Here is today’s daily missive from Sydney Williams.

Thought of the Day
“Complacency in Bond Land?”
May 7, 2013

“The problem with generational-long trends is that five years doesn’t make much of a difference to
the historian looking back, but those years can seem endless for the one who made a bad bet, an
example being those who thought interest rates would move higher. In his recent Grant’s Interest
Rate Observer, James Grant traces the rise and fall of interest rates over the past 150 years. The
cycles are long. Rates fell for the 35 years following the Civil War, then rose for 20 years. In
1920 they began falling, and did so through the end of World War II, when they began rising
again. That trend ended with the Ten-Year Treasury yielding 15.3% in September, 1981.

Percy Bysshe Shelley ends his “Ode to the West Wind” with the well known line that is filled
with hope, “O wind, if Winter comes, can Spring be far behind?” As Mr. Grant points out, spring
came to the bond market in 1981 and is closing in on its 32nd birthday. Those three decades would
suggest that not only did spring arrive, but it suggests we must be in the waning days of summer,
awaiting the onslaught of a chilly autumn. Can the rally in bonds extend for another four or five
year? Anything is possible. There may be an Indian summer, but we know that this too will end.
For the one constant common to all markets is change. But picking the apogee and nadir’s of
trends is a job for clairvoyants, not mortals, and certainly not pundits like me who profess to no
such expertise.

In November, 2008 the Federal Reserve implemented its first round of quantitative easing. The
yield on the Ten-Year had already fallen to 2.96% (from 3.83% at the end of September.)
Concern about the possible inflationary consequences of the Fed’s purchases pushed bond prices
lower; so that just over a year later, in December of 2009, the yield on the Ten-Year was 3.84%.
However, once markets realized that the Fed would keep its foot on the accelerator, bond prices
moved up and yields fell. With the economy still sluggish, and despite stocks and bonds having
rallied, the Fed, in the summer of 2010 instituted QE 2. Again, the first response was for rates to
rise and bond prices to fall. The yield on the same bond was 2.48% that August. By March of
2011, it had risen to 3.45%. And still the economy did not respond as expected; but stocks
continued to do well and so did bonds, after initially faltering. Then last October, with
unemployment still around 8% and with the Ten-Year now yielding 1.67%, the Fed began QE 3.
The initial response has been the same. Treasury rates are nominally higher, and unemployment
has dipped, but the numbers of employed workers remains substantially below where they were
when the recession began. The bet that most pundits make is that the process will continue as it
did before.

While Treasury yields have fallen 40% since QE 1 began, the yield on High Yield bonds have
fallen 67%, indicating a willingness to assume more risk in the illusive search for yield.

Low interest rates are double-edged. As Bill Gross of PIMCO writes in his May “Investment
Outlook,” “The government’s gain, however, is the saver’s loss.” ‘Government’ is simply a

euphemism for taxpayers. Thus what we are seeing is a perverse wealth transfer, from the elderly
and retired to Wall Street. For the principal beneficiaries of low interest rates have been the TBTF
banks and buyers of commodities, bonds and stocks. In his eponymous news letter, Mr. Grant
points out that, contrary to the prognostications of government officials and most market
commentators, there has been “rip-roaring inflation in the price of income. The cost of
retirement…has gone through the roof.” In 2002, a million dollars invested in Ten-Year
Treasuries produced $62,000. Today, to generate the same level of income, the retiree would need
about $3.7 million. Low returns in “safe” securities have forced investors into riskier securities.
For the individual whose 6% Ten-Year bonds are maturing, and now needs to replace the income,
must now buy junk bonds.

As mentioned above, the Federal Reserve is in its third iteration of quantitative easing. They have
been purchasing $85 billion in Treasuries and asset backed mortgages each month, roughly the
annual cost of sequester. In purchasing these securities, the Fed is injecting money into the
economy. “The money,” as Dallas Fed president Richard Fisher recently noted, “should,
theoretically, be put to use: by banks lending to consumers and businesses that will expand
employment, and by investors who, rediscounting valuations in the fixed income and equity
markets, will drive those markets higher, creating a wealth effect.” The latter has worked, as we
have seen in stock and bond indices, while the former, other than aiding the housing market, has
been less successful. The irony is that the stock market is caught in a pushmi-pullyu enigma.
Equity holders hope for economic growth to surge, driving earnings, but at the same time realize
that if that happens, interest rates will rise, knocking out a critical support for stocks.

Markets are self-correcting mechanisms. But no one can forecast peaks, valleys or timing. And,
perhaps more importantly, no one can control the rise in rates when that happens. Nevertheless,
the threat of rising rates hangs over taxpayers and investors alike, as a sword of Damocles. Total
federal debt is about $16.8 trillion, of which the public portion is about $11.7 trillion. In the fed
budget, no allowance is made for the accumulated interest rate cost on government-owned debt.
The average interest rate on the public portion of the debt is just under 2%. In contrast, a dozen
years ago the average rate cost was 5.3%. In April 1997, the yield on the Ten-Year was 6.7%;
today it is 1.77%. Interest expense on the public portion of the debt approximates $223 billion, or
roughly 6% of the expected $3.7 trillion 2013 budget. Should rates revert to the 2001 level,
interest costs would consume 16% of the budget. If we went back to the mid 1990s, the cost
would be even higher. This is an event that will happen. What we don’t know is when. But it is
this indisputable fact that renders so serious the need to reduce debt.

What is going on in the Treasury markets violate basic economic rules of supply and demand.
When the market is flooded with any product, the price usually goes lower. Not so in the brave
new world of fiat currencies. When currencies were tied to a commodity like gold, they could
only be issued in proportion to the amount of gold held by the central bank. Fiat currencies have
no such restraint, which one would think might make them less valuable, yet the proliferation of
them, over the course of all three quantitative easing programs has only made them dearer.
Nevertheless, it should not be surprising, despite the U.S. being seen as the best horse in a field of
nags, that the dollar is only one percent higher than it was at the end of December, 2008.

As Warren Buffett wrote in this year’s letter to shareholders, “…every tomorrow has been
uncertain. America’s destiny, however, has always been clear: ever-increasing abundance.” That
is likely to be true, but timing is something Mr. Buffett worries less about than do most.
Complacency does not appear to this observer to be a concern in equity markets, but four years
into a bull run and now selling at 11.5X estimates – estimates that have been coming down – it is
far from the bargain it once was. But the bond market seems different. Many prominent and

highly successful bond managers have expressed reservations, but claim to be still playing the
game. The question becomes: will they all be able to get off the speeding train unhurt before it
inevitably reaches a point of no return? I don’t pretend to have the answers, but these are
questions worth asking; for complacency is always the enemy of investors.”