Bonds are going to blow…
This latest warning on the dangers lurking in these supposedly “safe haven” assets comes by way of another one of the special guests at our 2017 Inner Circle roundtable event in Baltimore last month, David Stockman.
David knows a thing or two about the dangers of debt – and politicians’ love affair with issuing as much of the stuff as they can get away with.
As President Reagan’s budget director in the early 1980s, he was the chief architect of the “Reagan Revolution.” The idea was to slash taxes and take an ax to entitlement programs to allow the private sector to grow.
In 1981, David sat down with the newly elected president to crunch the numbers.
The result: the first Reagan budget. It wasn’t perfect. But it went further than previous presidents had dared in curtailing the growth of America’s “welfare state.”
But it soon became clear to David that, although it was keen on cutting taxes, the Republican Party had no real appetite for reducing government spending.
This meant spiraling federal budget deficits.
And just four years later, he quit the Reagan administration in protest and wrote the New York Times best-seller The Triumph of Politics: Why the Reagan Revolution Failed.
To this day, it’s the single most insightful account of why it’s so difficult to get anything meaningful done in Washington.
You can probably tell why we invited David along to our roundtable session…
He spent years in the Washington “swamp.” And he’s seen firsthand how hard it can be to push through truly conservative agendas. Candidates may talk a big game about reining in government spending, but when the rubber meets the road, the temptation to spend out of an empty pocket can be too great.
As he explains in this week’s Q&A, this has led to the mother of all bubbles in supposedly “safe” bonds.
And when it bursts, it’s going to make the 2008 financial crisis look like a picnic…
But before we got to talking about what lies ahead…
I wanted to get David’s perspective on my Inner Circle roundtable interview with former Fed chief Alan Greenspan… the full transcript of which you can find here.
You see, David knew Greenspan going all the way back to the early 1980s.
Still in his early 30s, David was the youngest member of President Reagan’s cabinet. And Greenspan, who had been an economic adviser to President Ford, was keen on introductions to the Reagan team.
So first, I wanted David’s personal perspective on some of the comments Greenspan made in our one-hour session with him…
Q&A With David Stockman
Chris Lowe (CL): The financial crisis you see coming is closely linked with the immense influence Alan Greenspan had over the economy… during his almost two decades as the world’s most powerful central banker. We got to sit down and talk to Greenspan about this in Baltimore on behalf of our members. What was your big takeaway from that meeting?
David Stockman (DS): A lot of stuff that came out of our meeting is worth highlighting. But I want to focus on a couple of the whoppers I picked up on.
I want to be respectful. I have known Alan a long time. I understand that each of us has to do what he has to do. But his claim that the kind of central banking we have now… the kind he pioneered and practiced… was meant to “replicate the gold standard” – that was a proposition too far.
Activist central bankers do the opposite of what the gold standard did. Alan got it right in 1966 when he wrote his essay “Gold and Economic Freedom” for Ayn Rand’s newsletter, The Objectivist.
CL: Can you quickly run through the thesis of that essay? Not all our readers will be familiar with it.
DS: Sure… In the pre-1913 world – when the gold standard collapsed under the strains of World War I – there were six or seven recessions. They called them depressions or panics back then.
In each case, when the system ran out of gold, this garroted the excess credit commercial banks were creating. You had a recession. The world moved on.
Today, central banks actively try to trigger a “wealth effect.” Instead of letting the recession happen, they support the stock market by lowering interesting rates.
This is supposed to make stock and bond owners feel wealthier and encourage them to rush out and spend. The problem is you’re now indirectly setting the price of all financial assets – from stocks all the way over to the money market rate.
CL: Why is that such a big problem?
DS: Central bankers believe they can forecast the future. And based on their forecasts, they believe they can set the right interest rate level… and the right level for the stock market. But that’s impossible.
