Why Bond Market Bulls Are About to Get Crushed
L: We are speaking today with Casey Research Chief Economist Bud Conrad. Bud, in my mind, the thing that makes your insights so valuable is that you're not actually a career economist with a Ph.D. in the subject. You are an engineer, and you bring an engineer's systems analysis perspective to bear on economic questions. So, how does the system of the world's economy look to you today? Is it really on the mend, as so many economists are saying?
Bud: That's a very broad question. Thanks for mentioning my background. We so often see economists arguing with economists about their points of view. I think it helps to step back and have a fresh look at things, focusing on what the data tell us, rather than focusing on their ideas based on theories... which I don't think are correct.
L: That reminds me of the old joke about a physicist, engineer, and an economist stranded on a deserted island. The only food they have is a can of beans, but they have no can opener. The physicist has an idea to use fire to open the can, but that would ruin the beans. The engineer has an idea to use rocks to open the can, but that would ruin the beans as well. The economist says: "Let's assume a can opener."
Bud: [Chuckles] I have to say, I really do think that the intellectual bedrock of modern economics is very weak. The reality today is that governments around the world - not just the United States, but also in Europe with the ECB and Japan with Abe's mandate to the Bank of Japan requiring it to maintain an inflation rate of 2%, and other governments as well - they are all moving in the direction of printing more money. The United States is not the worst offender, but only because we have a rich country that can afford substantial deficits.
We have a system in which the government finds it easy to print money in an effort to meet everyone's needs. Those needs include the baby-boomer generation going into retirement, with $75 trillion in future obligations, and a large and ever-growing military - much larger in proportion to GDP than what any other country in the world is maintaining. Coupled with this, we have a lack of interest in raising taxes among politicians, who see that as unpopular with voters. The politicians have no will to fix our deficits.
The deficit has been papered over by the Fed printing money. However, the problem is not a matter of just this last year. Nor is it just this last recessionary period that started in 2008. The bubbles really started forming back in the 1990s when Greenspan turned on the spigots after the 1987 stock market crash. That brought on the first modern big bubble, the one in tech stocks. The dot-com bubble was very large, and its bursting should have been a lesson and a warning about what was to come.
In response to the crash that followed the popping of the dot-com bubble, Greenspan lowered interest rates to around 1%. At the time, that was a new record in easy-money policy on the part of the Fed. This led to the housing bubble. The bursting of this bubble was not well predicted, not by most people, but it was by me.
L: When and where, Bud?
Bud: I predicted the end of the housing bubble back in 2006, when you and I were both working on the <em>International Speculator</em>, before we pulled out the big-picture economics and started publishing that material in <em>The Casey Report</em>. There was an issue in 2006 called <em>The Coming Currency Crisis</em> in which we said the housing bubble was bursting. But in 2007, Bernanke was still saying that the problems in the housing sector were contained. Of course, it is the nature of his job to avoid frightening people with dire comments, but in looking at the minutes of the Fed meetings it's clear that they really didn't have a clue as to what was going on.
L: Ah, I remember that one. We got a lot of things right - made me laugh to see Bernanke on TV after the crisis hit in 2008, saying that no one could have seen it coming.
Bud: Indeed. I knew we were in a bubble, just looking at the subprime lending phenomenon. Many in the mortgage industry knew we were in a bubble. The Fed's response to the bursting of the housing bubble and everything else that's gone wrong since 2008 has inflated a third bubble - the bond bubble, which I think is now peaking. It's harder to predict when a bubble will burst than to identify the fact that we're in one, which is what I'm saying now.
We have the lowest interest rates in 250 years - lower than at any time since the founding of the country - created by the Federal Reserve forcing interest rates to zero in the short term. In addition, we have the Fed encouraging banks to help lower rates through buying Treasuries. On top of this, we also have some $350 trillion of swaps derivatives of interest rates - more than half of all the derivatives out there are interest-rate derivatives. Banks use these swaps to transmit lower rates to other debt instruments based on what can they can get from the Fed. This drives all rates down.
L: Sounds pretty questionable... Good thing the government saved us from evil bankers in 2008, cleaned house, and set us all on the path to righteousness.
Bud: I don't think our financial situation is any more solid than before the crisis. We've still got many undisclosed, not yet written down, toxic financial items out there. It may be better than the middle of the worst part of the crisis, but that's not saying much.
L: So what happens next?
Bud: We've seen 30 years of declining interest rates. I think we'll begin to see them move in the other direction this year. I think rates on everything from high-yield corporate bonds to government bonds - which are considered the safest - are way lower than they should be. Consider the high probability of inflation ahead, the currency exchange rate risk, and the eventual default risk. All three risks are totally undiscounted by the market, because of the distortion created by the Fed. That will hit its limit at some point.
