Don’t underestimate the power of rising interest rates to change your financial future.
Don’t assume they will stay relatively tame or that the Federal Reserve can keep them under control.
Above all, don’t forget the painful lessons of history — when millions of investors made similar assumptions, ignored the handwriting on the wall, and lost fortunes as interest rates surged.
THE BOND MARKET CRASH OF 1979-80
Two weeks ago, I told you my father’s story about the early 1930s — when bond markets collapsed unexpectedly and interest rates skyrocketed out of control.
This morning, let me tell you mine.
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 bi-weekly newsletter dedicated to the very subject of my e-mail today — U.S. and other bond markets.
Who were my subscribers? Mostly decision-makers and traders at major Japanese life insurance companies and property-casualty 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 both life and property insurance companies in Japan, and the financial authorities never forgot the experience.
So, ever since, to hedge against another “big one,” Japan’s Ministry of Finance has 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 Japanese newsletter on the subject 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., taking the Tozai line straight to Kayabacho 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 than they did.
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 Web 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 daily diary of key events. Here are some excerpts …
TOKYO, OCTOBER 1, 1979. The dollar has taken a huge beating in the last few years, and now 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.
In the first issue of my Gaikoku Saiken Nu-zu (Foreign Bond News), I warn them of a severe bond market decline ahead. I tell them to stick with the dollar, but to switch from long-term to short-term maturities.
Meanwhile, on the other side of the globe, the newly appointed Federal Reserve Chairman, Paul Volcker, has just flown to Belgrade for the annual convention of the International Monetary Fund.
Our company’s president is 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 inflation off at the pass.
If he doesn’t take action, say the delegates to the convention, there will be a new dollar collapse — one that will make its recent decline look like a picnic by comparison.
WASHINGTON, OCTOBER 6, 1979. Chairman Volcker has departed early from Belgrade for round the clock meetings with Administration officials in Washington. He has just announced the greatest interest-rate bombshell of the century:
* He’s raising the discount rate by TWO full percentage points!
* He’s imposing stiff controls on foreign borrowings by U.S. banks.
* Most important, Volcker is making a radical policy break with the past: From now on, the Fed will cease manipulating interest rates directly. Instead, it will go back to the old principle of controlling the amount of money flowing into the economy.
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 interest rates artificially. From now on, the American central bank will let interest rates rise to WHATEVER LEVEL IS NECESSARY to save the dollar and squelch inflation.”
NEW YORK CITY, OCTOBER 11, 1979. Fed Chairman Volcker apparently didn’t realize the bond market was a giant bubble. Nor did he realize that his actions of just five days ago would burst the bubble and cause an all-out panic in the bond markets.
Just 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.”
TEHERAN, NOVEMBER 4, 1979. Iranian students have just seized the U.S. Embassy. Fears of a new energy crisis — and a new wave of inflation — are sweeping the globe.
KABUL, CHRISTMAS 1979. The Soviets have invaded Afghanistan.
NEW YORK, JANUARY 1980. Concerns about a wider, longer war, plus an unexpected spurt in consumer price inflation, are sending bond markets into a nosedive. Will it be as bad as the October collapse of last year?
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, whenever 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.
“Faced with a prolonged buyers’ strike,” one seasoned pro tells the Wall Street Journal, “we decided to throw in the towel and get yields up to a level where some cash buyers might be shocked off the sidelines.” But even at 11%, most investors aren’t interested.
Wall Street believes that the Afghanistan invasion and the resulting inflationary fears are the causes of the collapse.
But in a speech to fellow analysts at our firm, I explain those are just iiwake — excuses. The real, underlying cause of the bond market collapse is the BOND MARKET BUBBLE — the fact that there has been a speculative boom in bonds, similar to the stock market boom of the 1920s.
Buyers, lured in at much higher levels, are now 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 holders 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 four or five 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 case of a price collapse. It’s a MARKET collapse in the literal sense of the word; the brokers themselves are going home!
NEW YORK, FEBRUARY 11, 1980. The pressures on the U.S. government are mounting by the minute. Some experts are saying that if Uncle Sam cannot find enough investors willing to buy his bonds, he will have to close up shop and start a new government.
At the same time, by some estimates, investors have had losses totaling at least 25% of the market value of their bond holdings in recent months, or more than $400 billion.
The Wall Street Journal quotes a source at one sizable bank in the East, 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.
And look at this thing I saw found this morning coming off the AP-Dow Jones wires a few hours ago:
“Unless those that brought us this disgusting inflation want to see a government, corporate and tax exempt market worth $3.5 trillion, along with a mortgage market worth $2.5 trillion, wiped out, it is clear they are going to have to do something … If that includes taking away the money that has made this sickening inflationary party possible, then we could have an awesome hangover.”
Hangover? Sickening? Disgusting? These are not words one expects to see coming off an international teletype machine, normally replete with technical mumbo-jumbo. Is it a warning of graver dangers still ahead?
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, double the 2.5% drop that had caused bond traders to refer to February 5 as “Black Tuesday.”
If the Dow fell by an equivalent amount, how many points would that amount to?
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, FEBRUARY 24, 1980. My phone is ringing off the hook, and our firm’s clients are panicking.
They’re apologizing for not having taken my advice to switch to short-term last year, saying that, until recently, Henry Kaufman, chief economist of Salomon Brothers, has been giving them the opposite advice.
Now the U.S. bond market collapse is about three times worse than the October 1979 collapse.
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.
WASHINGTON, APRIL 15, 1980. To help rescue the bond market, the White House has just announced credit controls. For the first time in history, a Democratic President, in an election year, has taken actions that will deliberately force the economy on a downward path.
VALUABLE LESSONS
Although differences abound, I’d be remiss if I didn’t point out the similarities between the events of then and today:
First, just as we saw back in those days, the dollar has just suffered a serious decline.
Second, much like during that era, oil and energy prices have surged.
Third, although it’s starting from a much lower level, inflation is beginning to heat up. Indeed, last week, the government announced that consumer price inflation was running at an annual rate of 5.1% in the first quarter and at an annual rate of 6.1% in March. That’s close to triple last year’s pace.
Fourth, as I detailed for you last week, we are witnessing an unfortunate expansion of the war, implying bigger deficits and potentially more threats to critical supplies of oil from the region. Back then, it was Iran and Afghanistan. This time, it’s Iraq and Afghanistan.
Fifth, and most important, like in the late 1970s, we have a great BOND MARKET BUBBLE — an unprecedented frenzy by investors all over the world to build up huge, speculative positions in bonds over the past few years.
When they start selling, watch out. The resulting plunge in prices — and surge in interest rates — could shock you. My advice:
ONE. Stick strictly with short-term maturities, despite the lower yield.
TWO. If you must borrow, go for fixed rates.
THREE. Beware of the potential impact rising interest rates may have not only on your bonds, but also on your stocks and your home.
FOUR. Build cash.
Good luck and God bless!
Martin
Martin D. Weiss, Ph.D.
Editor, Safe Money Report
Chairman, Weiss Ratings, Inc.
