Bond Yields can stay low - for decades?

[Austen Heller]

Every now and then, I start to buy into the idea that "interest rates have nowhere to go but up".  So I dug up this data on Japanese 10-Year bond yields dating back to 1990, showing that their rates haven't moved much since 1998.  I'm planning to come back to this post every time I get the itch to dump my long term bonds.

[MediumTex]

I have grown accustomed to people looking at me like I'm not too bright when I talk about how interest rates may fall lower than anyone could ever imagine and the long awaited interest rate rise may not arrive for a LONG time.

I have actually started feeling reassured when I get that look of pity because I know that means there are more bond skeptics left to be won over.

When these people begin telling me about how excited they are about the 1.9% 30 year bonds they just bought I am probably going to start feeling very nervous about bonds.

[Ad Orientem]

With the caveat that the future is unknowable, I would be extremely cautious about drawing too many comparisons between Japan and our current situation.  There are some extremely serious differences.  To name just a few Japan's debt is held almost entirely internally.  Also it is supported by a population that has the highest personal savings rate in the world.  By contrast less than half our debt is held internally.  Further Americans have one of the lowest personal savings rates, and one of the worst debt to income ratios in the developed world.

Yes, LTTs belong in the PP.  But I wouldn't touch them with my neighbor's 20 ft stick in a VP.

[murphy_p_t]

does Japan's central bank buy the Japanese public debt?

[Ad Orientem]

does Japan's central bank buy the Japanese public debt?

They have.

[Gumby]

The government-owned Bank of Japan has the authority to buy government bonds directly from Japan's Treasury (known as the Ministry of Finance). And, of course, any interest payments on the bonds is refunded back to the Treasury. The BOJ holds Japanese government debt equal to 100% of the nation’s GDP. And since the government owns the bank, the loan is always interest-free and can be rolled over indefinitely. An interest-free loan rolled over indefinitely is the equivalent of printing fiat money. And of course, like the United States, Japan's Treasury is where Japan's spending comes from. Like the Fed, the BOJ issues bank notes by buying Government Bonds from its Primary Dealers. But, of course, the Government Bonds can only be purchased by the Primary Dealers if the Primary Dealer's cash reserves exists before the Bonds are auctioned off. And that can only happen if their Treasury spends reserves into existence before it issues bonds.

As it was mentioned, above, the Japanese people own a lot of their national debt as well. But the reason they own so much of the debt has a lot to do with the Post Bank. The Post Bank started in Japan's post offices and offered a very easy way for Japanese citizens to save their money through highly popular savings accounts. The money was obviously invested in risk-free Japanese Government Bonds. Today the state-owned bank is currently the world's largest holder of private savings and the world's biggest deposit holder — holding over 1/5th of the entire Japanese national debt and becoming the nation's largest employer. The Post Bank actually became more popular than the post office and had to open up more branches than the post office!

So, you can see where this is going... The Ministry of Finance (the Treasury) can spend and issue as much debt as it wants to, since the BOJ can purchase the interest-free debt directly. And the Ministry of Finance can sell trillions of government bonds to the Post Bank because that's where the Japanese are stashing all of the cash that was spent by the MOF before the bonds are even issued. So, Japan's debt will simply continue to grow and grow, and it won't make a difference. They will have no problem servicing their debt.

The fundamental difference between the Fed and the BOJ is that the Fed can't buy Treasuries directly from the Treasury itself — the Fed must go through the Primary Dealers. And the only way the Primary Dealers would have the cash reserves to purchase Treasuries in the first place is if the reserves existed in advance of the bond auctions (occasionally with the help of the Fed's repos, when necessary). And the only way the cash reserves can exist before the bond auctions (other than repos) is if the Treasury spent money into existence — since you can't use bank loans to purchase Treasuries.

What's clear is that the Fed and the BOJ can't just print money into the private sector unless the private sector has purchased some collateral in advance. So, in both cases, all of the net spending all comes from the Treasury. Which makes total sense, since the politicians are deciding what the money should be spent on.