Let me illustrate that by way of an anecdote…
In June 1987, I got a call from Alan. We knew each other fairly well at that stage. He said, “I have good news and I have bad news. The good news is I’ve been asked to become chairman of the Fed. The bad news is that I have 30 people working for me at my economics forecasting firm Townsend-Greenspan. If I go to the Fed, I’m going to have to disband the firm I’ve built up over 30 years. I feel an obligation to the people who work there. So, I have a proposition: Would you like to buy Townsend-Greenspan and make a go of it?”
I said, “Well, that sounds pretty interesting. Let me come down.”
I met with him. I met his staff. He got out the financials. I went through them. And to my surprise, I discovered the firm had been losing money for years. The only reason it was reasonably solvent was that Alan gave a lot of speeches and got big honorariums for them.
My point is that Alan Greenspan, one of the most famous economists of his day, who had a big practice selling economic forecasts from this giant model, couldn’t make any money forecasting the economy. So, what do you think happened when he took over the Fed, essentially became the world’s central banker, tried to forecast global and domestic GDP, and tried to set the price of debt, money, stocks, and other financial assets based on those forecasts?
Shortly after, he had his confirmation hearing in front of the Senate Banking Committee. And as he mentioned to us in our meeting with him, he told the committee he had some very libertarian and unorthodox views. He didn’t believe in the minimum wage. He didn’t believe in farm subsidies and all the rest of it.
What he didn’t mention to us was that, in that same hearing, he had this interesting back and forth with the famous Senator Proxmire from Wisconsin – who, by the way, got a great rating from the National Taxpayers Union when Bill was running it because he was the one Democrat oriented toward fiscal integrity, thrift, and so forth.
Well, Proxmire got out the last 10 years of forecasts from Alan’s forecasting firm, Townsend-Greenspan. And all of them were wildly wrong. They weren’t even close.
It’s truly amazing: The whole proposition of modern central banking is that these guys can forecast the price level… the unemployment level… the federal funds rate… and so forth. But they’re constantly completely wrong.
CL: You and Bill – like Greenspan in his pre-Fed days – believe that the gold standard is a better, more honest money system than the fiat money system Greenspan presided over at the Fed. Why?
DS: Gold and the free market are part and parcel of the same thing. For example, under a gold standard, interest rates are set by supply and demand for this finite resource – gold. A gold standard also curbs credit expansion. Banks have to back their loans with gold.
In other words, market forces controlled credit conditions when we were on gold. There was no sense of macroeconomic management. There were no targets for unemployment… inflation… GDP growth… housing starts… retail sales… or anything else.
Today, we have the exact opposite. We have monetary central planning. We have a massive debt bubble. And it all started with Greenspan as the central banker of the world, beginning in 1987.
The numbers don’t lie. Between 1987 and 2006, when Greenspan was at the Fed, the Consumer Price Index went from 110 to 200. Over that 19-year period, inflation nearly doubled. Put another way, the buying power of every dollar you had saved nearly halved.
Meanwhile, U.S. household debt went from $2 trillion to $14 trillion – a sevenfold increase – while GDP barely doubled. None of that could ever have happened under a gold standard.
CL: I spent about half an hour talking with Greenspan in Bill’s office before our official meeting began. At one point, I mentioned to him that he was meeting with a group of “gold bugs.” He lit up at that. And he said, “Me too.”
As you mentioned, in 1966, Greenspan wrote one of the most spirited anti-statist, pro-gold standard, and pro-laissez-faire essays of all time with “Gold and Economic Freedom.” What happened to Greenspan the gold bug when he got into the Fed?
DS: Once he got inside the Fed and the whole central banking fraternity, he got into their groupthink. He began to believe things that were the opposite of that essay – which is quite brilliant, by the way.
CL: Greenspan isn’t the only one who drank the Kool-Aid. Since the 2008 financial crisis, central banks around the world have increased their balance sheets by nearly 200% – from just over $6 trillion to just over $17 trillion. World debt is at a record high. And central banks in Japan and Europe have set their target lending rates in negative territory. Where does that leave us?
