Not Even Harry Browne Thought It Was Going To Be This Bad

[Tyler]

IMHO, the article suffers from a familiar weakness:  Assume they're totally right.

What should an investor do?  How does "government psychopathy" only affect the PP?  What is a better alternative?

[AdamA]

...for the first time since it's inception, the managers of the fund have realized that we are dealing with a new market condition that Browne didn't account for in his writings: Government Psychopathy and the sci-fi thriller which is the global economy.

I think HB was very much aware of this, and would probably not be that surprised by what's occurring today.

In January, the fund made an historic announcement that they would deviate from Brown's full-proof formula specifically changing their strategy in their bond portfolio. 

I am curious to know what they changed. 

From the article (regarding PRPFX):

Something began to change in 2012 as the fund began experiencing volatility well beyond the tolerance of the conservative investor.




...I imagine the average investor in the PFPRX are hard working folks who scrimped and saved every penny and all of a sudden they find themselves on a rollercoaster ride of volatility that they never expected.

Maybe, but here's what PRPFX looked like in 2000-2001:



So it wasn't that much different then, and patient investors were rewarded in the following years.

[HB Reader]

Craig, any comments on this http://www.tfmetalsreport.com/blog/4809 ... en-lantern

"However, for the first time since it's inception, the managers of the fund have realized that we are dealing with a new market condition that Browne didn't account for in his writings: Government Psychopathy and the sci-fi thriller which is the global economy. In January, the fund made an historic announcement that they would deviate from Brown's full-proof formula specifically changing their strategy in their bond portfolio.  For the first time in the portfolio's history it was not living up to it's original mission as a conservative, fool-proof, fail safe fund to guard against all economic conditions. Investors began voicing their concern related to the bond market being a dangerous gambit and evolving into a bubble of epic proportions although I believe the fund might be downplaying it by calling bonds "overvalued" in light of rising interest rates.

I wasn't aware PRPFX announced a change in its bond portfolio.  Does anyone have link to that? 

I was aware that a totally separate fund they manage, The Versatile Bond Portfolio (PRVBX), had made some changes. 

[MediumTex]

Gadfly piece.

The comments about PP investors being performance chasers seems like an especially cheap comment.  All investors chase performance, not just PP investors.

RE the bond market, the chicken littles have been beating their chests since this time in 2008, long before the Fed's extraordinary steps even started.  They've mostly been wrong over the intervening five years.  Are they right now?  Maybe, maybe not.  Who knows?

Suggesting that Harry Browne didn't foresee all of this in his economic model says more about the commentator than it does Harry Browne.  Browne's insights do not lend themselves to being understood by the average hack financial journalist with a set of pet theories he's trying to work into every piece he writes, and it shows in almost every article I read that is pushing the "it's over for the PP" narrative.

Just noise.

Nothing has changed.

[MediumTex]

Craig, any comments on this http://www.tfmetalsreport.com/blog/4809 ... en-lantern

"However, for the first time since it's inception, the managers of the fund have realized that we are dealing with a new market condition that Browne didn't account for in his writings: Government Psychopathy and the sci-fi thriller which is the global economy. In January, the fund made an historic announcement that they would deviate from Brown's full-proof formula specifically changing their strategy in their bond portfolio.  For the first time in the portfolio's history it was not living up to it's original mission as a conservative, fool-proof, fail safe fund to guard against all economic conditions. Investors began voicing their concern related to the bond market being a dangerous gambit and evolving into a bubble of epic proportions although I believe the fund might be downplaying it by calling bonds "overvalued" in light of rising interest rates.

I wasn't aware PRPFX announced a change in its bond portfolio.  Does anyone have link to that? 

I was aware that a totally separate fund they manage, The Versatile Bond Portfolio (PRVBX), had made some changes.

It wouldn't surprise me if the thinly researched piece got the fund they were writing about wrong.

[craigr]

Craig, any comments on this http://www.tfmetalsreport.com/blog/4809 ... en-lantern

"However, for the first time since it's inception, the managers of the fund have realized that we are dealing with a new market condition that Browne didn't account for in his writings: Government Psychopathy and the sci-fi thriller which is the global economy. In January, the fund made an historic announcement that they would deviate from Brown's full-proof formula specifically changing their strategy in their bond portfolio.  For the first time in the portfolio's history it was not living up to it's original mission as a conservative, fool-proof, fail safe fund to guard against all economic conditions. Investors began voicing their concern related to the bond market being a dangerous gambit and evolving into a bubble of epic proportions although I believe the fund might be downplaying it by calling bonds "overvalued" in light of rising interest rates.

