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Right now, it’s 5 am, sunrise is still an hour away, and I’m in my home office, thinking about the single most important market event that can impact your money falling bond markets. Most people underestimate its power to affect their financial future. They assume the bond market is relatively sedate or that the Federal Reserve can always keep it under control. They forget the painful lessons of history when millions of investors made similar assumptions, ignored the handwriting on the wall, losing fortunes when bonds collapsed. Consider, for example … The Bond Market The time was late 1979, and, geographically speaking, I couldn’t have been farther away from the U.S. bond markets: I lived and worked in Tokyo. In every other respect, however, I couldn’t have been closer: I had joined Wako Securities, Inc., one of Japan’s top ten brokerage firms, and my job was to write a biweekly newsletter dedicated to the very subject of my e-mail today bond markets. Who were my subscribers? Mostly decision makers and traders at major Japanese life-health and property-casualty insurance companies. Why were they so interested in foreign bonds? The answer goes back to the great Tokyo earthquake of 1923, which devastated Tokyo and Yokohama, taking 140,000 lives and causing property damage in excess of one billion U.S. dollars at the time. The earthquake also devastated insurance companies in Japan, and the financial authorities never forgot the experience. So, to hedge against another “big one,” Japan’s Ministry of Finance insisted that its insurers keep at least some of their assets abroad. That’s why foreign bonds, especially U.S. bonds, were so important, and why my bond newsletter in Japan was so vital. At the time, Elisabeth and I lived in Ochiai, a quiet, tree-lined neighborhood about 20 minutes by subway from downtown Tokyo. To beat the morning rush hour, I’d often wake up at 5 a.m. and take the Tozai line straight to Kayabachou in the financial district, just one block from the office. My Japanese co-workers thought they were the only ones who worked long hours. They were surprised to see a gaijin arrive for work even earlier. But I needed the quiet time in the war room of Wako’s International Department to sift through overnight market information that came from wire services and from the firm’s branches in New York, London, Zurich, and Hong Kong. There was no e-mail or Internet in those days. But oversized fax and telex machines poured out streams of paper that piled up in messy heaps on the floor. From these and from my frequent meetings with Japanese bond traders and institutional investors I kept a diary of key events. Here are some excerpts … Tokyo, October 1, 1979. New inflation fears are sweeping the globe. Our clients Japanese insurers, pension funds, trusts, and banks are loaded with U.S. bonds, and they tell me they’re getting very nervous.
Mr. Saito, our company’s president, is also attending, and a fax from our London office says Volcker is coming under intense pressure from West European and Asian central bankers to do something anything to cut off inflation at the pass. If he doesn’t take action, say the delegates to the convention, there will be a new wave of inflation one that will make the recent inflationary surge seem mild by comparison. Washington, October 6, 1979. Fed Chairman Volcker has departed early from Belgrade for round the clock meetings with Administration officials in Washington. He has just announced the greatest bond-market bombshell of the century:
I’m visiting several of Japan’s largest insurers this week, and they want to know what this means. My response: “The U.S. Federal Reserve has given up trying to hold down rates artificially. From now on, the American central bank will let bond prices fall and interest rates rise to whatever level is necessary to squelch inflation.” New York City, October 11, 1979. In the past four days, the price of a 30 year U.S. Treasury bonds has plunged four full points. A $1 billion IBM issue, hailed weeks ago as a brilliant piece of corporate finance, is now being described by Wall Street analysts as “the greatest underwriting fiasco of all time.”
Iran, which supplies much of the world’s oil, is in turmoil. Already, crude oil prices have been surging, and the rising cost of energy has been spreading like wildfire across the globe. Now, with Iran in greater turmoil, fears of still another energy crisis and an even more virulent wave of inflation sweep the globe. At least, say political observers, the cold war is cooling. Detente with the Soviet Union, they argue, will give America an opportunity to reduce the growth of defense spending, gain better control over the budget deficit, and hopefully remove one of the pressures for higher inflation.
