The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (22 page)

As inflation and interest rates rise and the government debt spikes ever upward, investor psychology will turn increasingly negative. It is hard to believe now, but eventually investors won’t want to buy any of our debt. At that point, we will continue to make our interest-only payments with more printed money, but soon that will not work either because more money printing will push inflation higher and higher and interest rates higher and higher, too. At some point, massive money printing will have to end and our interest-only payments will not be made, and the U.S. government will be in default on its debt.

As of this writing in June 2012, Standard & Poor’s (S&P) rates the United States at AA+, while Fitch and Moody’s still maintains its AAA credit rating for the United States. But that could change with the next big federal budget showdown. Also, inflation and interest rates are low. But later, when inflation and interest rates rise enough to force an end to massive money printing, and when the government can no longer make its interest payments on the debt, U.S. government bonds will drop to XXX credit score very quickly, just like the mortgage market crash, because investor psychology will change very quickly.

Investors have some comforting reasons for not being too concerned about bonds (yet). First, as explained earlier, recent history has been very good for bonds. That is hard to ignore, especially when you want that good recent history to continue. In addition, investors draw comfort from the many nice safety features of bonds, such as the guaranteed return of the original principal, which other investments generally do not have. And, of course, bond investors draw deep comfort from their faith that the federal government can always print more money and buy more bonds, keeping the demand for bonds strong.

But even more than these reasons for their comfort with bonds, investors’ unwavering confidence in bonds comes from an even deeper and more powerful source: The
psychology of denial
. It is natural to want good things to last forever; that’s just human nature. It is also human nature to not want to face certain facts that might threaten the current good status quo until those facts absolutely have to be faced. However, we actually often quietly know more than we want to openly face. We lie to ourselves, but to a certain extent we sort of already know that it is a lie.

In the case of bonds, most investors actually already know on some level the very thing that they don’t want to face. Most of them know that quantitative easing (QE) causes inflation, that rising inflation causes rising interest rates, and that rising interest rates cause bonds to fall. Because they would rather not face these facts, they are highly motivated to believe that whatever the current level of money printing we are now doing is just the right amount. Like Goldilocks with her favorite bowl of porridge, the amount of QE is always “just right”—not too hot, not too cold, not too little, not too much. Each time more massive money printing occurs, CW investors and analysts declare it is just the right amount. No matter what is happening, it is all “doable,” it is all just fine because
the government will not let us fail
.

Denial is what will keep the party going in the stock market and the bond market right up until the moment when the denial suddenly evaporates and everyone wants out.
That is how you know it is denial
. If investors don’t already know on some level that things are not as wonderful as they seem, why is it so easy for them to change their minds on a moment’s notice and head for the door? Clearly, deep down, investors are more skittish than they let on, even perhaps to themselves. But when the time comes, they generally don’t take very long to figure out that they all want out. (This denial stage is the first of the six psychological stages of dealing with the coming Aftershock, described in more detail in our 2011 book
Aftershock
, Second Edition).

Investors will not all run out and stay out of the bond market at the first signs of trouble. That’s why the bond market will not fall all at once, but will decline in stages leading up to the Aftershock, before the biggest crash. Here is our best approximation of how that will happen.

As you may have noticed, during the global financial crisis of late 2008, while stock markets around the world were falling 40 percent and more, the bond markets remained generally unfazed. If anything, bonds benefited to a certain extent from the crisis because investors viewed bonds as a safe haven as they fled from stocks. This just provided more evidence to the CW cheerleaders that bonds are very low risk. But the fact that the bond market is currently trusting bonds, which is keeping interest rates low, doesn’t mean bonds actually are worthy of that investor trust. Lots of things can temporarily sell at the “wrong” price until investors figure it out. At that point, investors’ views of trustworthiness can change very quickly.

As long as the United States is still viewed as a safe haven, especially compared to Europe, and as long as massive money printing by the Federal Reserve keeps working to keep interest rates low, bonds will do okay. But bonds will become increasingly vulnerable over time. Clearly, any future rise in interest rates will hurt bonds, so the big question is what will happen next for interest rates? How much lower can they go?

With U.S. interest rates already so low, it is hard to see them going much lower, although they could temporarily. Interest rates could even fall below zero, but that clearly would not be sustainable. (An interest rate below zero means that the bond holder is guaranteed to lose money over time. Even if investors were willing to put up with that for a while, they certainly don’t want that over the longer term.)

