is heavily liquored up on instruments paying 1.5% that quickly jump to 2.1%, it's a 40% increase in the cost of money. That's even more devastating.
I recently locked in a rate of 3.61% on an investment property refinance over 15 years, and am waiting to close on the deal. I question whether that will even happen now. It would behoove the lending institution to let the lock expire, as the mortgage is already a loser for the holder.
That brings up another troubling question that has been gnawing at me. When interest rates continue to shoot up, is there a chance Congress could be forced to nullify mortgage contracts in order prevent the institutions holding all of that low-interest paper from becoming insolvent?
Thank you for your previous warnings, by the way. I dumped my holdings of the AGNC REIT because of a stop I put into place the last time you warned about them. Nonetheless, I was able to grab some great appreciation and dividends for several years while I held it.
Good points Phil, and it won't surprise me a bit if Congress screws the American people by voiding their low interest rates on mortgages. When push comes to shove, the powers that be will do whatever it takes to save themselves. But if you think about it, we the people are going to have to pay for all this debt one way or another, so what's the dif.
RePete – The difference ‘should’ be that Main Street of all countries should make those responsible for this fraud and deceit accountable. Why should the like of the Rothschild’s et al live in their huge multiple mansions they have scattered all around the world, bought at our expense?
When there is no food etc., left on the shop shelves, it’s not rocket science to know where food is to be found and that’s in the cellars of these homes. They have to eat just like us!
Gold … paves the road thru the deathly dark forest to the poppy field to per/OZ & the lying wizard. Gold is the lying wizard's ace in the hole … the bait the little fish will take …as a last hope … easily stolen, manipulated or confiscated by the wizard. Next stop. The twighlight zone.
Witch reminds me. I was in DC attending an esp seminar. I ran into Rod on a weekend midnight. Just me, him & the bartender in that tiny bar on a little street. That Monday back in Altoona I heard on the news he had died of heart failure. In Boston.
The productive work we do is the only real wealth. By such a skill we change fiat currency into real value. That is real magic.
Martin,
I hope you get a chance to read this. You have more experience than any other person I've read about the effects of collapsing currencies and bond markets.
I would like to know where is the best place to be, financially, when these things happen. You've seen first hand Argentina, Greece and other countries. Even your own home country, England in the 70's, was falling apart economically and socially.
Also, where should I be geographically when it happens? There will be areas that fair better than others.
You suggest getting your newsletter, but I would like to see something more comprehensive. What do wealthy people do in countries where their economy is crumbling so they come out of the situation successfully? What do they do to prepare for the inevitable?
What about world leading countries throughout history? How did the wealthy take advantage of their country's economic fallout and succeed? Countries like Greece, Rome, Spain,…?
I have been on Amazon and you only have two books listed (one of them is $341 used – if you have copies laying around, you could make some extra cash selling a couple of them). Maybe it's time for you to share your knowledge by writing a book to prepare us for what is coming.
Why is it coming? How much further down the road can the can get kicked? Is Japan the lead domino? For the past few years, we thought it would be Greece, Italy, Spain…but they have all bounced back, though a flat bounce.
It would be refreshing to read from someone who has seen collapsing bond markets and currencies first hand instead of reading something that was written by a journalist who speculates on what will happen.
If there are trends, you have seen them. Where do we want to be now?
You say gold is the place to be. What happens when it collapses when the bond market falls apart? Gold may go up later, but immediately all markets will collapse, won't they?
What about real estate? If people are out of work and the government is out of money for the type of handouts our government has been giving out since 2008, their won't be many people renting, they will be living on the street or several people will be living in one home. Will many parts of the country look like Detroit?
Should we wait until the fallout settles to start buying real estate? At this time, should I be selling my real estate holdings and hold cash?
Two of your peers, Steve Sjuggerud and Mark Ford (okay, maybe financially, he's not a peer) have suggested buying real estate for two years. So far they have been correct. But, reading your material, it looks like you think it's too early to buy real estate. Another one of your peers, RC Peck, agrees with you. He also says to stay in gold.
C'mon talk to us Martin. Write a book. I'll buy it…even for $341.
STAY IN CASH, MY FRIENDS
Sorry to say Martin, but your theory that physical gold might be a "possible antidote" seems wishful at best, at least during a depression and/or a period of concerted asset deflation. I already know that when global markets "crash" diversification is near useless and the correlation between different investment classes narrows to almost 1. ( Everything goes down at the same time: domestic stocks, bonds, real estate, commodities, emerging markets, foreign debt). This is the big flaw in "modern portfolio theory" that some financial advisors still cling to in their marketing. Its all they know. This outdated theory does not work in these kind of markets on the way down. It failed in 2009 and it will fail again.
In a big global downdraft, there is hardly anywere to hide, except possibly safe (secure) cash. Cash is the universal hedge. So, readers, save your shekels and stay in cash. If I were you, I would advise being patient and building up your cash reserves until interest rates normalize at the 5% level- and fasten your safety belts! Turbulence ahead. When the dust settles, you can buy up quality assets at a big discount and make money instead of losing it.
What if the FED goes completely insane and goes the way of Japan…..infinite money creation forever? The party can last a long long time.