Initially, resistance by Afghan mujahedin has melted back into the mountains. And Afghan citizens, perched on hilltops, overlook the scene passively. But the Soviets have greatly underestimated the resolve of the coming counter-offensive, potentially draining their financial resources for as much as a decade. New York, January 1980. The Labor Department has just announced an unexpected spurt in consumer and producer prices, including not only volatile items like energy and food, but also core items such as health care, transportation, housing, tuition and other services. New inflation fears are sending bond markets into a nosedive. Will it be as bad as the October collapse of last year when Volcker dropped his first bombshell on the market? New York, February 5, 1980. It’s cold in Tokyo, and I’m waking up a bit later in the morning. The subway is packed with commuters, and at each downtown station, when there’s a mad rush for the exits, my thoughts turn to the mad rush out of the U.S. bond markets. Indeed, yields on longest term U.S. Government securities have just broken through the 11% level the all time peak reached during the Civil War. Wall Street believes that the invasion of Afghanistan and the resulting inflationary fears are the causes of the collapse. But in a speech to fellow analysts at our firm, I explain that those are just iiwake excuses. The fundamental, underlying causes of the bond market collapse come from other sources:
Now, these buyers are looking for any excuse to get out. The threats of war and inflation are the most obvious ones. New York, February 6, 1980. Some panicky bond investors, including some of the Japanese insurance companies I talk to daily, are unloading at any price. But there are few takers. According to the AP-Dow Jones wire I dug out of the pile this morning, the flood of sell orders prompted all except a couple of the largest New York bond dealers to effectively abandon their market making role. The dealers are actually dropping out of the market! This is no longer merely a New York, February 11, 1980. The pressures on the U.S. government are mounting by the minute. Some experts are saying that if U.S. cannot find enough investors willing to buy his bonds, it will have to close up shop and start a new government. The price of a 30-year bond has fallen to 54, representing a 46% loss to investors who bought at par (100). And, just in recent months, investors have had losses totaling at least 25% of the market value of their bond holdings, or more than $400 billion. The Wall Street Journal quotes a source at one sizable bank in the Northeast, who says that, if he had to liquidate its Treasury notes, the loss would amount to more than $225 million, wiping out the bank’s capital. This is much worse than the October collapse of 1979. New York, February 19, 1980. The collapse continues to gather momentum. Treasury bonds lost over five percent of their face value in yesterday’s trading, the largest single-day decline in history. If the Dow fell by an equivalent percentage, how many points would that be? Ironically, however, since the crash is occurring in the relatively obscure bond markets, virtually no one including those who faithfully watch their network evening news with Walter Cronkite or David Brinkley has the faintest idea of what’s going on.
New York, April 12, 1980. My father just called me this evening from the U.S.
“Carter and Volcker are going to have to do something dramatic,” he says. “And it’s going to have to be even more dramatic than the draconian rate hike Volcker announced when he was first appointed. It’s not because he wants to. He has no choice. He has got to squash the inflation before it destroys the bond market.” Washington, April 15, 1980. Sure enough, to help rescue the bond market, the White House has just announced very strict “credit controls,” forcing many Americans addicted to credit cards to go cold turkey. The idea is that by controlling all borrowing, they will control inflation. And if inflation is controlled, bond investors will hopefully be willing to buy again. For the first time in history, a Democratic President, in an election year, has taken actions that could deliberately force the economy on a downward path. But despite that experiment, soon to be abandoned, the bond market plunge resumes, and it continues until late 1981. Back to the Present Although I don’t expect bonds to fall as dramatically as they did in 1979-81, I’d be remiss if I didn’t point out the similarities between the events of then and today … Similarity #1. Much like the 1970s, oil and energy prices have surged. Despite a correction, crude oil is still in the $60 area and holding firmly. Ditto for natural gas and heating oil. Similarity #2. Although it’s starting from a lower level, inflation is beginning to heat up. Last month, the government announced that month-to-month inflation is running at double-digit rates, and even year-over-year inflation, now at 4.7%, is more than double last year’s pace. Similarity #3. We are witnessing a convergence of events which are, in many ways, eerily familiar to anyone who lived through the 1970s.
Unlike Volcker, he’s known to be more inclined to let inflation run amuck. But he may surprise us. In order to counter the popular notion that he’s a wimpy inflation fighter, he may actually do some hefty rate hiking of his own. And if he doesn’t, the falling bond markets could force him to do it, much as they did to Volcker in early 1980.
In a fiery speech, Iran’s new president, Mahmoud Ahmadinejad, has vowed that the state of Israel “should be wiped off the map,” greatly escalating the already-heated conflict between Iran and the West over its nuclear program. Clearly, Ahmadinejad has plotted a new, more radical course for Iran. At the same time, Iran remains a critical source of crude oil to the West. If it is embargoed or disrupted, the impact on world oil prices, although not as great as in the 1970s, could still be explosive. Underscoring the new radical bent in Iranian politics, Ahmadinejad himself was identified by former American hostages as a student leader of the November 1979 takeover of the U.S. embassy in Tehran. Although he has vehemently denied this link to a sordid past, the denials have done nothing to soothe the nerves of anxious Iran watchers.
And this in a country which, unlike Iraq, was considered at peace! Now, with the conflicts in both countries escalating and any timetables for withdrawal fading, there is little hope that we will see a slowdown in defense spending. Similarity #4. Most important, much like in the late 1970s, we have
This is a Great Bond So in the weeks and months ahead, as the bond market selling gains momentum, watch out. Don’t let the resulting decline in bond prices and surge in interest rates catch you off guard. Right now, for example, falling bonds are dragging down a whole host of other investments: First, in addition to 30-year Treasury bonds, all other bonds, regardless of the issuer, are falling in value. Even the market price of medium-term 5-year Treasury notes has fallen to new, multi-year lows. Second, home lending and home construction stocks have been hit hard, and a recent rally attempt has been relatively feeble. “Non-prime” lenders, catering to higher-risk borrowers, have been especially hard hit.