This entire song and dance is really just used as a way to move cash into risk free assets and control interest rates in the process.

[Indices]

A huge percentage of America's debt is held internally as well, possibly a majority of it, so we are more similar to Japan than some might think.

[smurff]

Yeah, like by all those people in the various flavors of the permanent portfolio. 

[Austen Heller]

I put up this post back in March, and I was sure at the time that it would help me to see that bond yields can go low and stay low, and that there is nothing to fear.  Sadly, the fear took hold of me in May, when the 30-year rate dropped below 3%, and I sold my entire long-term bond (TLT) position, moving into short-term bonds (SHY).  I just could not justify the risk/reward at 3%, since I believed the rate can't go much lower.  I felt pretty foolish as rates kept dropping, even going below 2.5%.  Now I'm still stuck on the outside, hoping that rates will rise so I can get back in at some point, because my PP feels broken without that LT bond position.  The hard lesson: predicting future interest rates is tough.

[AdamA]

...my PP feels broken without that LT bond position. 

That's because it is! Just buy them!

[MediumTex]

That's a really great post.  Thanks for the follow-up.

When it comes to investing, we have many enemies to deal with, but I would say that our own emotions and psychological quirks are probably the most formidable.

[Austen Heller]

When it comes to investing, we have many enemies to deal with, but I would say that our own emotions and psychological quirks are probably the most formidable.

It's true.  Even today, the gambler in me says 'Hold out for a bit longer, and then buy those bonds when the rates rise a bit'.  The problem is, the longer that I wait, the more interest payments I will miss.  That is one of the things about the PP that I like the most: even if stocks and bonds are cancelling each other out, you still rack up all those dividends and interest payments, which can add up nicely over time.

[Ad Orientem]

When it comes to investing, we have many enemies to deal with, but I would say that our own emotions and psychological quirks are probably the most formidable.

It's true.  Even today, the gambler in me says 'Hold out for a bit longer, and then buy those bonds when the rates rise a bit'.  The problem is, the longer that I wait, the more interest payments I will miss.  That is one of the things about the PP that I like the most: even if stocks and bonds are cancelling each other out, you still rack up all those dividends and interest payments, which can add up nicely over time.

If I were a gambler I would eschew bonds entirely except for a large cash reserve (probably 20%). The rest I would pile into stock index funds and gold. Long term stocks outperform bonds. As long as you have enough cash to ride out 5 years of less than great stock returns I think you would likely be fine. But I am at heart a coward and I know I would freak out if we had another 2008 and would sell, probably at the bottom.

[MediumTex]

Long term stocks outperform bonds. As long as you have enough cash to ride out 5 years of less than great stock returns I think you would likely be fine.

Are you sure?

What if you buy stocks in the wrong country or the wrong industry?

I'll bet buyers of stocks in Rhodesia, Lebanon, and Cuba in the last 60 years or so would say stock were a terrible investment.

I've always thought that stock market performance was a bit misleading because you don't know which economies are going to be most productive, which governments are going to be most accommodating to the private sector and which industries are going to be most profitable in advance.

I can easily imagine a situation where a country's stock market performed terribly for an extended period, but the same country's bonds performed very well.  Japan in the 1989-2012 period comes to mind.  If the superiority of stock returns can't be observed over a 23 year period in one of the world's most productive countries, I don't know if it's true that stock always provide better returns than bonds.  Most investors are simply not going to be able ot weather a 23 year period during which stocks lose 75% of their value (as they have in Japan).

[Pointedstick]

I can easily imagine a situation where a country's stock market performed terribly for an extended period, but the same country's bonds performed very well.  Japan in the 1989-2012 period comes to mind.  If the superiority of stock returns can't be observed over a 23 year period in one of the world's most productive countries, I don't know if it's true that stock always provide better returns than bonds.  Most investors are simply not going to be able ot weather a 23 year period during which stocks lose 75% of their value (as they have in Japan).

With results like those, no wonder the Post Bank is so popular.