If the Permanent Portfolio fund has any weakness, it's that it overweights inflation hedging assets. Bonds are not the problem this year, gold is!

If I look at the bonds in the 4X25 Permanent Portfolio it is basically 50/50 long/short. So blended duration is around 7-8 years or so. Basically it emulates an intermediate term bond fund in duration so the risks are muted. The fund owns even fewer bonds so rising interest rates are even less of a problem for the fund. The fund's issue is again that it owns a lot of inflation protection assets and there is no inflation in the U.S. right now that is very significant...

It's unlikely that Browne or for that matter anybody in the alternative investment world back in the early 2000's, could have realized what we do know about the extent of the manipulation in the metals. Nor is it likely that Browne imagined the federal debt could exceed the size of the total economy nor the capability of Central Banks to counterfeit on such a large scale.

The problem with their assumption is there is big difference between money/credit being made available by banks and that same money/credit making it into the economy to cause inflation. In the U.S. we do not have high inflation now. There are pockets here and there (health care for instance), but it is not widespread. Same for govt. spending. I don't think govt. spending is very good long-term, but the effect in the economy has been pretty tame in terms of inflation so far.

Of course, that could eventually catch up and ignite inflation. But the Fed is trying to front-run it by changing their policies now. 

The MIT Billion Prices Project tracks online prices and gives a good proxy to the CPI:

http://bpp.mit.edu/usa/

So assuming their data is not being tainted, it is not showing abnormal inflation. This is also what I see just on a personal level.

...or the number of interventions in currency markets including the Swiss pegging the Swiss Franc to the Euro? The Permanent Portfolio Fund has always regarded the Swiss Franc as the currency with a high safe haven status but the Swiss taught us that all fiat currencies are subject to manipulation.

This one item I actually do agree with that the Swiss Franc should be dumped from the fund. It should have been done when the Swiss broke the last of the gold linkage 10 or so years ago. It definitely should have happened when they pegged to the Euro. At that point the Swiss Franc had lost all credibility as an inflation protection asset.

Browne saw a world where long term bonds performed well in a deflationary period and gold outperformed in an inflationary period. Well, here we are well into QE3 as The Fed continues to fortify the monetary base, gold and silver has been volatile with excessive short term risk. No longer can they be confident that gold and bonds will behave in a predictable fashion. Good ole Harry must be turning over in his grave.

I think gold is doing exactly as expected actually. The Fed is winding down their policies and this has lowered inflation expectations. It also started bringing rates from negative to positive real territory. Both of these are bad for gold. Rates are going up on the long bonds, but gold took the worst pounding as investors no longer feared inflation but thought the stock market might be a better place for their money.

So I don't know if I find much in this article that worries me. Besides, what is their solution to the mess? I don't know myself so I'm just buckled in for the ride at this point.

[Robert]

Oh no, it's different this time! 

[Libertarian666]

I'm not sure I follow your logic, Libertarian666. Are you saying that without Fed interference, interest rates would be much higher?

Yes, of course. They are the only purchasers of T-Bonds. What happens when the only purchasers of anything stop purchasing? The price will go... down. This isn't rocket surgery!

I'm not sure I see much evidence that the real economy can support high interest rates right now. The Fed could artificially raise interest rates of course, but I see no reason why they would benefit from doing that. I think there's much evidence that interest rates--especially at the long end of the yield curve--are controlled much more by market forces than by Fed policy.

There is no market in T-Bonds. There is only the Fed.

And why would they have to "destroy the dollar?" By this I assume you mean hyperinflate it… why is that a foregone conclusion? Japan has been doing everything we've been doing recently for two decades--their central bank can explicitly monetize their national debt and their debt-to-GDP ratio is far higher than ours. They've even been trying to create some inflation, and it hasn't worked. Not saying we're Japan now, but we clearly have a template for central bank impotence in the face of economic issues that the entire developed world is beginning to face en masse.

The difference is that the Japanese public is buying Japanese T-Bonds; they are not being monetized by the Japanese central bank, thus there is no inflationary pressure being built up there as there is here.

[AdamA]

Yes, of course. They are the only purchasers of T-Bonds.

Really?

[Pointedstick]

I'm not sure I follow your logic, Libertarian666. Are you saying that without Fed interference, interest rates would be much higher?

Yes, of course. They are the only purchasers of T-Bonds. What happens when the only purchasers of anything stop purchasing? The price will go... down. This isn't rocket surgery!

There is no market in T-Bonds. There is only the Fed.

So… those T-bonds I thought I bought recently… they're not really T-bonds? Or do I not count as being part of the market for T-bonds? I'm not sure where you're getting that the Fed comprises the entire market for government bonds. Can you provide some evidence for this?

