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There
is an old adage on Wall Street: no one rings a bell to signal a market top or
bottom. Yet, I have found that bells do ring; it's just that few
people know exactly what sound to listen for.
Perhaps
the biggest and most liquid of all markets is for US government bonds. That
market has been rallying for almost thirty years. The bull can be traced back
to 1981, when Treasury bond yields peaked at about 15%. At that time, high
inflation and a weakening dollar had justifiably squelched demand for
Treasuries. Even the ultra-high interest rates were not enough to attract
buyers.
But this
was also when the proverbial bell was rung. Fed Chairman Paul Volcker had
signaled, by jacking up interest rates so high, that he would stop at nothing
to break the back of inflation. Volcker's iron will, and Reagan's unflinching
support, restored demand for Treasuries for the next three decades.
We
have arrived today at a similar inflection point. After falling steadily for
30 years, bond yields are now heading north with a full head of steam.
Many
are taking the recent moves in stride. The consensus is that despite the
recent spike, yields are still historically low, and that they are unlikely
to go much higher from here. Once again, most on Wall Street are either tone
deaf or plugging their ears.
For
years, the Fed has been able to prevent market forces from correcting our
growing economic imbalances by inexorably pushing rates lower. This happened
in 1991, 2001, and most notably in 2008. These easing campaigns succeeded in
boosting the economy in the short term by greatly increasing the amount of debt
held by both the private and public sectors. As such, these episodes have
allowed our economy to delay and magnify the ultimate reckoning.
Just
like a junkie who requires ever-increasing doses of heroine to achieve the
same high, the Fed has needed to take rates ever lower to boost the economy
after its previous stimulants had faded.
To
stimulate after the bursting of the housing bubble (which itself resulted
from the low interest rates used to juice the economy following the bursting
of the dot-com bubble), the Fed lowered interest rates to practically zero.
At that point, rates could go no lower. However, when that stimulus failed,
the Fed decided to bring on the heavy artillery in the form of
"quantitative easing," or as it is known in the vernacular, "printing
money to buy government debt."
Lowering
the federal funds rate, its traditional weapon, tends to make the most impact
on short-duration debt. By its own words, the goal of quantitative easing
(QE) was to lower long-term interest rates. It was hoped that this would
achieve what low short-term rates had not: an increase in stock and real
estate prices, a rise in household wealth, and consequently greater consumer
spending, economic growth, and job creation.
However,
the Fed's plan backfired. The selling pressure on long-term bonds is
overwhelming the Fed's buying pressure. Spiking rates (which move inversely
to price) are powerful evidence that the bond bubble has finally burst. The
Fed threw everything but the kitchen sink at the bond market to force yields
lower, yet they rose anyway. If bond prices failed to rise given such a
Herculean effort to lift them up, there can be only one direction for them to
go: down.
In
true form, few on Wall Street hear the ringing. In a shocking display of
rationalizing cognitive dissonance, some (such as Wharton Professor Jeremy
Siegel in a WSJ op-ed) have even suggested that the spike in yields is proof
that quantitative easing is working. Siegel heralded higher rates as
indicative of economic resurgence, which supposedly was the Fed's goal all
along. In other words, QE2 worked so well, we skipped the lower rates and
went directly to the higher rates that go with growth!
There
is also a widespread belief that long-term rates will remain contained at
historically low levels. Four percent is seen as the ceiling above which
ten-year yields will not rise. I believe this ceiling will prove to be of the
thinnest glass. Once yields easily break that level, they may quickly rise
above five percent, where they will likely encounter some resistance, before
heading significantly higher.
In
fact, if rates approach six percent next year, we will be seeing a ten-year
high in ten-year yields. If our economy is this fragile with record low
rates, image how much weaker it will be with rates at ten-year highs? If the
Fed believes that lower rates revive an economy through the 'wealth effect,'
what does the Fed feel will happen when higher rates produce a reverse
'wealth effect'?
Not
only does this bell herald the end of the bond bull, but it also marks the
end of the Fed's ability to artificially engender economic "growth"
through monetary policy. More significantly, the new tax compromise President
Obama is about to sign will add more than $900 billion in new debt onto the
government's balance sheet over the next 10 years. This will put additional
upward pressure on interest rates, and more political pressure on the Fed to
monetize the debt. It is no coincidence that the real upward movement in
yields began immediately after the tax/stimulus deal was brokered in
Washington.
What
lies ahead is a new era of rising interest rates, soaring consumer prices,
increasing unemployment, economic stagnation, and lower living standards.
Instead of stimulating the economy, quantitative easing and deficit spending
will prove to be a lethal combination. Bondholders beware, the bell tolls for
thee.
Peter D. Schiff
President/Chief Global Strategist
Euro Pacific Capital, Inc.
20271 Acacia Street, #200 Newport Beach, CA 92660
Toll-free: 888-377-3722 / Direct: 203-972-9300 Fax: 949-863-7100
www.europac.net
pschiff@europac.net
Peter
Schiff is president of Euro Pacific Capital and host of The Peter Schiff
Show.
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