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David Rosenberg On What Happens When The Glorious 30 Year Great Bull Market In Bonds Comes To An End
From David Rosenberg's Wednesday letter: "The primary purpose of this comment is to suggest what things may look like when the Great Bull Market in Bonds, which began in 1981 with 30-year Treasury Bonds yielding 15.25%, finally comes to its glorious end. For starters, I think it is safe to say that the bull market in bonds will end reasonably close to the point in time that inflation (or deflation) bottoms. This is because we have determined that by far the major economic factor that correlates consistently with the direction of market-determined interest rates, at least for long term Treasury Bonds, is CPI Inflation (headline and core)...So what will be the cause of the next secular uptrend in inflation or hyperinflationary shock? It pays to look back at history. Prior to the inflation of the 1970s-early 1980s, periods of very high inflation were primarily associated with war. Increased credit demands to fund the war effort combined with the drop in productivity that goes along with blowing everything up is an inflationary stew." Alas, never before in the history of US society have we been at the point when noted economists, financiers, and socialites so frequently and openly compare the fate of our society to that of the Roman empire in its last days, when the Roman emperors, oblivious of personal harm, would debase the currency on a daily basis, and hike taxes, with the end result being the collapse of the empire itself. As we will demonstrate shortly, we ourselves may be getting quite close. And in those uncharted waters of the global economy and, in fact, civilization as a whole, where the central bankers fight for the very survival of the status quo on a daily basis, we are confident that prudence on long bond and inflation rates will be first to be jettisoned as the kleptocratic oligarchy fights to avoid the pitchforks and guillotines for at least one more day.
From Breakfast with Dave, July 28 Edition
THOUGHTS ON THE LONG-TERM OUTLOOK FOR INFLATION
Let me start out by saying that I do not believe that bonds are any “better" an investment than stocks, at least in principle. They both have their advantages.
For bonds, the advantages are that they provide an income stream – the principal and the interest payments are guaranteed in the case of most government securities; and in the case of the corporate sector, it inevitably comes down to the quality of the credit and the longevity of the company in question. In addition, the yield at the time of purchase is almost always at some significant positive spread over CPI inflation.
Stocks represent ownership in corporations that have assets and strive to make a profit, often paying out a portion of the profit in the form of dividends and retaining earnings to grow the business and increase the dividends in the future.
But the primary purpose of this comment is to suggest what things may look like when the Great Bull Market in Bonds, which began in 1981 with 30-year Treasury Bonds yielding 15.25%, finally comes to its glorious end.
For starters, I think it is safe to say that the bull market in bonds will end reasonably close to the point in time that inflation (or deflation) bottoms. This is because we have determined that by far the major economic factor that correlates consistently with the direction of market-determined interest rates, at least for long term Treasury Bonds, is CPI Inflation (headline and core).
The bond market, like politics, is an emotional issue and not well-liked in general by Wall Street because it has a negative correlation to the stock market most of the time. For a growth bull, the bond is the "enemy". The economic environment that most favours the long end of the bond market tends to be low or no growth and bonds have traditionally been an asset allocation decision that is bearish on the stock market.
As a result, fear mongering often takes the place of thoughtful and objective analysis when it comes to bond market commentary. One way or another, the long end of the bond market has continually been characterized as high risk for the last 30 years that it has been outperforming the S&P 500. That’s a little unfair – after all, it is the benchmark risk free asset for funding actuarial liability when taken to the extreme of a 0% Coupon Treasury Strip.
Let’s move on and make a sensible and objective effort at making a long-term forecast for core CPI Inflation. Based on our analysis, we could well see core inflation receding from around 1% now to near 0% in the next 12-to-24 months, which would imply an ultimate bottom in the long bond yield of 2.5% and 2% for the 10-year T-note. We should add that as long as the Fed funds rate remains at zero, reverting to a normal shaped Treasury curve would generate similar results for the long bond and 10-year note at the point at which the inevitable "bull flattener" reaches its climax. As we saw in Japan, this will take time, but yields at these projected levels will very likely come to fruition in coming years.