[Libertarian666]

To be more precise, they are purchasing ~90% of the new issuance of T-Bonds:

http://www.bloomberg.com/news/2012-12-0 ... bonds.html

And that is not counting the MBS (also government backed) that they are also buying.

Existing bonds, of course, are bought and sold all the time, but what would happen if the Fed stopped buying $1T of government bonds per year, much less started selling some of the ones they already have? I cannot imagine any possible way that the prices would not go down substantially in that situation.

[Pointedstick]

Your supply-and-demand analysis isn't wrong, but I think you're making an assumption that the Fed is creating artificial demand rather than crowding out demand from non-Fed market participants. If the Fed were to stop buying all the new bonds, what's to say that demand from private entities, foreign governments, and other central banks woudn't flood in and make up most or all of the demand shortfall?

Not saying that's exactly what I think is going to happen, but it doesn't sound all that implausible to me.

[Ad Orientem]

On the subject of Fed manipulation of the bond market, we have been down this road before. Direct and very aggressive debt monitization began in 1944 and continued until 1951. It was massive to the point where proportionately it was more aggressive than what we have seen in the 2008 - present Fed policy. Yes, it did spark inflation and when the Fed finally ended it's unrestrained money printing in 1951 we saw the end of the first 30 year secular bull market in bonds. But it did not spark hyperinflation nor was there an explosion in interest rates. Rates began to rise but it was a gradual process that continued until the early 1980's.

So I'm not seeing why the sky is going to fall this time around.

[Libertarian666]

Your supply-and-demand analysis isn't wrong, but I think you're making an assumption that the Fed is creating artificial demand rather than crowding out demand from non-Fed market participants. If the Fed were to stop buying all the new bonds, what's to say that demand from private entities, foreign governments, and other central banks woudn't flood in and make up most or all of the demand shortfall?

Not saying that's exactly what I think is going to happen, but it doesn't sound all that implausible to me.

That seems extremely implausible to me. Yes, at some interest rate the government could sell $1 Trillion of bonds per year, but not at these extremely low rates. Furthermore, every increase in their interest expense blows an even bigger hole in the budget, and thus increases the amount they have to borrow. Their average duration is only a few years, so this effect would snowball fairly quickly.

Obviously, if the Fed ever actually slows down their purchases, we will see the effects. However, my prediction is that the Fed will never taper, because they know this is what would happen.

[Gumby]

Technovolist,

You are just spouting myths and half-truths. T-Bonds have no credit risk, period.

Ever since the US went off the gold standard, T-Bond auctions have been nothing more than a way for the Fed to set interest rates. That's their entire job description.

David Beckworth has a nice post over at his site in which he argues that the Fed is not monetizing the debt.  He makes arguments that are similar to the ones I’ve previously made.  But I think the debate over monetization is even simpler than David notes.  The purpose of the fear mongering over the term “monetization”? is to imply that the Fed is funding the US government.  The term is used with an intended negative connotation that implies some sort of solvency constraint, as if the government couldn’t fund itself without this back stop which would result in us looking more like Greece with yields surging and on the brink of bankruptcy.  This is just patently wrong and those fear mongering over “debt monetization”? have seen their scary inflationary or default scenarios fall flat in recent years.  In other words, they’ve been wrong because they’ve misinterpreted what the Fed is doing.

In the end, this debate is rather simple and has already been won by those of us who predicted the market reactions in real-time .  If the Fed were needed to fund the US government then the fear mongers would have all been right when QE2 ended and yields would have surged because there would not have been enough demand for US government debt.  Investors like Bill Gross called the end of QE2 “D-Day”? because he was concerned about a lack of funding when the program ended.  I said, in real-time that he would be wrong and that yields would not surge and that there would be no lack of buyers.

Of course, Bill Gross wasn’t the only one saying this.  It was a common refrain back in 2010.  And despite their dire predictions, the exact opposite occurred when QE2 ended.  Yields declined!  The Fed was not directly funding the US government and the Fed was not needed to fund the US government.  After all, the US government always harnesses its banking system to fund its bond sales.  To argue that the Fed needed to back stop the Treasury is to misunderstand the dynamics at work between the Primary Dealers and the US government.  This is just one of the many misunderstandings surrounding QE2 and despite having already been thoroughly proven wrong, the myth somehow still persists….

Read David’s piece here.

