Market Signals, Debt and Democracy

Every six months, The Wall Street Journal, with the best of intentions, interviews the most prominent economists that predict interest rates on Wall Street. It's been doing this for over 20 years. How good have these forecasts been?

Jim Bianco of www.biancoresearch.com went back and studied the archives... all 43 of those Wall Street Journal economist surveys over two-plus decades. Amazingly, Bianco discovered that the professional economists as a group successfully predicted the future direction of interest rates just 13 out of 43 times.

Said another way... You can flip a coin to determine whether interest rates will go higher or lower in the next six months, and chances are your coin-flip prediction (with a 50% probability) would beat the collective guesses of the "pros" (who've been right only 30% of the time).

Actually, I have found Wall Street consensus estimates to be quite useful although not for the reasons they were intended. Betting on the consensus expectation is a very bad idea. Either it is right and you make no money because everyone expected this outcome, or more likely it is wrong and you are caught out on the wrong side of the market as expectations change. Market consensus is useful because it tells us what we should bet against to generate good returns.

2004 is yet another example of the consensus being wrong. The overwhelming view has been and still is that bond yields should rise. Yet they have fallen so far this year. If you really want to find useful signals you are far better off studying the markets themselves. The record of market based signals is a vast improvement on Wall Street pundits, however qualified they may appear.

Market Signals

No one signal or collection of signals is infallible, but here are 6 market signals that indicate that bond yields may still go lower over time. These are the factors that are not on most people’s radar screen. Please bear in mind, though, that the bond market has already had a very good move so you need to take care in finding a good time and entry point in the current rally, which is already very mature.

1. Since interest rates started rising at the end of June, the yield on 30 year bonds has fallen by over 40 basis points. This suggests that the bond market believes that the Federal Reserve’s tightening cycle is if anything early and may be over very quickly. Only once before in the past 35 years have US Treasury yields fallen when the Federal Reserve raised interest rates. Back then in the early 1970s the bond market was right and the Fed were soon cutting interest rates again before long.

 

2. In the last 4 years we have seen both gold and government bonds rally. The only other time we have seen this combination was during the extended deflationary period of the 1930’s, when bond yields reached record lows.

3. Bond yields are only relatively low in relation to where they have been in the last 30 years. The chart below shows that they are about average for the last 300 years. Our recent experience makes us biased into believing that currently bond yields are “low”. It may just be that we are still recovering from an exceptional period of high inflation and bond yields.

4. One of the most reliable forecasts of a recession is when the yield curve of government bonds goes negative, that is to say that the 10 year government bond yields less than the short term interest rate. We are unlikely to get this signal either in the Japanese or US bond market simply because short term interest rates are so remarkably low. In Japan they are zero making this impossible and short term interest rates in the US are still remarkably low and below inflation. Nonetheless we should realize that we now have flat yield curves in the UK and New Zealand, and are not far off in Australia. We do not yet have a clear signal yet that recession is on the way but this is a key indicator that we need to watch closely.

5. and 6. The only recent example we have of an economy that has experienced persistent and remarkably low interest rates is Japan. It is interesting to compare the price development of the US markets – both equities and bonds - since the top of the equity market in 2000 with the price development we saw in Japan from the equity market high in 1989. This is precisely what the two charts below show.

Remarkably for 4 years the markets in the US have almost precisely matched those of Japan. The markets are suggesting that so far we are right on track to repeat Japan’s deflation. In 1994 no-one in Japan anticipated that they were about to experience 10 years of deflation and no-one in the US would ever risk forecasting that the same outcome would now occur. But so far US markets are matching Japan’s pre-deflationary experience very closely.

Federal Reserve Policy

Alan Greenspan recently admitted that he had no idea why Japan had experienced 10 years of deflation. Theoretically in a fiat money system a central bank should always be able to generate inflation and avoid this outcome. This is hardly reassuring when debt levels in the US have now reached all time records in relation to GDP. The only other time debt levels reached anywhere close was at the end of the 1920s just before the US experienced its own period of deflation. This is another eerie parallel. And the chairman of the Federal Reserve clearly may not have a solution.

Federal Reserve policy got us where we are today but may not now be able to save us. The whole focus of policy has been solely on producing economic growth with low inflation. Quite reasonable you might say, but it has pursued this approach without regard to debt levels, asset prices, savings rates, and budget and trade deficits. Now these imbalances may end up swamping the economy with the Federal Reserve left powerless.

The key issue is the extraordinary accumulation of debt in all its forms, which we have referred to many times in these notes. Debt in the end has to be paid for one way or another, however long the date is put off. The US, aided and abetted by the Federal Reserve, has tried to ignore this painful truth, while at the same time continuing to rapidly increase its debt levels.