So what will be the cause of the next secular uptrend in inflation or hyperinflationary shock? It pays to look back at history. Prior to the inflation of the 1970s-early 1980s, periods of very high inflation were primarily associated with war. Increased credit demands to fund the war effort combined with the drop in productivity that goes along with blowing everything up is an inflationary stew.
Wars were typically followed by brief periods of deflation followed by stable prices until the next war. In the 1970s several factors other than war led to the brief bouts of hyperinflation and they are much debated. What is perhaps most important to recognize is that whether it is war, OPEC or rampaging Baby Boomers, history supports the notion that high inflation, at least at the core CPI level, tends to occur in brief bouts.
A quick look at the core CPI chart shows that for all but a brief period since WWII, inflation has been well below 5%. But it was the period from 1970 to 1980 that contained all readings above 5%. Coincidentally, this was the period in which the Baby Boomers were buying their first refrigerators to go along with a bungalow as they formed their households.
By 1983, core CPI was back down to 5% and never looked back, but the psychological damage was already done. Inflationary expectations were indelibly etched into the mindset of the Baby Boom cohort. So everyone positioned themselves for inflation by leveraging up their asset purchases. Inflationary expectations were the rationale for overconsumption and depleted savings rates.
What resulted was an interesting dichotomy. Asset prices inflated during the 1980s, 1990s and into the 2000s. Although the secular bull market in equities ran out of steam early in the last decade, most other asset prices (particularly residential real estate) went parabolic into the peak of the secular credit cycle in 2007.
Core CPI on the other hand, has been continually slowing since the peak of 13.6% in 1980 and even at the peak in the ratio of household debt to disposable income in 2007, was running no higher than 3%. Unlike geopolitical disruption or demographic shocks, asset bubbles and the credit cycle tend to have an important secular behavioral impact on society and therefore, the economy.
The credit collapse of the 1930s around the globe dramatically altered social norms related to consumption, speculation and saving. Those who were adults with families in the 1930s shunned debt and believed in “pay as you go” for the rest of their lives. By way of comparison, the inflationary shock of the 1970s enticed the Baby Boomers into a spending and speculative binge. Rather than save, they executed a failed strategy of speculating their way to a dignified retirement.
Now the clock has run out and household behavior is poised for a dramatic change. If the 55 year-old Boomer resolves to work longer and harder, cut the budget to save more and liquidate debt, can we really expect the politics to maintain the status quo? This type of behavior from the developed world will exert enormous deflationary pressure. In addition, the huge amount of debt and entitlement expansion that has occurred at the government level, particularly in response to the financial crisis, will be an enormous drain on economic growth as taxes are raised to service the debt and budgets are dramatically cut.
For this reason, it is appropriate to consider the possibility that the next secular uptrend in inflation must await the rebuilding of the household and government balance sheets to levels that launched the last uptrend. That, by the way was about 30% debt to disposable income in 1950, 60% in 1970, and realistically, it could take a generation to get back to that range from current levels of around 125%.
The outlook is not entirely dependent on the behavior of the developed world’s consumers and governments, however, if we are really trying to envision the next 20 years, the emerging market consumers (in places like China and India) have extremely low debt levels and high savings rates. Changes in emerging market consumer behavior should be, on balance, a source of counteracting inflationary pressure. Then again, the forces that most contributed to disinflation in the last three decades were globalization and technological innovation that lead to dramatic improvement in productivity and lower unit costs.
There is no reason to doubt that these forces will continue to be moderately supportive in the near future, even if higher marginal tax rates and reduced labour mobility (due to the fact that one-in-four Americans with a mortgage have negative net equity in their home and are thus "stationary") end up constraining the noninflationary growth potential in the United States (and Europe).
While the disinflation from 1980 to 2007 was mostly supply-side related, the deflation pressure now is coming from the demand side – a deficiency of aggregate demand caused principally by the contraction in credit (40% of the private market for securitized consumer and mortgage loans has vanished over the course of the past two years).