Source: http://pragcap.com/read-of-the-day-the- ... ut-the-fed

Read the rest here: http://pragcap.com/read-of-the-day-the- ... ut-the-fed

[Libertarian666]

On the subject of Fed manipulation of the bond market, we have been down this road before. Direct and very aggressive debt monitization began in 1944 and continued until 1951. It was massive to the point where proportionately it was more aggressive than what we have seen in the 2008 - present Fed policy. Yes, it did spark inflation and when the Fed finally ended it's unrestrained money printing in 1951 we saw the end of the first 30 year secular bull market in bonds. But it did not spark hyperinflation nor was there an explosion in interest rates. Rates began to rise but it was a gradual process that continued until the early 1980's.

So I'm not seeing why the sky is going to fall this time around.

The difference is that the US was the world's biggest net creditor in those days. Now it is the world's biggest net debtor, running unprecedented deficits, and its creditors are loaded up to the gills with its debt. I notice that no one has answered this question: "Who is going to buy those bonds if the Fed doesn't?"

[Ad Orientem]

On the subject of Fed manipulation of the bond market, we have been down this road before. Direct and very aggressive debt monitization began in 1944 and continued until 1951. It was massive to the point where proportionately it was more aggressive than what we have seen in the 2008 - present Fed policy. Yes, it did spark inflation and when the Fed finally ended it's unrestrained money printing in 1951 we saw the end of the first 30 year secular bull market in bonds. But it did not spark hyperinflation nor was there an explosion in interest rates. Rates began to rise but it was a gradual process that continued until the early 1980's.

So I'm not seeing why the sky is going to fall this time around.

The difference is that the US was the world's biggest net creditor in those days. Now it is the world's biggest net debtor, running unprecedented deficits, and its creditors are loaded up to the gills with its debt. I notice that no one has answered this question: "Who is going to buy those bonds if the Fed doesn't?"

That's simply not true. The debt as a % of GDP was over 120% in 1944.

[Gumby]

I notice that no one has answered this question: "Who is going to buy those bonds if the Fed doesn't?"

http://pragcap.com/who-will-buy-the-bonds

Mind you, when he wrote that, he answered that 16 trillion-dollar question in real-time as QE2 drew to a close, and he was 100% correct.

Libertarian666, please stop fear-mongering. You really need to learn how bond auctions work before you start running for the hills. The money to buy government bonds generally comes from government spending.

Bond auctions are just a reserve drain that are conveniently used to set interest rates (i.e. the government spends money and people/banks choose to give the money back to the government in exchange for a risk free T-Bond). Ho hum.

[Libertarian666]

On the subject of Fed manipulation of the bond market, we have been down this road before. Direct and very aggressive debt monitization began in 1944 and continued until 1951. It was massive to the point where proportionately it was more aggressive than what we have seen in the 2008 - present Fed policy. Yes, it did spark inflation and when the Fed finally ended it's unrestrained money printing in 1951 we saw the end of the first 30 year secular bull market in bonds. But it did not spark hyperinflation nor was there an explosion in interest rates. Rates began to rise but it was a gradual process that continued until the early 1980's.

So I'm not seeing why the sky is going to fall this time around.

The difference is that the US was the world's biggest net creditor in those days. Now it is the world's biggest net debtor, running unprecedented deficits, and its creditors are loaded up to the gills with its debt. I notice that no one has answered this question: "Who is going to buy those bonds if the Fed doesn't?"

That's simply not true. The debt as a % of GDP was over 120% in 1944.

The external debt or the internal debt? The former is the main hazard.

[glennds]

Your supply-and-demand analysis isn't wrong, but I think you're making an assumption that the Fed is creating artificial demand rather than crowding out demand from non-Fed market participants. If the Fed were to stop buying all the new bonds, what's to say that demand from private entities, foreign governments, and other central banks woudn't flood in and make up most or all of the demand shortfall?

Not saying that's exactly what I think is going to happen, but it doesn't sound all that implausible to me.

If there is a sufficient non-Fed market to buy Treasury Bonds at present rates, then why is the Fed buying them?

[Pointedstick]

Your supply-and-demand analysis isn't wrong, but I think you're making an assumption that the Fed is creating artificial demand rather than crowding out demand from non-Fed market participants. If the Fed were to stop buying all the new bonds, what's to say that demand from private entities, foreign governments, and other central banks woudn't flood in and make up most or all of the demand shortfall?

Not saying that's exactly what I think is going to happen, but it doesn't sound all that implausible to me.

If there is a sufficient non-Fed market to buy Treasury Bonds at present rates, then why is the Fed buying them?

To drive down rates, for the purpose of making non-bond assets seem more attractive. But the point is that even if and when the Fed stops this program and rates start to rise (gently, as Ad Orientem pointed out), it's not as though the government will face some kind of looming solvency or budgetary constraint. The increased borrowing costs will simply be paid by issuing more debt, which will be purchased by participants in the open market, Primary Dealers, or the Fed.

