Our view on global investment markets:
February 2011: The Long Bond Con
Keith Dicker, CFA
Chief Investment Officer
[email protected]
www.IceCapAssetManagement.com
First publication June 2010
February 2011:
The Long Bond Con
Redford & Newman excelled at this game
“Con man” is a term for Confidence Man – in his usual role, the con
man does something to gain someone’s trust or confidence and then
when the person is least expecting it, the con man steals some form
of wealth from the unsuspecting victim.
There are two types of cons – the short con and the long con. The
short con refers to a theft that occurs relatively quickly, like the card
game on the street corner.
The long con however is much more elaborate and requires more skill
and patience. To pull off a successful long con, the con man needs
help from other con men as well as many months of preparation.
The key difference between the two is the potential payout. While
the short con steals dollar bills from his victims, the long con is
looking for a 7 figure payday.
The greatest long cons to come out of Hollywood naturally include
the 1973 Oscar winning “The Sting” featuring a young Robert Redford
and Paul Newman, as well as the 1988 hit “Dirty Rotten Scoundrels”
supported by Steve Martin & Michael Caine.
Unfortunately for the World, today we are also experiencing another
long con and it’s in the bond market. This is a very dangerous con and
the victims have no idea it is occurring.
The Debt Bomb
Much has already been written about the debt problem that exists in
the World today. This is a good thing. Everyone should be made aware
that the entire Western World has been living beyond its means and
that the time has come for everyone to pull up their socks, pants and
knickers and become fiscally prudent. While the Americans, British,
Irish, Spanish and the Greeks discovered the hard way that they can no
longer use their house as an ATM to withdraw cash at will – others
including Canadians and Australians are not that far off from
potentially experiencing déjà vu.
A little bit of debt is a good thing. Otherwise, you’d have to pay 100%
cash down for your car, scooter or house – and unless you are an
investment banker with Goldman Sachs, most people seldom find an
extra $200,000 sleeping in the bottom of their pocket. This is where
the banks step in and provide a vital service for the World’s economy.
The unfortunate part of this story is that banks are also profit seeking
companies which incentivizes them to lend, lend and then lend some
more – it’s fair to say this kind act is a part of their DNA (why else
would they lead people to financial ruin?). What makes this
unfortunate is that banks the World over have provided easy access to
credit and therefore encouraged people to borrow, borrow, borrow so
that they can spend, spend, spend.
While individuals have started to pay down their debt, the fiscal
management skills of most governments is (and we’ll try to say this
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February 2011:
The Long Bond Con
The tipping point
politely) – crap. It’s a fact that politicians do not spend their money,
they much prefer to spend your money and lots of it. At the same
time, politicians are not particularly fond of raising taxes either – this
act has been a time-proven strategy of how not to be re-elected.
The result is that year-after-year-after-year, the difference between
what they have spent and what they have collected from taxes is
negative, resulting in one big fiscal deficit. Subsequently, the only way
for countries to continue to provide the services to which we have
become accustomed is to borrow money each year.
For an individual, this is equivalent to receiving a salary of
$100,000/year, but then to turn around and spend $110,000. Repeat
the insanity again the following year and the year after that. The
tipping point is reached when the banks no longer answer your phone
call for more loans. The outcome is simple, either you learn how to
make more money, or you dramatically change your spendthrift ways.
Countries are no different (see Chart 1 on next page). Most have been
growing their fiscal deficits for years with no restraints in sight. The
result has been astronomical growth in outstanding debt. The day of
reckoning should have occurred a few years ago; the only saving grace
was low interest rates. The very same low interest rates that allowed
individuals to borrow recklessly were also available for countries to
grow recklessly – the difference being...well, there are no differences.
Sooner or later, countries will also have to face the Reaper and repay
their debts.
This is where the Long Con comes in to play. Central bankers in the US,
Europe, Britain and Japan (and hopefully at least a few elected
government representatives) fully understand that some day they’ll
have to pay back the debt they owe. They also know that it is virtually
impossible to fix their deficit overnight, and therefore the amount of
money they need to borrow continues to increase. The result is that
the only way out of the mess is to try to keep the cost of borrowing as
low as possible for as long as possible.
The con therefore is to keep short-term rates as close to zero as
possible, while printing money to keep longer-term interest rates as
low as possible.
