Saturday, June 25, 2005

James Grant on the coming bear market on bonds

On Wednesday, I had the opportunity to spend some time with James Grant, editor and publisher of Grant's Interest Rate Observer at the annual meeting of the Detroit Investment Analyst's Society. He had a lot of very interesting things to say about interest rates and the economy going forward. I have taken some of the key points from his talk, and added some of my own analysis below.
Grant had made the following observations:
  • We are nearing the end of a bull market on bonds, which started in 1981. In 1981, the yield on a 30-year Treasury was almost 16%, today it is around 4.25%. Historically, bond market (and thus interest rate) trends can last generations. The last bear market on bonds started in 1947 and peaked in 1981.
  • Bond yields are so low that there is almost no risk premium. To quote Grant, we are at the point where we have gone from "Risk-Free return to return-free risk". Institutional investors and central banks are so desperate for yield that they are assuming a lot of credit and payment risk so minimal incremental return. Grant sites the example that Government of Greece 10-year bonds (hardly an example of fiscal conservatism) were being issued at yields slightly above German bonds (which are legitimate AAA). Corporate spreads to Treasuries are also ridiculously narrow as well, offering little margin of safety.
  • There is inflation in the market, and it is not reflected in CPI numbers. This is due to the bubble in housing market, which is not reflected in CPI, but rather an equivalent rent is imputed, which is just a guess. Plus there is price pressure on other items not reflected in CPI. Grant guesses that real inflation is closer to 5% than 3%. The problem of inflation is just an issue of too much money - specifically too much cheap credit.
  • Grant has no confidence in the Federal Reserve, which he mentions is the "last respectable bastion of government price fixing". He also mentions that Greenspan is still nothing more than a civil servant, and that should be kept in mind when people talk so reverently about him.
  • The U.S. current account deficit is unsustainable in its current state - which is America consumes foreign goods and services in return for paper - paper with no intrinsic worth (since it's no longer backed by gold) called U.S dollars and Treasury securities. The federal reserve trying to tinker with interest rates will not remedy this until it starts making major efforts to tighten reserves and the money supply.
Taking this theme to the next step, here are some of the things that I wanted to emphasize in addition to Grant's comments:
  • The housing market is in a bubble and rising interest rates will burst it. Some of the hottest and most speculative real estate markets in the country (Florida and California) are being fueled by variable rate, interest only mortgages. A major spike in mortgage rates will effectively deflate this market. The increase in rates won't necessarily create a crash nationally, but will slow down purchase activity and keep prices level (rather than the double digit price increases of the past few years).
  • Sub-prime mortgage lenders (less than good credit, second mortgages, home equity lines, etc) will fell the pinch the most. This is because: (1) they will have fewer and fewer transactions as rates rise, reducing their fee revenue; (2) increased defaults as lenders cannot service their debts; and (3) losses on foreclosures as home prices plummet and demand for housing drops due to increased rates....
  • Which leads to the mortgage industry in the U.S. as a whole. Margins are being squeezed as it stands, with most mortgage originators making their money on transactional volume. When this dries up and defaults occur, who is left holding the bag? There is a real risk that taxpayers will be on the hook (via government sponsored mortgage entities like Fannie Mae and Freddy Mac), and it could make the Savings and Loan fiasco look like chump change in comparison.
  • When we finally have a prolonged bear market in bonds, what happens to the institutional investors (i.e. pension plans)? Considering the mass of unfunded pension liabilities that many defined benefit plans have, this only exacerbates the issue. Most plans have been taking on a lot more risk to get any additional return they can get to close the gap, and rising interest rates on a sustained basis can/will clearly illustrate the folly of this near-sighted strategy. We've started to see this already with the airlines, and auto makers. Guess who ultimately is on the hook for this? The taxpayers get to foot the bill for the pension administrator's ineptitude.
  • What are the implications on the national and international economy. Rising interest rates and tightening of credit pulls a lot of money from the market. This reduces investment, home purchase activity, and consumption. It also reduces the current account deficit. It also reduces demand for foreign goods, which impacts nations whose economies are dependent on exports to the U.S (i.e. Canada, China, Mexico). Thus it depresses overall economic activity.
  • What are the best ways to hedge against this trend? Gold is probably one way, since it has intrinsic value and cannot really be manipulated by central banks. Stocks that are reasonably valued, with a margin of safety factored into the price, that have solid balance sheets (i.e. not leveraged), good cash flow, and are not interest rate sensitive come to mind. Consumer staples and other noncyclical stocks (pharmaceuticals, health care, utilities, and utilities) are the types of securities that tend outperform in such an environment.
The key things to remember is that: (i) markets are ultimately cyclical, and some cycles can last a long, long time (like interest rates); (ii) markets can remain irrational longer than I can remain solvent; and (iii) a top or a bottom to a market only becomes apparent well after it has passed. Anyone who says that the markets have undergone 'structural changes' or 'it's different this time' is naive.

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