Rising Interest Rates

[EdwardjK]

Has the Permanent Portfolio ever been tested under a period of rising interest rates?

Interest rates have been steadily declining since the 1980's.  We are currently experiencing the lowest interest rates in.. well maybe forever.  If/when short-term interest rates rise again to 4%-5%, long-term bonds will take a shellacking.  What component in the PP will offset that?

[melveyr]

Well, interest rates usually go up in times of inflation, so in the early phase of rising interest rates I suspect gold will be going up.

Now, to fight inflation, the federal reserve will be forced to raise short term interest rates. Eventually, short term interest rates will go up enough to curb gold speculation. At this time I suspect cash will be the best performing asset class. In 1981 cash gave you high double digit returns!

Rising interest rates are when cash really shines, especially at the tail end of the cycle because inflation finally gets broken and you are getting such a high interest rate!

[moda0306]

The 1970's were a time of inflation, rising interest rates, and amazing PP performance.  LT bonds were paltry to negative performance every year, but owning ST bonds and more importantly, gold, gave you great gains during that time.  It's a real test of the PP's ability to keep your purchasing power up.

[moda0306]

KevD,

And with all that, I can think of no better allocation than the PP.  If US debt were to be downgraded, which I don't think is reasonable given your point about them being able to print, gold would sky-rocket, and your short-term bonds would yield very decent nominal return.  The PP seems to be the only portfolio I've seen with enough precious metals in its allocation to provide that immediate explosion during times of "paper panic."  Nothing else works quite like it.  Real estate, other commodities (oil, copper), stocks, TIPS... nothing works like gold.

This is coming from a guy who's still trying to fathom how gold can have any real intrinsic value... but thousands of years of history and human preferance can't be ignored.  I agree this is one of the most mind-boggling times to try to invest in history, as everything seems overpriced except guns and generators.  I can think of no better portfolio for my piece-of-mind than the PP (plus maybe that gun and generator I mentioned).

[MediumTex]

One thing I'm concerned about is a downgrade of U.S. debt.  The ratings agencies have been warning about it and last week, their warnings got a little bit more pointed.

The ratings agencies!!!

The same ratings agencies that missed the entire housing bubble, financial crisis and insolvency of the PIIGS countries?

I predict that the first ratings agency to downgrade U.S. debt would be labeled a terrorist organization and would find all of its assets frozen.

Seriously, though, the ratings agencies are sort of like a weatherman that reports yesterday's weather.

[gizmo_rat]

IMO the barbell is the better choice if starting the PP at a relatively high interest rate time point, whilst a ladder is potentially better if starting from a relatively low interest rate time point.

Clive, I'd like to understand this, could you step me through the rationale, please ?

[MediumTex]

One thing I'm concerned about is a downgrade of U.S. debt.  The ratings agencies have been warning about it and last week, their warnings got a little bit more pointed.

The ratings agencies!!!

The same ratings agencies that missed the entire housing bubble, financial crisis and insolvency of the PIIGS countries?

I agree.  But they do move markets.  I have a small speculative position in a stock that was doing very well.  Then it got slammed by a downgrade from S&P.  It's taking months to recover.  Before I'd just laugh at their pronouncements.  Now I watch for them and dread them, no matter how ludicrous they are. 

Japan was downgraded today.

Long term Japanese bond yields rose one basis point in response.

I think the whole ratings agency thing is a meaningless exercise and I'm not sure what its purpose is.  I agree with you that ratings agency downgrades can have a negative impact on corporate issuers and smaller governments, but when we are talking about international reserve and reserve-like currencies and their bond markets, it seems like everything is pretty well priced in, regardless of the new world that some goose-like ratings agency may wake up in on a given day.