To understand the financial benefit, let’s simplify the numbers. The US
is currently paying about $414 billion/year in interest. Yes, $414 billion
– you can buy a lot of Cosmopolitan magazines with that much money.
The obligation to pay $414 billion is based upon a borrowing rate of
2.99%. What keeps people awake at night is the following question –
what happens if interest rates increase from 2.99% to 4.5%, or what if
they double to 6% (see chart 2 on page 5)? All else being equal, the
math is pretty easy as the interest paid increases to $621 billion and
$828 billion respectively.
We can all be excused for being stunned by these large numbers,
however the key point to remember is that everyone, and every
country has a tipping point – a critical moment when something has to
change. The potential for long term interest rates to rise substantially
has pushed many countries to the tipping point.
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February 2011:
The Long Bond Con
Chart 1: Johnny Cash would have been proud
Source: Reuters EcoWin, PIMCO
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February 2011:
The Long Bond Con
Chart 2: 10 Year US Treasury Yield
16%
14%
12%
10%
8%
6%
An increase to 6%
will cost the US
$414 billion in
additional interest
payments and
signaling an end to
the long-con
4%
2%
0%
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February 2011:
The Long Bond Con
Happy hour should be mandatory
Core Inflation
The ability to objectively assess the credibility of any profession lies
within the skill (or willingness) to make fun of yourself. It’s a given that
lawyers, doctors, mechanics and teachers all have a chuckle about
their misgivings while enjoying their end-of-week drinks – this is
perfectly healthy. In the investment World, and more specifically
within the imaginary World of economics, this ability has gone AWOL.
The reason for this unexcused absence of sanity – core inflation. Let us
explain.
The financial services industry bombards us with data on a daily,
weekly, monthly, quarterly and annual basis. If that isn’t enough, we
have CNBC blaring every second of the day. Some of the data is quite
important and market moving, while other data is useless.
Probably one of the most important data points released is the
monthly CPI (Consumer Price Index) report. This data tells us if the
price of stuff is going up or down. If prices are going down, stocks and
bonds act silly. If prices are going up, stocks and bonds also act silly.
With all of this silliness happening, you just knew someone would try
to act like an adult and try to restore some common sense to the
situation. The problem is, the adult turned out to be an economist
who never ever had end-of-the-week drinks with his co-workers. This
defiant act allowed him to conjure the most silly economic data of all –
“core” inflation.
However, the only silliness that now exists is the method of calculating
“core” inflation. To arrive at this magical number, economists have
decided to eliminate from the calculation any input that actually
fluctuates. This will ensure the World (and CNBC) will report a stable
number each month. If that isn’t enough, they have even decided to
report inflation to the 3rd decimal point – you can’t make that up.
The result? In the USA housing prices, energy prices and food prices
are all eliminated from the Core CPI report. Does this make sense? Of
course not. I’m pretty confident that every American can tell you that
their heating and grocery bills are paid with real money on a regular
basis. If gas hits $4 per gallon, inflation is definitely present.
The silliness is even sillier in Japan as they have decided to exclude, get
ready for this, “sushi” from some of their inflation calculations. Yes,
you can’t make that up either.
Many products and services in the Western World have not seen price
increases and this is reflected in the “core” inflation data. Without a
doubt, economists and central bankers happily drift off to sleep every
night with this data under their pillow. Meanwhile, everyone else on
the planet is awake worried about higher energy prices and higher
food prices. In the real World, inflation is very much alive and it is
affecting the quality of life for many.
The objective of core inflation is to produce a monthly number that
would put a stop to all of the silliness in the stock and bond markets.
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February 2011:
The Long Bond Con
Hope has never been a good strategy
How is this related to the Long Con
Let’s not forget – the World’s economy is at a critical juncture; saddled
with 0% interest rates, money printing by central banks and
uncontrollable fiscal deficits. There are only two outcomes possible:
1) A return to a normal economy
2) Or something very different
Central banks have already demonstrated that they can keep shortterm interest rates very low for a very long time. The con that keeps
long-term rates low is the real game to watch. An unsuccessful
outcome will have the undesirable effect of seeing the cost to borrow
skyrocket, with the net effect being a decline in your standard of living.
