There is one path in investing that is sure to lead to ruin. It’s a dangerous path because it lacks one critical ingredient for success – thought. The path we are speaking about is called “following the consensus”.

It is both intellectually and emotionally easy to follow a majority of bullish analysts. Unfortunately the ‘consensus’ is seldom right and hardly ever leads to BIG profits.

The consensus today is that the stock market is risky and treasury bonds of all maturities are safe. But just how safe are treasuries?

Consider the following:

1. Commodities are surging ahead, which is a surefire sign of inflation and higher rates.
2. Money supply the world over is gushing out as central bankers try to pump up their economies. The positive correlation between MS and price inflation and interest rates is overwhelming.
3. Long-dated treasury bonds are at generational lows and short-dated rates are practically zero. Real rates are negative and penalize savings. Can interest rates go much lower?
4. If the US dollar continues to fall, China and the rest of the world won’t hold treasuries for much longer. Unless rates rise to protect the dollar, the inevitable consequence will be wholesale dumping.

Another consensus view is that we are heading into a period comparable to the 1970s. Stagflation.

However, we have problems with that view too:

Chart 1 - 30yr yields 1940 to today

courtesy chartrus

For one - long-term interest rates were already rising in the 50s and the 60s before commodities or price inflation really got going in the 70s. Contrast that with today, where interest rates have been falling precipitously for two decades.

Another thing that worries us about a comparison with the 1970s is wages. Wage inflation increased sharply in the mid- to late-1960s, from around three percent per year to seven percent and then finally 9% in 1980. Wage inflation is completely absent today, which is surely attributable to cheap labor in emerging countries and the internet.

Whilst there are similarities with the 70s, we don’t think the comparison is apt.

Here’s another reason we think something different is going on rather than plain ‘ol vanilla monetary inflation:

Chart 2 - various bond ETF returns over 6-months

The above chart shows the performance of various fixed income ETFs over the last 6 months. Admittedly the worst 6 months in fixed income markets for many years.

Excluding dividends (the ETFs pay interest from the underlying bond), the following returns have been achieved:

• Municipal Bonds (TFI): (minus) –1% (yield 3.8%)
• Investment Grade Corporate Bonds (LQD): –1% (yield 5.7%)
• 7-10yr Treasuries (IEF): 6.65% (yield 3.7%)
• Mortgage Backed Securities (MBB): 2.82% (yields 3.4%)
• Treasury Inflation Protected Bonds (TIP): 7.87% (yields 5.6%)
• SHY – 1-3yr Treasuries 4.89% (yields 2.3%)

Hardly returns from a collapsing market!

TIPs have admittedly performed best, so inflation concerns are entering the market, but what surprised us most is the decent returns on the ‘dismal’ segments of the market: corporates, munis and mortgage backed securities. Even the worst category of bonds have benefited from lower interest rates.

The one thing that has changed is the blow out in spreads. The price of default risk has sky rocketed whilst the underlying cost of debt has not. Our view is that we are entering a period of wholesale debt deflation and that is why assets with very little credit risk, such as gold, oil and even treasuries, are being marked up.

However, regarding treasuries, they are backed by central bankers hell bent on debasing their currency to prevent debt deflation. Given a little more time and a little more pain, the consensus will realize that treasuries are not a good hiding place at all. The bond bubble will ultimately get pricked and interest rates move much higher.

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Greg Silberman

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