So, putting it all together, it is reasonable to conclude that prices are most likely to be stable for a generation. By stable, I mean flat and perhaps oscillating around plus or minus 2% (look at Japan, where there has been no such downward price spiral – the CPI sits right where it was 18 years ago). Because the economy is still gripped with overcapacity in several sectors, real estate and labour in particular, we may be headed towards an outright deflationary backdrop over the near- to intermediate-term, but a deflationary spiral seems overly pessimistic considering all the good things in the mix, including a reflationary policy backdrop which certainly helped establish a price floor in Japan in recent years.
That said, a “V” shaped recovery has always been off the table from our perspective because we still have so far to go in the secular credit collapse, so all the balance sheet expansion that the Fed has done and will do in the future should continue to offer up little more than an antidote. In turn, a reversal of CPI or core CPI trend to the upside for the next couple of years seems like a low- probability event, particularly given the demographic and retirement pressures that increasingly favor savings over spending in the broad consumer sector.
And what about the end of the Great Bull Market in Bonds? It could come pretty soon. You heard right. Long-term Treasury Bond yields could reach a secular bottom in the next couple of years. And what will it look like?
Well, rates will likely be much lower than anyone expects and, as typically occurs at secular market peaks, the public will probably swear by long bonds at the primary lows in yields. After all, what other safe investment has delivered inflation plus 2% or much better, guaranteed, in the past 30 years? But in order for the public to adore 2.5% yielding long Treasury Bonds, it will first have to believe in stable or modestly deflating core CPI as a long-term forecast. At last count, households still have a near-3% long-run inflation expectation according to the most recent University of Michigan survey.
The public will also need to be fed up with risk and, judging by the performance of stocks and real estate in recent years, who could blame them? And for the Baby Boomer at 55 or 60, “Gambler’s Ruin” isn’t an option. We can see that they are already voting with their feet as the mutual fund flows clearly indicate – increasingly towards income and away from capital appreciation strategies.
Finally, the public will probably need to be afraid to be out (of the bond market, that is). That will most likely be due to a “flight to quality” as we continue suffer the secular bear market in stocks and real estate and suffer the economic setbacks of renewed recession sooner than many pundits think.
One last thought on stocks: Like I said before, bonds are not better than equities. They are different. Every asset class has its time to be the leader. It goes without saying that the best time to allocate to equities is at the point of maximum pessimism and when the market is trading very inexpensively as it was at previous post-war secular bear market bottoms.
We know that historically, that “moment” has coincided with valuations below 10x on trailing “reported” earnings and dividend yields above 5% as measured by the S&P 500 Index. Note that while many a pundit cites the consensus as being $96 EPS for “operating” earnings for 2011, it is closer to $76 on a true “reported” basis (so apply a 10x or even a 12x multiple on that estimate!).
We also know that the conventional wisdom is oh, so wrongly linear at inflection points, so not only is the market cheap at these secular lows, but the future is much brighter than generally perceived. Pulling the trigger at that magic moment when bonds have peaked (yields have bottomed) and stocks can’t hurt you anymore, with dividend yields secure at twice the Treasury rate, would be nice. But you never know for sure at the right time, or you think you know for sure but are too early.
For now, we are not even close. Sentiment toward long bonds and inflation are still extreme and recent survey data show the typical balanced institutional portfolio manager with a 68% allocation towards equities. As for bonds, the yield on 30 year Treasury was recently core CPI plus 3%; 4% for a BBB corporate bond; and a 6% real yield in the BB space. The S&P 500, meanwhile, sports a P/E multiple of close to 15x and the dividend yield is barely over 2%.
In this light, it would seem highly appropriate to maintain a SIRP – Safety & Income at a Reasonable Price – strategy for the near- and intermediate-term, while keeping a close eye on the exit plan from this recommendation, though that could still be a few years down the road.
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How do you price a bond if the rating agencies aren't creditable?