[gonetowindsurf]

Clive - instead of buying each of the treasuries in ladder increments - what are your thoughts on STPZ - a 1-5 year ladder inflation treasury etf? which is designed to replicate theThe BofA Merrill Lynch 1-5 Year US Inflation-Linked Treasury index.
I am intrigued by your finding and looking for simplification - but perhaps the inflation component built into these treasuries may skew the overall design and counterbalance aspects of PP.
There appears to be no etf that offers a plain vanilla 1-5 ladder except in Canada.
thanks for your impressions,
mike in pepsicola

[gonetowindsurf]

Clive - thank you for your thoughtful reply!
The US treasury bond market (non-etf) is a mystery to me.
How does one implement a 5 yr ladder portfolio?
Sorry for the basic question - but i have to figure out how to accomplish this with 4, individual retirement accounts for the 25% of our total portfolio?
thanks,
mike in pensacola

[moda0306]

Not to step in as a defender of the treasury/fed, but is it really partial default if you know they have the ability to do it before hand?  A default is a breach of contract.  As in, "I agree to pay you this money back.".. but you don't.  It is fully understood that the fed has the ability to print money and devalue the dollar.  Nowhere do they claim they won't do that.  In fact, they are congressionally mandated to sustain full employment if price-stability isn't at risk, and it is priced into the interest rate on the bonds, to some degree.

That's why PP investors tend to invest in gold as well.  As we very well should, we understand the fed can inflate away debt.  I don't think any bond investor should feel bad for themselves if they get burned on bonds, as it's an obvious risk they run, but still governments and individuals are lining up in droves to loan our government money at between .5 and 4.5%.

[moda0306]

I really get my head in a bind when trying to figure out the fed's effect on the market.  Take 2008 for example:  Economy is near collapse, let's pretend the fed does nothing, and tons of banks and businesses fail... deflation abound... and default risk way up.  What would interest rates have been in that environment?  One could say ridiculously low, as deflation's running rampant and growth is nill.  One could also argue somewhat high, as default risk enters into the equation (for businesses & mortgages anyway).  Either way, the US government would probably have been looking at extremely low rates, as they can't default.

So did the fed really "artificially lower rates" if the inflation they caused (or deflation they prevented) kept rates higher than they would have been?  If quantitative easing increases the risk of inflation, how could rates lower:  Probably the marginal cost of the inflation risk is much less than the now-decreased supply of risk-free return assets available to the open market (as the fed purchased $600 million or so off the market). 

So that brings me to the question/point that maybe the treasury (in borrowing money) and the fed (in buying those bonds), because of their power and size (bad as it is), are able to offer the market what no private entity can, and they use that to give the market what it strongly desires... for instance, after 2008, demand for risk-free bonds (treasuries) went through the roof.  Should we not ablige as a nation, if we can simultaneously keep businesses from closing their doors?  Isn't this the flexibility we paid for by selling bonds at rates that included a premium for our ability to print money?

Just food for thought...

[MediumTex]

The Fed is playing a perfectly legitimate function in acting as a lender of last resort in a crisis.

I have no problem with that.  Every financial crisis in history could have been mitigated (and often was) through the skillful use of a lender of last resort to keep essential credit flowing (by essential, I mean short term credit needed to facilitate normal buying and selling of goods).

The question becomes what the role of the central bank should be once the crisis passes.  Should it then allow the market to find its own equilibrium, or should it attempt to force assets back up to their bubble level prices?

[Pkg Man]

I think part of the problem is that "we" expect too much from the Fed and government in general in terms of smoothing the business cycle.  The 2001 recession was one of the most mild on record but the Fed and government tried to make it an even milder recession.  In the process the seeds were sown for the "Great Recession" by keeping rates too low for too long. 

At some point it is better to just let the economy right itself than to delay the pain and possibly create a larger problem down the road.  But politicians work on a very short time horizon.

[gonetowindsurf]

Thanks Clive - awesome and very detailed information. Really helps me understand - cheers!
mike in pepsicola

[Gumby]

The question becomes what the role of the central bank should be once the crisis passes.  Should it then allow the market to find its own equilibrium, or should it attempt to force assets back up to their bubble level prices?

Here's an interesting view of how QE is fueling the current stock market bubble.

http://www.chrismartenson.com/blog/how- ... last/52040

...like you, he also wonders what may happen after QE and if the Fed is too late recognizing the momentum of inflation.