[Ad Orientem]

Long term stocks outperform bonds. As long as you have enough cash to ride out 5 years of less than great stock returns I think you would likely be fine.

Are you sure?

What if you buy stocks in the wrong country or the wrong industry?

I'll bet buyers of stocks in Rhodesia, Lebanon, and Cuba in the last 60 years or so would say stock were a terrible investment.

I've always thought that stock market performance was a bit misleading because you don't know which economies are going to be most productive, which governments are going to be most accommodating to the private sector and which industries are going to be most profitable in advance.

I can easily imagine a situation where a country's stock market performed terribly for an extended period, but the same country's bonds performed very well.  Japan in the 1989-2012 period comes to mind.  If the superiority of stock returns can't be observed over a 23 year period in one of the world's most productive countries, I don't know if it's true that stock always provide better returns than bonds.  Most investors are simply not going to be able ot weather a 23 year period during which stocks lose 75% of their value (as they have in Japan).

That's one reason why even in the PP I favor keeping around half of the stock part in international or just using VT vs VTI. But even so there is always the possibility of a prolonged global catastrophe, albeit most unlikely. Another reason why I am not a big time gambler.

[Reub]

If you read Hussman's weekly take of the economic climate and the market you would consider owning any US stocks precarious. Hence, the PP where you don't have to worry about it.

[MediumTex]

If you read Hussman's weekly take of the economic climate and the market you would consider owning any US stocks precarious. Hence, the PP where you don't have to worry about it.

John Hussman is a brilliant guy. And yet, if he is so smart, why is the fund that is based on his view of the economic climate such a dog?

Because the future is unpredictable.

It eats brilliant guys for breakfast.

I'm surprised that this simple insight has such difficulty getting traction with people.  The future simply never turns out the way people think it will.  Never.

[craigr]

If you read Hussman's weekly take of the economic climate and the market you would consider owning any US stocks precarious. Hence, the PP where you don't have to worry about it.

John Hussman is a brilliant guy. And yet, if he is so smart, why is the fund that is based on his view of the economic climate such a dog?

Because the future is unpredictable.

It eats brilliant guys for breakfast.

I'm surprised that this simple insight has such difficulty getting traction with people.  The future simply never turns out the way people think it will.  Never.

As I'm fond of stating: I've made far more money ignoring market timers than I ever have by listening to them.

[Pointedstick]

I'm surprised that this simple insight has such difficulty getting traction with people.  The future simply never turns out the way people think it will.  Never.

Brilliant people have difficulty admitting that they're not brilliant at everything, and an even harder time understanding that some things really are random and unknowable, even with the logical analysis power of blinding intellect. Some of the smartest people I knew were ones whose lives were the most difficult because they couldn't understand that the world is full of things that you can't understand and manipulate, you just need to go with the flow. This drove them nuts, and they would repeatedly bang their heads against things that less intelligent people had no trouble with.

[stone]

If you read Hussman's weekly take of the economic climate and the market you would consider owning any US stocks precarious. Hence, the PP where you don't have to worry about it.

John Hussman is a brilliant guy. And yet, if he is so smart, why is the fund that is based on his view of the economic climate such a dog?

I think the Hussman approach is that he is correct and the market is wrong  .

Would Craig be able to persuade Hussman to do an interview about the PP? As market timers go, Hussman seems a very reasonable guy. I'm struck time and again by how the Hussman aims and the GMO aims are essentially those of the HBPP and yet they never ever mention why they don't just follow a HBPP.

[MachineGhost]

Would Craig be able to persuade Hussman to do an interview about the PP? As market timers go, Hussman seems a very reasonable guy. I'm struck time and again by how the Hussman aims and the GMO aims are essentially those of the HBPP and yet they never ever mention why they don't just follow a HBPP.

I'd say it is because they want a superior return/risk ratio than what the PP provides.  To achieve that within an investing framework, you have to suffer periods of underperformance when the market is acting irrational.  The PP is not as good a hedge against irrationality mean reversion as market timing is, but it is leagues ahead of every other portfolio strategy out there.  If it was not, I wouldn't be using it.