Who needs credibilty. Do you remember this:-
"It's not based on any particular data point," a Treasury spokeswoman told Forbes.com Tuesday. "We just wanted to choose a really large number." - http://www.forbes.com/2008/09/23/bailout-paulson-congress-biz-beltway-cx_jz_bw_0923bailout.html
But people selling bonds must be faced with the question of how the yields are justified if the rating system is not trustworthy. There does not seem to be any way to hold off the pressure for higher yields without a credible rating system.
historical note (and speculation): prior to christmas '08, the ten year tsy sold for a low yield of 2.08% with the long bond around 2.55%, the twenty year somewhat higher. so have we already seen the near-term lows in yield, even though we may not have seen the bottom in deflation? could it be the bond market would price the avalanche of debt and anticipated debt 2009-2012 (say) differently in the immediate future than it did, when more naive, in late 2008?
deflation increased in the early thirties and long tsy yields rose. long tsy yields fell to much lower yields toward the end of the depression at the onset of ww2. they were significantly lower the year following the end of the war than they were at the peak of the banking crisis, say '32-'33. (sources: u.s. treasury website and sidney homer's a history of interest rates)
use your own brain?
The Fed will rate the Treasury's bond issues. Watch and see.
I don't care what galaxy your from, that's got to hurt.
Timmmaaay is going to make damn sure of it.
I wish someone had edited this piece. It is, I think, fascinating and nearly unreadable.
I was able to read it just fine.
Maybe it was my time at the Zoolander institute for kids who don't read good.
ZH newbie's are cute. I think s/he meant to say "Too many words."
I believe the technical term, as applied by those newly graduated from 4chan to ZH, is: "tl;dr"
+9000 A 4Chan reference on ZH, now I have seen it all. I think that breaks all the evolutionary rules.
Yes, first rule of editing: half as long.
Don't expect interest rates to turn around in a year, or copper to suddenly resume the bull market. Just sayin'.
Good point. The focus on copper with all this negative economic data is hilarious. Me, I say the recent run on pork bellies shows the recovery will continue because people eat bacon before going to work.
Who, exactly, is this "public" to which Dave refers? It certainly isn't J6P, he is more interested in football and beer. If you discussed long term financial aspects of beer and football J6P might sit up and take notice. However, if the assumed "public" is the vast majority of financial planners then I might agree, however the analysis would have to include their take, their overhead, which is a costly consideration.
Posted the following over in "morning gold fix" - any help would be appreciated. Thanks.
"VI has finally gotten around to thinking about building a modest position in physical. I don't have the first clue on what forms of Au to hold (bars, coins, mixture?), nor where to buy. I have seen several posts regarding all of this, and failed to save any of it. Would anyone mind posting some links for me? Much appreciated."
american gold eagles 1 oz. for maximum purity-credibility and fungibility. get them from one of the national reputable sellers. silver in 10 oz. bars from your localist coin shop.
thank you.
apmex.com has been reliable
they have good deals on 1oz bullion coins
Any legitimate downside to bullion coins over gov't stamped?
Hard to say, if you're in the USA. Some argue that the govt-stamped stuff is legal tender and will be left alone. Seems unlikely to me, but there's no telling what a desperate government might do. Others think that quasi-collector coins (pre-1933 gold, whether US or foreign) will be exempted.
I would avoid .999-pure coins. They're too easily damaged to serve as a circulating medium in a crisis. K-rands are a good choice for recognizability. Mexican, French, British, etc. are good for getting the most gold ounces for a given amount of money (i.e., lowest premiums over spot). Small coins are better than large ones if you ever need to barter them. I find French or Swiss 20-franc pieces to be a nice size.
Check out the Kitco.com forums for this type of information. I agree with the above response regarding Gold American Eagles. I would also suggest Krugerrands, as they're the global choice outside of the US. The premiums for Krugs are much lower than for AEs as well. APMEX is a reputable dealer, as is Bullion Direct.
thanks again.
Apmex has worked for me. Don't use NW Territorial Mint under any circumstances. I think the Canadian Maples look better than the Eagles, a bit smaller too. Personally, I think they will work better in the case of barter - as trust in the US at that time might be relatively low. Just some thoughts tho.
I am totally satisfied with NW Territorial Mint's service. Ordered from them many times. They delivered on time, as ordered. Purchased silver only, no gold.
What's your beef with NWT Joe?
thanks.
dupe - thanks for the help
How many times do we have to refute the Japan Scenario?
Always one more time. That zombie is never quite dead.