The steady rise in US debt and deficits has proved better than the plausible alternative of a world slump. But the fact that the alternative to the unacceptable is the unsustainable should worry any prudent observer of the world economy. Unless the US quickly addresses its current account deficit problem, foreign debt is set to rise for as far as the eye can see. Nouriel Roubini of NYU and Brad Setser of Oxford point out that US international indebtedness could be closing in on 300% of exports by the end of 2004. By way of comparison, pre-crisis debt-to-export ratios hit about 400% in Argentina and Brazil.

Consider how you would react if your next door neighbor lived an extravagant lifestyle by borrowing money to the point that they were heavily in debt, while they continued to save nothing. Still they expected you to continue to lend them money. And, oh by the way told you how you should be living your life. You might just have a few things to say and at some point you will become reluctant to continue to lend. But did you stop to think that this is how the US collectively behaves towards the rest of the world?

Sooner or later and the sooner the better, the US has to come to terms with its debt. Not just the existing $1.5 billion dollars a day it requires to finance its existing lifestyle, but also it must come to terms with the promises that no-one believes that it can keep. Clearly, neither the IMF nor Alan Greenspan believe that future entitlements spending is feasible and in the US we also have plenty of other concerns, among them a pension crisis developing and out-of control derivative exposure.

Debt workout

"In true dialogue, both sides are willing to change." - Thich Nhat Hanh

But the question remains when and how it will be addressed. Peter Peterson’s excellent book – “Running on Empty” - describes the situation very well and does have some proposals. However, there are currently no realistic proposals on these issues from either of the main political parties, and there does not seem much chance of a realistic bipartisan discussion taking place, let alone a solution. Addressing so large a problem and its painful solutions will clearly be hard for anyone to do. Perhaps the only way this issue can be resolved is through some crisis. But this makes the outcome far more unpredictable.

 

An individual confronted with these problems would probably see the error of his ways and quickly put them right. But collective problems require a collective solution. Introducing group dynamics is what makes this such a difficult problem to resolve. So often “group thinking” leads crowds to behave in an absurd fashion.

Bill Bonner describes this well. “ ‘Group thinking’ is, like ‘honest politicians,’ an oxymoron. Groups do not think. Instead they desire. They fear. They panic. They go mad from time to time – sometimes believing they can all get rich without working or saving …. sometimes believing that they can all live at someone else’s expense ….. sometimes believing that expensive stocks will become even more expensive. An individual knows he cannot spend his way to wealth. But put him in a group, and he’s willing to believe that ‘consumer spending’ can make the whole society rich. An individual knows he cannot kill another individual without risking jail…. or hell. But put him in a crowd, and he is ready to declare war on people he’s never met for reasons he’s never understood.” 

Factional polarization and endless borrowing from posterity, figure heavily in Edward Gibbon’s “Decline and Fall of the Roman Empire”. Excessive debt preceded the 1930’s depression in the US. Reparations after the First World War burdened Germany with excessive debts it could not manage and lead to hyperinflation and social disintegration. Japan’s problems in the 1990’s were also primarily a debt issue, albeit mainly in the financial sector.

Debts and unfunded promises create challenges for any society but the temptation is always to pretend they don’t matter or hope that somehow they will fade away with time. But, of course they never do. “Lying rides upon debt’s back,” said Ben Franklin. It is so much easier to collectively lie to ourselves about debt and the unfunded promises we make for ourselves. In a developed democracy it becomes hard to find a majority that is prepared to vote for less. Livy, the eminent historian in the Age of Augustus, noticed a similar mood among his Roman contemporaries. “The people can bear neither their ills nor their cures,” he wrote. America still has time to put its house in order, but it is now running out of years to do so.

Conclusion

If you live on the coast in South or Eastern parts of the US this can be a difficult time of year. At any time a Hurricane can come your way and blow your house away. You better have not only an escape plan but also very good insurance.

In the same way excessive debt represents hurricane season for investors. Most of the time the focus is on earnings, interest rates, inflation and economic growth. But when debt spins out of control investors better prepare for a financial hurricane that can overwhelm normal considerations. Excessive debt creates violent economic conditions. Investors need to be armed with a good understanding of what can happen as well as a plan do deal with the consequences of debt, as it can easily swamp all other considerations.

Market consensus has once again been too bearish on the bond market. We have shown 6 market indicators which suggest why this may be so. How the US comes to terms with its debt workout is now a key factor in market dynamics that almost no-one seems to consider. Debt resolution has not even begun, but no investor can afford to ignore the US’s balance sheet problems and the economic and political consequences that surround it.   

 

 

 

 

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