The irony is that if long-term rates continue to rise, the Federal
Reserve and the European Central Bank will be forced to buy even
more long-term bonds in an effort to keep long-term rates lower (yes,
QE3 may be here before you know it). This effort to keep rates down is
equivalent to holding a basketball underneath water – at some point
your arms grow tired and the ball will explode upwards, exactly the
same way long-term rates will react to continued interference by
central banks.
Unfortunately, the World today is truly a small place, and the cheap
money being produced in the Western World is being exported to
emerging markets resulting in a gasoline-on-fire effect for their
economies. The result? Significantly higher food and energy prices.
And there you have it; the identification of the con man should be no
surprise to anyone – it is the central banks of the United States, the
European Union, Japan and Britain. The con is to keep long-term rates
as low as possible, the victims in this case are everyone on the planet
who will inevitably be exposed to sky rocketing rates at some point. In
Hollywood, we all cheered for Robert Redford and Paul Newman to
pull off the con. In today’s World, let’s all pray that Bernanke and
Trichet are not able to accomplish the same feat.
European Credit Crisis
IceCap has written about the malaise of the European banking system
and sovereign debt crisis now on several occasions. Our view has not
changed.
While Egypt has certainly (and justifiably so) dominated the news, the
European financial crisis continues. Next up is Portugal, who despite
their heroic attempts to calm markets will require a bailout within
hours. There is also a concern that the outcome of the upcoming Irish
election may place strains on their “agreement” to accept their
bailout. Belgium is also on the list – as are the original perpetrators –
the Greeks.
While this may all sound confusing, the only fact investors need to
understand is that each bailout is a financial transaction to ensure
bond investors do not lose any of their money. The other salient point
is that the bond investors being saved are mostly other European
banks. The bailouts have effectively become a transfer of wealth from
the tax payers to the banks. While many believe all is fine in Europe
these days, we think otherwise.
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February 2011:
The Long Bond Con
Kick the can
The Arab World
The speed of which events are sweeping across north Africa, the
Middle East (and now China) has caught everyone off guard. The
suggestion that both Tunisia and Egypt would have kicked-out out their
dictators over a 3 week period would have been laughed at by the
World’s elite if it hadn’t happened.
Understandably, chaos and havoc is escalating within the region –
however, chaos and havoc of a different kind is happening at the
Pentagon. The Americans have been involved in the Middle East for a
long time and have established allies of varying degrees, most notably
with Egypt and Bahrain. The point we make is that those who believe
these events are either “over” or don’t affect them may be dearly
wrong. The blueprint for how the game is played is changing and
worse still, no one will know the rules or the players until the dust has
settled.
Whereas financial markets have decided to shrug-off the news, energy
and agricultural commodities are rising. We do not know the eventual
outcome, however we do acknowledge (and respect) that the
probability of oil supplies being disrupted are considerably higher
today than 8 weeks ago. The same can be said for various food
commodities. The point we make, is that the complacency shown by
the stock market may be misplaced and should be monitored closely.
Our Strategy
In previous publications, we have detailed the dangerous balancing act
being orchestrated by the central banks and governments. On one side
of the axis we see the real economy which remains at stall speed,
while the other side is drugged up on unprecedented monetary and
fiscal stimuli; the most recent addition being the $850 billion tax
package in the US and the European bailout of Portugal.
The “dangerous” part of this act is the deteriorating fiscal deficit of
much of the developed world. The Americans will now have an
accumulated fiscal deficit of about 96% of GDP, a level that has not
been seen for over 65 years – now that’s progress! The can has been
kicked down the road for another year, and we only hope the private
sector is able to pull its weight once the governments are unable to
continue with their money printing and spending ways.
As a result, the game or con has squarely shifted to the bond market
and more specifically longer-term bonds. While main stream media
are very capable of reporting rioting in Tunisia, Greece and Spain – we
look forward to see how they handle rioting in the bond market should
governments fail to get a grip on reality.
Our strategy hasn’t changed that much, we continue to hold gold in
our portfolios. This strategy will provide insurance and protection
against being burned by wayward government policies, while we
remain cognizant of the desire for stock markets to go higher. Our
growth strategies are focused on the commodity related strategies in
both our stock and commodity portfolios. Agricultural commodity ETFs
continue to trend higher and this obviously makes us and our clients
happy.
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