[moda0306]

Gumby,

I think the "momentum of inflation" can't happen without rising wages.  Otherwise all you get is a spike and subsequent crash like 2008.

This is where SOME people think that you need at or close to full employment for inflation to get "baked into" the economy and be tough to reverse like it was in the 70's. 

Much like strongly falling commodity prices aren't necessarily looked at as "deflation.  Think of the cheap oil of the 90's... it actually helped spark a lot of the growth during that time.

[Gumby]

Gumby,

I think the "momentum of inflation" can't happen without rising wages.  Otherwise all you get is a spike and subsequent crash like 2008.

This is where SOME people think that you need at or close to full employment for inflation to get "baked into" the economy and be tough to reverse like it was in the 70's.  

Much like strongly falling commodity prices aren't necessarily looked at as "deflation.  Think of the cheap oil of the 90's... it actually helped spark a lot of the growth during that time.

I don't think anyone's trying to predict if inflation will be permanent or not. Momentum and permanence are very different things. I don't believe I was saying the momentum equals runaway inflation. It takes momentum to cause a spike. Either way, both are damaging.

Keep in mind that inflation is rising in China and Hong Kong. Workers are demanding higher wages to feed their families.

[moda0306]

Well momentum implies a sustained period that's difficult to stop (or at least that's how I interpreted it).... I didn't mean permanent until the end of time... just basically a self-fulfilling inflationary trend.

[Gumby]

Well momentum implies a sustained period that's difficult to stop (or at least that's how I interpreted it).... I didn't mean permanent until the end of time... just basically a self-fulfilling inflationary trend.

Either way, inflation is often used as a tool to fight unemployment.  Maybe it's better to just quote von Mises:

The panacea they recommend to fight unemployment is credit expansion and inflation, euphemistically called "an easy money policy."

As has been pointed out above, an addition to the available stock of capital previously accumulated makes a further improvement of the industries' technological equipment possible, thus raises the marginal productivity of labor and consequently also wage rates. But credit expansion, whether it is effected by issuing additional banknotes or by granting additional credits on bank accounts subject to check, does not add anything to the nation's wealth of capital goods. It merely creates the illusion of an increase in the amount of funds available for an expansion of production. Because they can obtain cheaper credit, people erroneously believe that the country's wealth has thereby been increased and that therefore certain projects that could not be executed before are now feasible. The inauguration of these projects enhances the demand for labor and for raw materials and makes wage rates and commodity prices rise. An artificial boom is kindled.

Under the conditions of this boom, nominal wage rates which before the credit expansion were too high for the state of the market and therefore created unemployment of a part of the potential labor force are no longer too high and the unemployed can get jobs again. However, this happens only because under the changed monetary and credit conditions prices are rising or, what is the same expressed in other words, the purchasing power of the monetary unit drops. Then the same amount of nominal wages, i.e., wage rates expressed in terms of money, means less in real wages, i.e., in terms of commodities that can be bought by the monetary unit. Inflation can cure unemployment only by curtailing the wage earner's real wages. But then the unions ask for a new increase in wages in order to keep pace with the rising cost of living and we are back where we were before, i.e., in a situation in which large scale unemployment can only be prevented by a further expansion of credit.

This is what happened in this country as well as in many other countries in the last years. The unions, supported by the government, forced the enterprises to agree to wage rates that went beyond the potential market rates, i.e., the rates which the public was prepared to refund to the employers in purchasing their products. This would have inevitably resulted in rising unemployment figures. But the government policies tried to prevent the emergence of serious unemployment by credit expansion, i.e., inflation. The outcome was rising prices, renewed demands for higher wages and reiterated credit expansion, in short, protracted inflation.

Inflation Cannot Go On Endlessly

But finally the authorities become frightened. They know that inflation cannot go on endlessly. If one does not stop in time the pernicious policy of increasing the quantity of money and fiduciary media, the nation's currency system collapses entirely. The monetary unit's purchasing power sinks to a point which for all practical purposes is not better than zero. This happened again and again, in this country with the Continental Currency in 1781, in France in 1796, in Germany in 1923. It is never too early for a nation to realize that inflation cannot be considered as a way of life and that it is imperative to return to sound monetary policies. In recognition of these facts the administration and the Federal Reserve authorities some time ago discontinued the policy of progressive credit expansion.