Some people say the Fed can keep up its juggling act forever. I don't agree.
L: Doug has been describing the bond market as "a triple threat to your capital" for some time now. I understand that it is difficult to predict exactly when a market bubble will pop, but can you give us some indicators to watch for? What would be conclusive evidence that the popping is actually under way?
Bud: That's a tough question. I've done extensive work on when countries explode. The premier take away from Carmen Reinhart and Ken Rogoff's best-selling book, <em>This Time Is Different</em>, is that when debt gets to 90% of GDP, that's when things get risky. Well, we have $15 trillion in GDP and $16.4 trillion of debt. That's well-publicized now, because of the political wrangling over the debt ceiling, which we've actually already exceeded.
L: So we're already in the red zone?
Bud: We do have some advantages over other countries. We have a big military, which does cost us, but also tends to make other powers more cooperative. Most of our debt is denominated in our own currency, which gives us a big advantage over a smaller country that has debt denominated in US dollars - if their currencies fall against the dollar, their troubles are compounded. So we can probably push things further than the 90% threshold. That's not a hard number by the way, just an average within a fairly wide footprint.
However, with our level of debt to GDP, most countries would already be looking at something on the order of 10% interest rates, whereas we've got something in the neighborhood of 2% for the 10-year Treasury. This is an extreme distortion from what the market would dictate under such circumstances.
So, will interest rates start rising now that we're over 100% debt to GDP? I know rates can't go much lower, so I expect they will be heading up from here. Look at the trillion dollars a year in new debt we're accumulating, and consider that in four years we will have more than $20 trillion in government debt. At 5% interest, that would require a trillion dollars a year in interest payments. We only collect $2.5 trillion in federal taxes. I don't see how we could reach such a number without something breaking. That's four years away, but since we know it's coming, we should already be preparing for the problems that can be anticipated.
All that's needed for things to break down is some event that causes a panic. Such an event might be some foreign government with a huge trade surplus with the US that it has invested in US Treasuries deciding that the 2% they're getting paid to hold them is not worth it in the face of 5% inflation in the things they need to buy, like raw materials. If something like that were to happen, it could spark a race to head for the exits on US bonds. This highlights a real Achilles heel we have, compared to other countries that don't have as huge a trade deficit as we do.
L: So a good sign that the balloon is going up would be that the interest rates start rising despite the government's efforts to keep them down?
Bud: Yes. There will come a time when the Fed announces a new easing program and the market ignores the announcement so that rates rise rather than fall, and stocks fall rather than rise. At that point the game is surely over.
Watching interest rates is certainly important in terms of keeping track of the turning tide. If they move from 2% toward 4% - which is not a very large change in historical terms - they could then accelerate and push the whole mess off a cliff very quickly.
L: The Keynesians will just answer that all this deficit spending will stimulate the economy, which will then grow at a more rapid rate and enable us to afford the debt. But is that even possible? Wouldn't we need a double-digit GDP growth rate, such as China used to enjoy, to pull that off?
Bud: Well, in the simplest terms, if your debt is growing faster than your GDP, you won't ever be able to pay it off. It's simple math.
Now if you look at the kind of debt problems governments get into, there comes a critical point at which people recognize that the problem is too big to be solved. The most recent high-profile example of this is what happened to Greece. In such a case, there are only a few things you can do. The first is to find someone bigger to bail you out. Greece found that the ECB was able to bail it out - at least for a time, but they're still in trouble. The United States is too big for that.
The second thing you can do is to hope you can grow out of it, as you just suggested some might argue. The US's debt growth has been bigger than GDP growth for decades. It's just not credible to argue that we can grow our way out of our debt.
The next alternative is to simply declare default, as Argentina and Russia have done, among others. This is what many countries along the southern fringe of Europe are likely to do, in my opinion. The public in these countries is rebelling against the austerity plans the ECB is requiring. Default of some kind is their only alternative. Default is very destructive in the short term, greatly reducing the ability of governments to borrow and spend in the future. It's also politically very unpalatable, especially in places like the US, where most people can't even conceive of their government defaulting on its obligations.
This leaves only one alternative: printing money to try to kick the can down the road. This is the path we are on. It too is highly destructive, but that destruction is hidden and delayed. It is not, however, sustainable, and I think we will see a breakdown in the not-too-distant future.
L: How "not-too-distant?"
Bud: My current intuition is that we will begin to see this happening in the near term, meaning this year. As that gets going, it will build momentum and accelerate. That's my current prediction: the third bubble created by the many years of easy money policy by the Fed, the bond bubble, will pop soon.