BTW, if Hussman hadn't played it conservative by worrying about Great Depression conditions and adjusting his strategy to account for such, I estimate the returns chart would be approximately 20% higher from where it is now from not missing the 2009-2010 rally.  My question is: why didn't he have the pre-WWII data already factored into his approach from the outset?  What a dumbass!

[stone]

I think Hussman did have 1930s data in his mind. He thought the 2008 crash would be followed in quick succession by a second crash at least as bad just as happened in the 1930s. When he now says he has modified his models he means that he is taking into account what has happened since 2008. IMO it is straying into nonsense when someone says that they have a model that constantly changes based on what has just happened and as such would cope very nicely with what has just happened. I could always retrospectively win last weeks lottery with such a model.

[MachineGhost]

Would Craig be able to persuade Hussman to do an interview about the PP? As market timers go, Hussman seems a very reasonable guy. I'm struck time and again by how the Hussman aims and the GMO aims are essentially those of the HBPP and yet they never ever mention why they don't just follow a HBPP.

I'd say it is because they want a superior return/risk ratio than what the PP provides.  To achieve that within an investing framework, you have to suffer periods of underperformance when the market is acting irrational. 

Exactly. One of his mission statements is that the fund should [out]perform the stock market over a full cycle [i.e., bull/bear] with less volatility. I don't think he is anywhere near that goal in the last decade. His attempts [and failures] to guess where the market should go have not turned out too well lately.

I looked at the historical record and the fund did outperform from 2000 to 2009.  Since 2009 was the trough, there has not been enough time for another trough-to-trough cycle.  So, the SPX needs to decline at least 15% for the fund to catch up to the SPX and then surpass that loss to have a superior risk adjusted return.  Given the two separate 50% declines over the past decade, it doesn't seem seem unfathomable.  Secular bear markets are supposed to be excruiciating until the last one to leave shuts off the light.

One advantage the PP has over market timing is you do not have to pay for the upfront costs of active hedging.  Most of the decline since 2010 in the fund looks like its coming from the costs of buying put options and rolling them over and over.  Since the PP is always 25% in LT bonds, it is always perfectly hedged to the 25% in stocks.  The back-loaded costs will come later on when bonds go into a long-term bear market and the negative returns drag down the entire portfolio.  There is no free lunch in the marketplace.

[MachineGhost]

I think Hussman did have 1930s data in his mind. He thought the 2008 crash would be followed in quick succession by a second crash at least as bad just as happened in the 1930s. When he now says he has modified his models he means that he is taking into account what has happened since 2008. IMO it is straying into nonsense when someone says that they have a model that constantly changes based on what has just happened and as such would cope very nicely with what has just happened. I could always retrospectively win last weeks lottery with such a model.

Wrong.  Hussman wrote that his model only accounted for post-WWII data and that he was concerned that 2008 credit crisis was out-of-sample.  So he spent time devising a way to include the pre-WWII data that with acceptable reward/risk characteristics, because in a very economically analogous situation to the 1930's the market went on to decline another 80% or so after the equivalent of the March 2009 bottom.  So the implication here was that the model as of 2008 simply had too much drawdown risk when run on Great Depression era data, so a new method had to be found and that contributed to missing the rally of 2009-2010.  Apparantly, it took over a year to figure a successful way to do it.

Still, I find that oversight inexcusable when you are a mutual fund managing hundreds of millions of dollars.  It's certainly not a data availability problem when you have that much resources at your disposal.  He should have dealt with the issue long before starting any kind of money management business.  To only start at WWII is simply naive.  1971 would have been a better justification!  That he didn't, is why the fund is -20% vs the SPX.  On the other hand, the model wouldn't be blindsided going forward unless conditions are out of sample to the past 112 years...  that might take Armegeddeon.

My question is: How well would the PP have performed if we repeated that 89% stock market drop in the 1930's?  It doesn't take being under a gold standard to have a Great Deflation.