DS: It leaves us in unbelievably troubled waters. In 1987, when Greenspan went to the Fed, no one in their right mind would have predicted that you could have 96 months running of practically zero interest rates. No one would have thought it was even remotely less than lunatic to have $45 trillion of sovereign debt in the world. Or that, as of last August, $13 trillion of it would be trading on negative yields.
No one would have thought, either, that the balance sheets of the central banks could have exploded to the degree they have. Let’s just look at the Fed. On the eve of the so-called Lehman crisis in 2008, the Fed’s balance sheet stood at about $900 billion. Over the next seven weeks, Ben Bernanke doubled it. Over the following 13 weeks, he nearly tripled it. And today, it has ballooned to more than $4 trillion – a roughly 350% jump.
As I’m sure your readers are already well aware, central banks are way off the deep end… so much so that they are lost, paralyzed, divided, and essentially out of dry powder.
People say, “Well, they can just keep doing QE.” But I don’t think they can just keep doing QE. The Fed finally stopped because even Janet Yellen realized that you can’t keep creating something from nothing. You can’t keep imposing on people what is essentially fraud, although they would never call it that.
CL: Greenspan also talked about his experience on “Black Monday” in 1987… which happened just months after he took over at the Fed. The Dow plunged 23% that day. Greenspan was widely seen as saving investors by dropping interest rates to prop up the stock market. What is the effect today of the “Greenspan put,” as this practice later became known?
DS: It has house trained the entire global financial system to price securities based on what central banks are doing rather than on discounted cash flow or other fundamental values. It has also created the greatest bond bubble in history.
This is not just a result of the $17 trillion in bonds that central banks took out of the supply in their godforsaken effort to manage the economy via QE. It’s also the tens of trillions more that were bought by smart guys in hedge funds. Seeing what central banks were doing, they said, “If the European Central Bank is buying Italian debt, I am going to buy it first. If they’re going to be buying it for the next two years, I’m safe until they stop buying it.”
The problem is that bonds around the world are now mispriced. In fact, everything is drastically mispriced, but people don’t understand the knock-on effects.
You see, almost all other financial assets trade off of the yield on the 10-year Treasury note. This drives the present value of stock market earnings… and real estate cash flows. Low Treasury yields also make it cheap for corporations to issue debt to fund buying back their own stock. That feeds into the stock price because these corporations then cancel the stock they buy. This pushes up earnings per share on the remaining shares… which pushes up stock prices.
The sheer size of the bubble is staggering. Over the roughly two decades Greenspan was at the Fed, world debt went from about $40 trillion to about $230 trillion. While world GDP went from something like $30 trillion to roughly $70 trillion today.
CL: Do you have any recommendations for Inner Circle members based on what you see coming down the pike?
DS: Sure. Sell stocks, sell bonds, sell the house, mortgage the kids, and get out of the way.
What to Do
Chris here – We first warned you of the dangers in the bond market last July.
Because of their “nosebleed” valuations, Tim Price in our London office described bonds as a “Vesuvius waiting to blow.”
Tim’s recommendation: “Be careful about which bonds you own. In extremis, don’t hold any.”
If you haven’t done so already, now may be a good time for a quick “check-up” on the bonds… or bond funds… you own in your portfolio.
Keep in mind that, if interest rates keep rising, bonds with longer maturities will fall further in price than bonds with shorter maturities.
Also, take a look at any corporate bonds you may own. Are they investment grade? Are they in companies with solid balance sheets?
What about international diversification? Owning a global portfolio of bonds will cushion the blow from a blow-up in one specific country or region… like, say, the eurozone.
Bottom line: Don’t treat bonds as “safe” assets. They are anything but.
Until next week.
Editor, Inner Circle
P.S. Don’t forget that you can read the full Q&A of my interview with Alan Greenspan in your special bonus report here. Did you spot any whoppers that David didn’t already cover above? Write me at [email protected].