[glennds]

Your supply-and-demand analysis isn't wrong, but I think you're making an assumption that the Fed is creating artificial demand rather than crowding out demand from non-Fed market participants. If the Fed were to stop buying all the new bonds, what's to say that demand from private entities, foreign governments, and other central banks woudn't flood in and make up most or all of the demand shortfall?

Not saying that's exactly what I think is going to happen, but it doesn't sound all that implausible to me.

If there is a sufficient non-Fed market to buy Treasury Bonds at present rates, then why is the Fed buying them?

To drive down rates, for the purpose of making non-bond assets seem more attractive. But the point is that even if and when the Fed stops this program and rates start to rise (gently, as Ad Orientem pointed out), it's not as though the government will face some kind of looming solvency or budgetary constraint. The increased borrowing costs will simply be paid by issuing more debt, which will be purchased by participants in the open market, Primary Dealers, or the Fed.

Okay, so I think we agree that there isn't a sufficient non-Fed market to buy t-bonds at present rates, at least in enough quantity to fund the budget deficit. I agree that if and when the Fed stops there won't be a solvency catastrophe. After all, the US Government is probably still the most attractive creditor a bond holder could have and as such will always have access to capital, just not at present rates without the Fed.

I"m not sure I necessarily agree that when the Fed buying program stops, the rise in rates will be gentle. I suppose we'll find out if and when that time comes.

[Pointedstick]

Okay, so I think we agree that there isn't a sufficient non-Fed market to buy t-bonds at present rates, at least in enough quantity to fund the budget deficit. I agree that if and when the Fed stops there won't be a solvency catastrophe. After all, the US Government is probably still the most attractive creditor a bond holder could have and as such will always have access to capital, just not at present rates without the Fed.

I'm not sure I necessarily agree that when the Fed buying program stops, the rise in rates will be gentle. I suppose we'll find out if and when that time comes.

I think it depends on what interest rates would be without Fed intervention. If the Fed works to drive down rates that were falling anyway, then their action isn't really all that consequential, for example. That zero lower bound is a harsh mistress for your average central banker.

So I think rates would be pretty low even without the Fed's intervention. In my mind, our economy is one that can't really support rates that are all that high. This is all speculation of course, but I think at the present moment, absent Fed intervention, it's doubtful that the 30-year T-bond rate would be much higher than 4.5%, if even that high.

[glennds]

On a related note, I have heard it said that an unprecedented amount of money is sitting on the balance sheets of major banks, including the treasury primary dealers, in the form of excess reserves. The Fed's money expansion strategy relied on the banks as a whole to put the money created by the Fed into the system through lending and investing activities which would convert the excess reserves into required reserves. This has not happened and is one of the reasons behind the slow growth of money supply despite the QE activities, and a declining rate of money velocity. This in turn has contributed to low inflation and falling gold prices. This subject has come up in Bernanke's testimony  in recent congressional committee hearings.

I am interested in what will happen if the tide turns and the banking system as a whole begins increasing its investing and lending activities, and we see a progressive conversion of excess reserves into required reserves which should drive up the money supply. The potential is there to create the inflation that the Fed has been ostensibly seeking and bring about the exact inverse of of the recent effects on gold. Theoretically it should also stimulate the economy due to enhanced inflation, dollar devaluation thus an advantageous export position. I don't know if this will happen or not, but it's certainly possible, and if it does, we'll be glad to have gold in the Permanent Portfolio.

To focus for a moment on HB's defined economic conditions, I happen to believe right now we are in a tug of war between deflation and tight money recession. If the Fed has it's way, we would be somewhere between (controlled) inflation and prosperity. If the excess reserves in the banking system end up mobilized and into the money supply, the Fed might have it's way. If they overshoot the goal, we could whipsaw from where we are today to not-so-controlled inflation in which case we'll applauding HB and the gold allocation in the PP. There's no way to know for sure how this will all play out.

[MediumTex]

If the Fed announced that it was going to stop buying all bonds, it would cause the stock market to crash because everyone would assume that the economy was being taken off of life support (which it has been on for going on five years).

When the money in risk assets began running for safety in response to such an action, where would it go?  Into the treasury market, of course, just like it did in late 2008, when rates were just as low as they have been since the Fed has been buying bonds on a large scale.

In other words, rates are going to stay low either way.

Look at credit levels and demographics and that really tells you all you need to know about what is likely to happen with interest rates in the U.S., with or without the Fed monkeying around in the bond market, and Bernanke knows this.