“The Fed has somehow managed to take the income out of fixed income and the yield out of high yield,” said bond market maven James Grant at the Fixed-Income Management 2012 conference held last week in San Francisco. His topics were the political and policy dimensions of interest rates and the unintended consequences of current monetary policies, lessons from history and human error that endures.
“Muscle memory should be required of all CFA candidates,” said Grant. “For 150 years interest rates have risen and fallen at generation-like intervals.” From 1861 to 1899 rates fell, and the United States enjoyed a 38-year bull market in bonds. Painfully long bear markets included the periods 1900–1920 and 1946–1981. In the current bull market — which started in 1981 and is now 32 years old — “interest rates have fallen, and they can’t get up,” Grant said. “Ain’t it grand!”
Grant gave a “cook’s tour” of the “reigning errors and foibles” that are being made in today’s bond markets and that have led us astray in committing capital.
- The Fed’s problem with the price mechanism. “Interest rates are prices, and they are under the thumbs of our monetary mandarins,” Grant said. “How many of you eat organic? Free-range chickens are of course the most tasty and desirable. It is apparent that Chairman Ben Bernanke does not like ‘free-range interest rates.’ The Fed even has its hooks in the stock market, and plugs the ears of equity investors to warnings of impending poor corporate earnings.”
- Overreliance on econometric models. Economists have an obsession with mathematics. “When I am chairman of the Federal Reserve — it could happen — none of my hires will have ever received higher than a B in calculus!” The dominant model for the economy used by the Fed and the economics profession as a whole is the dynamic stochastic general equilibrium (DSGE) model. As the Committee on Science, Space, and Technology of the US House of Representatives aptly told us in July 2010, “The DSGE model excludes from the model economy almost all consequential diversity and uncertainty — characteristics that in many ways make the actual economy what it is.”
- A single-minded focus on the Great Depression. It blinds us to conflicting and contrasting evidence. Why not look at other periods in history? As examples, in the depression of 1920–21, after a devastating drop in industrial production and wholesale prices, and a significant rise in unemployment, the government took a hands-off approach, and a rapid and vigorous rebound in the economy followed.
- The belief that economic slack means no inflation. With today’s exceptionally low volatility, the bond market seems to have it in its head that: (1) The Fed is “in charge” (command and control); and (2) if there is slack in the labor and product markets, then there is no need to worry. Grant’s research shows, however, that over time there is a slightly less than zero correlation between slack in the economy and the amount of inflation. For example, inflation and unemployment fell together between 1992 and 2001. Inflation and unemployment accelerated together in the 1970s.
- Faith that the Fed will see inflation coming and prevent it. Grant said the QEs matter and are either intrinsically inflationary or contingently inflationary. “If the QEs are only inflationary in a contingent manner, the markets believe that surely the Fed will see it coming and take action to forestall it,” he said. Grant quoted John H. Cochrane of the University of Chicago about the possible path of inflation going forward and what the spiral of inflation may look like as Cochrane described in an article in the fall 2011 edition of National Affairs.
The true problem in Grant’s opinion is not today’s debt but tomorrow’s unfunded entitlements. “To me,” said Grant, “the fiscal cliff is the Y2K of 2012. Everyone frets about it, and some have discounted it, but it is not the thing. The thing is tomorrow’s unfunded entitlements.”
Under what Grant calls “Cochrane’s postulate” he said, “The real value of government debt must equal the present value of investor expectations about the future surpluses that the government will eventually run to pay off the debt.” It makes sense, but how do we calculate the present value when there’s no free market for interest rates? Professor Alan J. Auerbach at UC Berkley and William G. Gale of the Brookings Institution in their August 2012 paper, “The Federal Budget Outlook: No News is Bad News,” made a good estimate of the real value of debt as the present value of unfunded liabilities (or the long-term “fiscal gap”) at roughly $115.5 Trillion. (For comparison the IMF calculates world GDP at about $72.5 trillion today!) Has Mr. (Bond) Market done the math? Can anyone imagine, Grant asked, a US Congress that would set in motion the realization of budgetary surpluses anywhere close to the projected budgetary shortfalls?! Yikes!
Grant closed with several observations about today’s investment environment: (1) For the first time in history, Fidelity is managing more money in bonds than equities; (2) Bernanke has 100% confidence in the Fed’s ability to reverse its radical monetary policy in a timely manner; and (3) you “just never know” in finance. Given all of this, Grant believes that US government bonds at 3% do not afford a margin of safety. Rather Grant is eyeing investments outside the bond market for income. For example, he likes those very adaptive companies selling at market multiples.
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