The euro, for example, has just plunged below a critical support level near the 1.20 area, ushering in a steeper decline against the U.S. dollar, at least for now. Reason: The Europeans have not yet raised their interest rates to match U.S. rate hikes. And until they do, international investors are likely to continue selling the euro. Fourth, gold, which is now moving more or less in synch with foreign currencies again, could also suffer temporarily. I just spoke to Larry last night, who is watching the markets from Asia. He says he wouldn’t be surprised if the gold correction takes it back down to the $435 – $445 area. He has not changed his views about the long-term bull market in gold. But, like me, he sees the falling euro as a temporary negative for the gold market. Fifth, investors are also dumping European bonds, driving them into their worst 2-week tailspin since 2003. This is their way of sending a message to the European Central Bank: “Look! Rates are going up in the United States. Now you’d better jack up your rates as well. Either you do that, or we’re going to continue dumping your European bonds, forcing you to raise rates whether you like it or not.” It’s the same kind of response we’re seeing to the Fed’s wimpy quarter-point rate hike last week. And it’s the same message central bankers are going to start hearing from bond investors everywhere. This is why … Our Recommendations 1. Move your keep-safe funds out of long-term bonds and into shorter- term maturities, especially U.S. Treasury bills. Plus, for my favorite conservative investments in this environment, see my Safe Money Report. 2. Unload your interest-sensitive stocks, including shares in banks, insurers, brokers, mortgage lenders, and real estate companies. Any company that is directly or indirectly hurt by falling bond prices (rising interest rates) should be avoided. 3. Register at www.WeissWatchdog.com to get an instant evaluation and continuing e-mail alerts on all your stocks, mutual funds, banks and insurance companies. If they’re not rated B- or better, consider moving your money elsewhere. 4. Keep a core portfolio of investments that benefit from inflation, including gold and mining shares. But if you feel you’re overloaded in this area, and you want to reduce your exposure, do so now before a further correction in gold, not after. Conversely, if you are mostly out of gold, wait for better prices before jumping back in to any large extent. To get his favorite picks and precise timing signals, see Larry’s latest report. 5. Further declines in oil and oil shares are always possible. But with winter fast approaching, growing demand for natural gas and heating oil is bound to drive energy markets higher. So hold all current positions. 6. For your speculative funds, you now have two unusual profit opportunities: First, with put options on interest-sensitive investments. And second, with call options on energy-related investments. Both involve risk of loss, but only up to the amount you invest plus any commissions you pay your broker. Moreover, both are investments that can double and triple in value, just with relatively minor market moves. And with the large surges in energy and interest rates that I see coming, the profit potential is several times greater. Good luck and God bless! Martin About MONEY AND MARKETS MONEY AND MARKETS (MAM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Larry Edelson, Tony Sagami and other contributors. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MAM. Nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MAM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical inasmuch as we do not track the actual prices investors pay or receive. Contributors include Marie Albin, John Burke, Michael Burnick, Beth Cain, Amber Dakar, Scot Galvin, Michael Larson, Monica Lewman-Garcia, Julie Trudeau and others. 2005 by Weiss Research, Inc. All rights reserved. |
Bond Market Bubble
In recent weeks, with inflation surging and interest rates rising, I have thought frequently about old friends that have been out of touch for a while. So I thought I’d send you my daily updates on what’s happening right now and what it means to you. There is no subscription fee. And naturally, you can opt out at any time. 
Meanwhile, on the other side of the globe, the newly appointed, cigar-smoking Federal Reserve Chairman, Paul Volcker, has just flown to Belgrade for the annual convention of the International Monetary Fund. 
Tehran, November 4, 1979. Iranian students have just seized the U.S. Embassy, raising their fists in victory as they march down a nearby street. 
Kabul, Christmas 1979. Suddenly and without warning, Soviet tanks have crossed the border into Afghanistan. Instantly, any hopes of an early end to the cold war have been dashed. 
case of a price collapse. It’s a market collapse in the literal sense of the word the brokers themselves are shutting down and going home!
Washington, early April 1980. President Carter is huddling with top advisers and with Fed Chairman Volcker at Camp David. What will he do to end the bond market crisis? Respected Wall Street economists are predicting an end to our democratic system of government unless some immediate action is taken.
He says he has just dictated a special report for our U.S. subscribers forecasting good news for a change a major rally in the bond markets. But it’s going to require a lot of pain and sacrifice. 
For example, much as in 1979, a new Chairman of the Federal Reserve has just been appointed Ben Bernanke. 
Meanwhile, in Central Asia, we also see events that are reminiscent of the late 1970s in more ways than one. 
Meanwhile, in neighboring Afghanistan, Allied helicopters are beginning to encounter some of the same fierce resistance that Soviet tanks experienced a quarter century ago. 
Third, even foreign currencies are under pressure right now from falling U.S. bond prices. Previous post: Bonds Falling!
Next post: Raging Inflation
