Jim Grant, editor and founder of Grant’s Interest Rate Observer, is one of a handful of credit-market luminaries who have declared the end of the 30-plus-year bond bull market that began in 1981. Interest rates, Grant argues, probably touched their cycle lows during the summer of 2016. And as the secular bear market begins, investors who have uncritically accepted obvious aberrations like Italian junk bonds trading with a zero-handle will face a painful reckoning.
"...and since interest rates are critical in the pricing of financial instruments, these distortions preceded the uplift in all asset values.. and the manifestation of this manipulation is in many ways responsible for what we are now seeing in the markets."
So Grant explains in an interview with Erik Townsend, host of the MacroVoices podcast, where he shares his views on topics ranging from his opinion of the Fed Chairman Jerome Powell to inflation to the flawed logic of risk parity.
Grant begins the interview by praising Powell, whom he prefers to former Fed Chairwoman Janet Yellen because Powell lacks a PhD and is able to communicate with lawmakers and the public in plain English - not tortured Fedspeak.
Well, Jay Powell has one commanding credential. And that credential is the absence of a PhD in economics on his resume. I say this because we have been under the thumb of the Doctors of Economics who have been conducting a policy of academic improv. They have set rates according to models which have been all too fallible. They lack of historical knowledge and, indeed, they lack the humility that comes from having been in markets and having been knocked around by Mr. Market (who you know is a very tough hombre).
Jay Powell at least has worked in private equity. He knows a little bit about the business of buying low and selling high. Also he’s a native English speaker. If you listen to him, he speaks in everyday colloquial American English, unlike some of his predecessors. So I’m hopeful. But not so hopeful as to expect a radical departure from the policies we have seen.
Moving on to market conditions, Townsend poses the question that credit-market analysts are probably sick of hearing from their clients: What, exactly, is driving this market? Is it Trump? Is it inflation? Is it the global reining in of intrusive central-bank stimulus?
Believing that one man - even the most powerful man in the world - could have a unilateral impact on markets is almost an expression of arrogance. Instead, Grant believes credit markets turn on multidecade cosmic cycles - and that the bull cycle that began in 1981 has just about run its course...
I’m a little bit more fatalistic. You know, we have come to accept that financial markets are driven by people and by policies and by personalities. And, what is Chairman Powell going to do? What will President Trump tweet next? As if they were in charge.
Well perhaps sometimes they are not in charge. I have observed over the years that the bond markets have tended to move in generation-length cycles. Anywhere from 20 years to 35 years. This is not an ironclad law of physics, but it is an observation from the middle of the 19th century forward.
So we have concluded (perhaps) the bull market in bonds that began in 1981 and that maybe ended in the early days of July 2016 (I think). So it might just be that interest rates are going up because they are going up. It sounds a little bit mysterious and indeed fatalistic, but I’m a little bit less inclined than others to assign causation to people and policies.
Moving on, Townsend turns the discussion to risk parity funds, and what Grant describes as the “flawed” thesis that bonds are inherently less risky than equities…
First, risk parity, as you know, is based on the proposition that bonds are inherently less risk-fraught and less volatile than equities. To someone who was around in the ‘60s and ‘70s and ‘80s, that proposition is somewhat contestable. But that’s the idea.
Now that may work in a gently trending market. It has not worked at certain times and junctures in which both stocks and bonds decline together. So my sense is that there’s a lot of money in risk parity and that a forceful rise in interest rates, a steep decline in bond prices, is going to force liquidation of some part of the risk parity portfolios.
Now, Erik, you wonder how far it can go. People, I think, are arguing that it would be inexpedient if rates went a lot higher. They say impossible. What then actually mean is inconvenient.
I forget now exactly what the size of the interest expense of the public debt is, about $400 billion. The government is paying 2.2 or something on its debt. Doubling of yields to 4-something and doubling of gross interest expense to $800 billion or so would certainly be an inconvenience. It would require very painful political choices. But, no, it is not impossible.
So I think that, yeah, the stock market is going to run into trouble. It’s richly valued. But I don’t look for Armageddon. I look for higher rates, and I look for appropriately lower price-earnings multiples. And I look for a much higher interest bill on the part of the US Treasury.
Having discussed the historical trajectory of nominal rates, Townsend and Grant move on to the next logical topic: A historical analysis of inflationary trends. As Grant explains, central bankers who are hoping for higher inflation should be careful what they wish for - because, historically, shifts from periods of low inflation to high inflation have been accompanied by uncomfortable shocks.
Well, Erik, I happen to be in the inflation camp. I’m most humbly placed there. There are powerful arguments on both sides of the question. But something to bear in mind is that nobody issues a press release at the start of an inflationary cycle. It kind of creeps in on little cat’s feet.
The 1960s are a case in point. In the early ‘60s there were four consecutive years – 1961 to 1962, ‘63, early ‘64 – in those years the measured rate of inflation in the CPI was, if memory serves, less than 2%. In fact in some years it was less than 1%.
...Suddenly, the US was mired in the Vietnam War, and the quiescent interest rates of the 1960s transitioned into 1970s-style stagflation.
This historical example is just another reminder that macroeconomic trends can shift in unexpected and mysterious ways...and that central bankers hoping to catalyze an increase in inflation toward the 2% target should be careful what they wish for…
Scrying these secular shifts in the direction of inflation and real interest rates isn’t always helpful, Grant points out.
What is helpful, however, is to perform a simple risk-reward analysis of markets as they are: Think about the volume of debt rattling around the global economy, and the artificially suppressed level of interest rates, and ask yourself: Does this make any sense?
Grant reminds listeners that the 'end of the bond bull market' does not necessarily mean disruptive change...
"it took ten years for the long-dated Treasury to move from its low in 1946 of 2.25% to 3.25% in 1956..." but, as Grant points out, it's different now, "that was before risk parity and the leverage that is now in financial instruments surrounding the bond market."
However, Grant warns that he "suspects the tempo of a bond bear market will indeed be faster now than it was in 1946-56."
Later in the interview, Grant shared his view on the direction of gold, the dollar and the feasibility of long-term debt monetization by the Federal Reserve.
Listen to the interview in its entirety below:
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Once again Grant is correct in his diagnosis of the symptoms... and the prognosis - all of which reminds us of his rhetorical question - What will futurity make of the [so-called] Ph.D. standard [that runs our world]?
Likely it will be even more baffled than we are. Imagine trying to explain the present-day arrangements to your 20-something grandchild a couple of decades hence - after the crash of, say, 2019, that wiped out the youngster's inheritance and provoked a central bank response so heavy-handed as to shatter the confidence even of Wall Street in the Federal reserve's methods...
I expect you'll wind up saying something like this:
"My generation gave former tenured economics professors discretionary authority to fabricate money and to fix interest rates.
We put the cart of asset prices before the horse of enterprise.
We entertained the fantasy that high asset prices made for prosperity, rather than the other way around.
We actually worked to foster inflation, which we called 'price stability' (this was on the eve of the hyperinflation of 2017).
We seem to have miscalculated."