L: In discussing this last week, Doug and I likened this to a house of cards. Everyone knows it's shaky, and nobody wants to get caught when it comes down. That means that when it starts, the collapse should come very quickly. Do you think we could see a 2008 level of crisis arising from the bursting of this bubble as early as this year?
Bud: I don't want to predict exactly what will happen when, but I am willing to say that we have seen the lows in interest rates and they will start rising this year.
L: That's still a bold statement. Do you have a theory as to why European countries - most of which are far more overtly socialist than the United States - are struggling to embrace austerity measures, while in the US, aside from some small budget cuts generating big headlines, there's no real consideration being given to actually trying to live within our means?
Bud: I would simply say that the Europeans have better PR. I really don't think they are that much different. The ECB has said it will do whatever it takes to defend the euro - that means printing more euros. The public statements about austerity have been effective enough that they haven't had to do much printing in the last six months, but Europe looks no better off to me now than it did six months ago. France is weakening greatly, and that's one of the pillars of strength being relied upon to help carry the others. The ECB is kind of a paper tiger. It's supposed to be able to print up money and rely on the strong countries to back them up. But can anyone take the idea of France bailing out Italy and Spain seriously? It's just another house of cards.
Most people don't realize that not only is there the ECB, but each country has its own central bank. While in theory the central bank of each country is not allowed to print euros, a loophole that is not understood is that the TARGET2 money transfer system causes them to enlarge their balance sheets. This is the same thing as printing money. This is particularly true of the German Bundesbank, which is owed money by the ECB, which is owed money by Spain and other importing countries. The system is unsustainable, and I think the process of collapse is starting, though it may take a while to gather momentum. I admit that I'm surprised by the current relative strength of the euro. I think that it will weaken from here.
I see enough problems in the world's financial system and our own to say that while the dollar may not look particularly weak in foreign exchange, all of these paper currencies are tragically flawed. At some point people will wake up to their lack of intrinsic value and not care whether it's pesos or dollars you're offering them - they won't take anything backed by nothing.
L: Gee, Bud, you're as gloomy as Doug!
Bud: [Laughs] It's not a contest! It's just what the data are telling me: Europe is in recession. Next up is Japan, which is trying to bail itself out for the 43rd time in the last 20 years by printing money. I think the US will be the third domino to fall - I think we're heading for stagflation by the end of this year.
L: We should also probably warn people against speculating in real estate, because even though those assets are real, real estate is going to get slaughtered if interest rates rise.
Bud: Good point. But the fact remains that the size of this bubble is bigger than the other two that have popped already. The debt market is on the order of $53 trillion across all sorts of debt. The stock market is only $15 trillion. The home real-estate market is $20 trillion. So when the debt market crashes, it'll be two or three times worse than the previous bubbles bursting. The resulting wealth transfer will be much larger than most economists can even understand - most don't really focus on debt. It's critical that the measuring stick they're using, the dollar, is made of rubber. They are going to be caught off guard, and many people are going to be wiped out.
L: Okay, so how do we position ourselves to invest?
Bud: I don't know if I would pick an inverse interest rate ETF or futures market short position yet. The fundamental thing is not to keep your cash in a bank account that is essentially paying you a zero interest rate. I look to invest in safe-haven assets like the precious metals, essential needs like energy, and real estate - particular things like productive agricultural real estate. I might even add stocks in general to the list...
L: Doug disagrees on that last one.
Bud: Mainstream economists are saying that the worst is over and that the blue chips will head higher. I'm saying the worst is not over, and with inflation on the way, higher nominal stock prices will not translate to big returns in real terms. They might do better than your .01% CD, but the gains will not be attractive in terms of increased purchasing power. I didn't recommend stocks because I think they're going to be big winners, but simply as a way to avoid losing money on bank deposits. I'd rather own gold, personally. But the important thing to understand is that as paper money is being made worthless, we need to protect ourselves.
L: Okay, I get it. I think I need a beer... or better yet, a hug from my children - that always makes me feel better. But I do appreciate your candid assessment. It helps to explain some of the things Doug's guru-vision has been telling us. Thanks. I think.
Bud: You're welcome. Thanks for giving me a chance to give my warning. I just hope people will listen.
<em>Bud Conrad is the author of </em>Profiting from the World's Economic Crisis<em>. He also shares his economic and investment insights in </em>The Casey Report<em>, a monthly advisory that focuses on profit opportunities in emerging trends</em><em>. For more information on the topics discussed, </em><em>listen to Bud's recent interview with Jim Puplava of </em>Financial Sense.