So far, the 25+ year bond bull market has been totally unfazed by the following:
- An explosion in government deficits to the tune of over $14 trillion
- An expansion in unfunded, off-balance sheet obligations of additional trillions
- A derivatives casino which has now expanded into the quadrillions.
- A total meltdown in various Latin American debt markets (Mexico, Argentina, etc.)
- The outright default of Russian debt
- The 1987 stock market crash
- The greatest stock bull in history, from 1994 to 2000
- The tech bubble collapse
- The spectacular run in commodity prices in 2007 - 2008
- A near tripling in gold prices
- Harrowing rides in the currency markets
No matter what kind of boom/bust cycles occur in the financial markets, no matter how much volatility occurs, the lust for AAA-rated, gilt-edged U.S. Treasuries has remained unquenchable.
And as of today, virtually 98% of all U.S. Treasury bond buyers the last 20 years are still in a winning position.
LOL...
Sounds like everyone is on one side of Das Boot.
http://en.wikipedia.org/wiki/Das_Boot
http://en.wikipedia.org/wiki/Das_U-Boot .......for the HFT programmers among us. :>)
Man the torpedoes. Dive, dive, dive!
How much of the current last gasp of this bond bull is due to the circle jerk of discount window borrowing by the banks to rebuild their balance sheets? Dunno how long that will last, but it's not very sustainable for the long-term.
Rosie's thinking is predicated on the assumption that the dollar will remain the world's reserve currency. I don't think the dollar will be the reserve currency by 2020. Once the dollar is out, inflation will come a'knocking.
Exactly. How the hell do you prepare for that?
I disagree. I think there will be a structural re-org in the west, where public sector gets cut, pensioners get cut, retirees get cut, taxes get cut, and real estate prices/rents get cut. These cuts, combined with rising energy costs, will reduce wages and thus outsourcing, and we will remain the reserve currency.
However, this may also be accompanied by a dollar revaluation (perhaps from green dollars to blue dollars worth 20x-100x as much as the green ones).
Isn't a revaluation of a reserve currency, a zero-sum game?
None of those drastic changes will happen without a MAJOR crisis first.
You are correct that we will turn to domestic default prior to international default (aside from our continued/normal default through inflation). We will cut back on everything domestic to save the ship... health care entitlements, social security, other retirements, corralling (more) money into treasuries, decreasing hand outs to states, etc.
I disagree though that the former will be enough to adequately keep up with our outstanding liabilities given the inevitable feedback loop and discipline of the citizenry to abide by laws forced upon them (e.g. TARP, which was overwhelmingly opposed). Effectively, we'll be able to prolong our demise, but not avoid it. We're living on borrowed time.
PS, revaluation = death... we won't be going that route until other avenues have been closed.
Whoever emerges the strongest from the coming world war will be the reserve currency. It's the law of the jungle man.
Idiot Savant,
What do you think are the most likely options for the world's reserve currency? What are some of the requirements? And what might be the process of moving from where we are today to the new reserve currency?
This line of questioning is what leads me to believe that one of the reasons an alternative reserve currency has never taken hold (aside from our military hegemony of course) is that our relative gold holdings, as compared to any countries likely to challenge our reserve currency status, is substantial enough to render their efforts immediately curb stomped, supposing we decide to hop back on the gold standard (lack of audit aside).
Aside from the fact, of course, that the entire world is all in on the USA reflation trade... either this bitch pumps up or we lose control and where it stops nobody knows.
A lot goes into the reserve currency scorecard. Gold reserves and military strength are two of the top 10 for sure. The reserve currency is the one that is better than all the rest.
If it were just about gold, why isn't the Euro the world's reserve currency? The Eurozone has more gold than the U.S. (even excluding Germany they get pretty close). A EU/Russia combined currency backed by gold, energy, and Russian military would look pretty good, wouldn't it? But would it supplant the dollar? I doubt it. And the reasons why such an EU/Russia currency is unlikely also serves as an illustration of one of the dollar's strengths.
Yes, but a tie and anything close to a tie go to the incumbent. I don't think these other contingencies can muster enough to meet their burden.