It is not the task of this short article to deal with all the consequences which the termination of inflationary measures brings about. We have only to establish the fact that the return to monetary stability does not generate a crisis. It only brings to light the malinvestments and other mistakes that were made under the hallucination of the illusory prosperity created by the easy money. People become aware of the faults committed and, no longer blinded by the phantom of cheap credit, begin to readjust their activities to the real state of the supply of material factors of production. It is this — certainly painful, but unavoidable — adjustment that constitutes the depression.

Source: http://mises.org/daily/2989

[MediumTex]

Von Mises spells it out so clearly.

If I was a politician or central banker I would say "Von Mises!" the way Jerry used to say "Newman!" on Seinfeld.

[Wonk]

Keep in mind that inflation is rising in China and Hong Kong. Workers are demanding higher wages to feed their families.

Bingo.  Wages are rising, just mostly outside of the U.S.

[Gumby]

Coincidentally, Bernanke held a press conference at the National Press Club today. He was asked if there would be a QE3, and he responded by saying that if unemployment is still too low, then QE may continue. He went on to say that if we're moving towards full employment, then we won't need to stimulate more.

Meanwhile Gold spikes the more he talks. (It started spiking the minute his speech was released to the public.)



The cycle continues...

[Plumbline]

He was asked if there would be a QE3, and he responded by saying that if unemployment is still too low, then QE may continue. The

Gumby, did B mean to say "too low" for unemployment to create QE3 or continued high unemployment would result in QE3?  Anyway, going to see the Wizard of Oz play on Sunday; I'll get some solice from all the symbolism L. Frank Baum drafted within the story that basically paints the Fed a Big Fat Fraud. 

[Gumby]

He was asked if there would be a QE3, and he responded by saying that if unemployment is still too low, then QE may continue. The

Gumby, did B mean to say "too low" for unemployment to create QE3 or continued high unemployment would result in QE3?

He admitted that he would choose to implement QE3 if unemployment remains high.

In his speech, Bernanke also said...

"...It will be several years before the unemployment rate has returned to a more normal level. Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established."

In other words, get ready for QE3 this summer.

EDIT: Here is the full quote from the press conference that he gave when answering if there would be a QE3:

The approach is more or less the same we always use for monetary policy. I mean how do we make decisions about the Federal Funds Rate? What we do is, we do our best to create an outlook for the economy: See where are things going, where is employment going, where is output going, where is inflation going. And we ask ourselves, given the level of monetary accommodation we have now, is the economy on a trajectory that will give us the best possible outcome in the medium term. If not, if inflation looks to be very low or deflation risk is there, or if output is too low and unemployment is too high and that would be a situation that requires more stimulus. Vice versa, if inflation becomes an increasing problem, the economy is growing quickly, that would be the reason for us to scale back. And so, in the same way that we adjust monetary policy, under normal circumstances, with the short term interest rate, by looking at the outlook and trying to gauge whether the economy is growing at a pace that's consistent with eventually returning to full employment and stable prices. By the same approach we look at that outlook and based on that we will either provide more stimulus if necessary, or scale back, or stay with what we have. So, it's really not a simple answer, but we have to use the best we can in terms of our forecasting models to try to assess where the economy is headed.

When you hear that response, and when the text of his prepared speech says, "It will be several years before the unemployment rate has returned to a more normal level. Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established," one can easily conclude that QE3 is very likely this Summer.

You can view the Q&A here: Bernanke answers questions at rare press event

[Plumbline]

"So, it's really not a simple answer, but we have to use the best we can in terms of our forecasting models to try to assess where the economy is headed."  BB

Where the economy is headed? What he should have said was this is a race to the bottom.  First currency over Niagra Falls wins.  Thanks for the content Gumby.  Time to call Tulving for another few golden eagles.