It is much more likely that interest rates will rise, not fall, over time. In the short term (2012 and 2013), interest rates will not likely rise too dramatically. But remember, any rise in interest rates will have a negative impact on bond prices. Please go back and take another look at
Table 5.1
if you need any further convincing about how fast bond values drop as interest rates rise. Even a small rise in interest rates will hurt bonds. The saving grace for bonds in the short term is that whenever stocks take a significant dip, investors typically like to move temporarily into bonds in a flight to safety. This will help keep up demand for bonds, even if interest rates start to creep up a bit.

As time goes on, interest rates will creep up even further. What will make interest rates rise further? Well, by now you know all too well what we are about to say: Massive money printing will lead to rising inflation, and rising inflation will eventually bring us rising interest rates. This is not something we can get out of by pretending it isn’t there. Even if the Fed were to stop all money printing today (and they already said clearly that they will not), we have already increased the money supply threefold since March 2009. That is more than enough to give us plenty of future inflation and rising interest rates.

High inflation and high interest rates are not going to occur overnight. It will happen over time. The more time that goes by, the greater the risk to bonds. Rising interest rates will clearly make bonds fall more and more.

As money printing and other manipulations begin to backfire, inflation and interest rates will rise, and bond prices will decline much further. But not every bond will crash in value overnight. Bonds from weaker issuers—the ones with higher interest rates that some investors thought would pay off big—fail first, as those companies can no longer secure cheap debt to prop up their earnings and are forced to default.

Leading up to and during the Aftershock, companies will be forced to liquidate, but with so many going on the market at the same time, they will have little value, and hordes of bondholders will line up for their many pieces of a very small pie.

Bankruptcies, decreased lending, and a mass exodus of foreign investment will lead to a collapse in the stock market, and suddenly even the most rock-solid companies will start to look like another Lehman Brothers. While a stock market holiday may be declared (see Chapter 11), there will be no need to declare a bond holiday. The bond market will effectively shut itself down.

The federal government can, and will, ease the pain of this for as long as it can with more money printing. But as we’ve said, eventually this medicine becomes the poison, and there will be little the Fed or anyone else can do without just making things worse. Right now, the Fed can put money into the system with very few short-term consequences, as any potential inflation will lag at least by a couple of years behind QE. But once inflation gets going (in the 5 to 10 percent range), the lag time behind any new money printing will become shorter and shorter, until eventually the economy responds almost instantly to any additional money printing by the Fed by raising prices.

This is truly being stuck between a rock and a hard place for the federal government. With tax revenues dropping due to high unemployment and expenses skyrocketing due not just to inflation but to bailouts and covering guarantees on pensions, insurance, and other debt obligations, the government has no choice but to go deeper and deeper into debt. But with inflation at exorbitant levels, no one wants to put their money into Treasury debt without significantly higher interest rates. Traditionally, here is where the Treasury could turn to the Fed to print money and finance its debt, but with any increase in the money supply leading to near-instant inflation—not to mention terrifying investors everywhere—that “solution” becomes self-defeating.

Treasury debt can’t be paid. Guarantees can’t be covered. Expenditures are out of control. When the federal government can no longer borrow money, there’s no longer any need to worry about its credit rating. They’ll probably call it something like “repudiating payment,” but make no mistake: This is where the most rock-solid of debtors, the U.S. government, goes into default. Not all government obligations will be repudiated, but it’s likely that most outstanding bonds will cease to be paid. Cases of hardship will be given priority, but then that’s not a position that most investors will want to be in.

In the Aftershock, the government safety nets for bonds of all kinds will fail because the government will not have the money to cover them. We will not be able to print money forever due to the rising inflation. Once we can no longer print money, the government will no longer be able to make its interest payments on the federal debt and the government debt bubble will pop. Needless to say, at that point, nearly all dollar-denominated bonds and other assets will crash.

Clearly, just as for stocks, being
100 percent out of all bonds
before the Aftershock hits is essential. If U.S. Treasurys are in trouble, no bond of any kind will be safe. However, remember that we are not there yet. That means there is still time before inflation moves up high enough and interest rates rise high enough to kick off the coming multibubble pop and the Aftershock that will follow. Before that occurs, some bonds will hold up better than others. So in the shorter term, it is still okay to own some bonds,
but only if they are part of a well-diversified, Aftershock-based, actively managed portfolio
that includes a variety of asset types, such as stocks, bonds, gold, foreign currencies, and more (see Chapter 11).