Geopolitical issues are such that the likely candidates to throw their hats in the ring would end up infighting so much, the political stability of the currency would be questionable at best...
Tyler, thanks for the almost daily posts on Rosenberg, very unbiased and high intellect
George,
get your own, Buddy...
http://www.gluskinsheff.com/
At $5M, not many can afford it.
Finally somedoby other then Peter Schiff realizes that there is a bubble in bonds.
+1
Marc Faber also.
http://www.youtube.com/watch?v=cQjD2sw_eg4
Hugh Hendry says there will be no inflaion.
While I too am waiting for QEII, and think there might be one last gasp into bonds, I wonder if a double top has been formed in TLT (which I use as a proxy) at 102. Pretty short-term chart-watching though.
The trouble for me with shorting bonds, is that you might be right in a dramatic jump in rates, and perhaps even some sort of default (shorting bonds held in a Chinese account would be good), but you will get paid back your profits in the fiat as it is slipping away. You might be unable to purchase hard assets in time - i.e. you'll win the battle but lose the war.
There may be a bubble in the bonds, but the sad reality is you maintain the vast amount of capital investment. Name an investment class one can invest in where the value will remain constant over a matter of days, weeks or months? Real estate and equities do not make the grade. Savings accounts earn 0 % in insolvent banks. Yes, one day the bond market will blow up. Until that day arrives, bonds will remain strong for this simple reason.
I would like to posit that for a long time now, stocks and bonds have had identical behaviour in terms of their treatments as an asset class.
I say that because just like a stock price is a fraction of a complex mix of present and future value of a productive enterprise and is many times removed from in terms of liquidity (cash is fastest, raw material is slowest velocity), similarly, when CDO's (and their parent, debt insurance) were introduced, the underlying asset (debt) lost all connection with the liquidity creating Complex Debt Instruments.
Both markets were created to give liquidity to essntially illiquid base assets.
They can be equally traded and price discovered and manipulated.
I rest my case and welcome some intelligent response.
ORI
http://aadivaahan.wordpress.com
I agree with nearly all of the premises in this well-written article, and many of the conclusions. Except for one major difference: I'm not convinced that future patterns in the stock and bond markets will follow the same predictable patterns as in the post-war period that just came to a dramatic end. Many variables have been reset irrevocably. As evidence just take the "bonds up, stocks up" patter of the past year. Or the contradictory strong dollar.
Rosy is taking a "this time is not different" approach to his projections, while keeping the timing vague. That premise would be true if geopolitical forces were the same as in the post war period. But they're not. I think this has major implications for economic policy. But rather than just a nip and tuck, policy will gradually drift into new territory.
In the inflation-deflation argument I rarely see anyone talking about the fact that you can have a deflationary lack of demand (due to credit contraction) but have prices rise anyway due to a currency crisis. Even if demand is low, in a currency crisis no one wants the fiat paper so they exchange it for hard assets driving prices up. Basically the supply-demand curve goes out the window until the no-confidence currency is replaced by something more sound.
This is what you have in Zimbabwe. Demand is low because everyone is broke due to government policy yet prices skyrocket due to no confidence in government or currency. Why couldn't that happen in the US?
Most people when asked about their confidence in the US government respond with some cynical remark about bumbling idiots - yet most folks still believe the government idiots are capable of managing the US dollar. When will this disconnect be resolved by the realization that the emperor has no clothes and that the currency is worthless?
Same for Germany.
Problem with Treasury bears (and cash hoarders in general) is almost all of them conflate the FRN with the concept of a magical pure "dollar" that can somehow be traded into. Anyone who thinks we can possibly enter a secular bear market in Treasuries vs. FRN without a complete reset is delusional.
this author states that because inflation will be low because of deleveraging, it will drive down demand, therefore bonds yields will stay low.
Two other variable effect bond prices, i.e. ability to make timely principle and interest payments, and the value of the currency that the payments will be made in.
Low corporate rates will not last in another deflationary panic because the ability to repay will come into question.
If the gvt, cannot borrow to roll over their 6T of short term bonds, either taxes are going to half to rise, or fed will print thus causing the dollar to fall.