Unsafe at any price

Everyone is bullish. Contrarians know that must be bearish. However, everyone has been bullish for a while, yet the S&P 500 rose to a record high of 2117 on April 24. That’s because everyone has finally figured out that fighting the Fed in particular and central banks in general is dumb. So we are all smart now. As a result, bullish sentiment is at a record high, though the bull market, which is more than six years old, is no spring chicken.”

–       Dr. Ed Yardeni, ‘We are all bulls now’.

There is one thing riskier than investing in a free market: investing in a rigged market when you think the central bank has your back. At some point, the free market returns with a vengeance, like a coiled spring made out of pure risk. This may account for the confusion last week in the German government bond market, where 10 year yields suddenly spiked from just 8 basis points to 37 basis points. That may not seem like much, but with yields so slender, a move of that magnitude is easily enough to put a few leveraged funds out of business. And there is a practical proof that attempting to front-run central banks is ultimately a fool’s errand, in the form of Robert Schuettinger and Eamonn Butler’s ‘Forty centuries of wage and price controls’ – a magnificent, if depressing, history of dumb governments’ consistently doomed attempts to buck the market.

There comes a point when the game of playing in the government bond market simply isn’t worth the candle. Western government bond markets long since entered the realm of the pointless, at least for any rational investor. Vanishingly thin yields have transformed the nature of the bond markets, in the same way that crowding into supposedly safe stocks makes them dramatically unsafe, because a price boosted by the popularity of the crowd removes the last vestige of any margin of safety in the first place. Let’s face facts: government bonds now offer return-free risk, and nothing more. That holds whether you’re contemplating 10 year US Treasury yields (2.1%), 10 year UK Gilt yields (1.84%), 10 year German government bond yields (0.37%) or bug-in-search-of-a-windshield 10 year Japanese government bond yields (0.32%). To repeat, bonds have never been more expensive in human history, and yet their supply has never been higher. There’s a six-letter reason why, and it’s spelt BUBBLE. (In the interests of complete transparency, there’s also a 12-letter reason why, and it’s spelt MANIPULATION.)

Time will tell whether last week’s spike in German Bund yields amounts to a sea-change in the mood of the bond market, or just another brief tumble as bond traders insist on continuing to ascend their wall of insanity. Rational investors will not care because rational investors will not be wasting their time in markets offering such a ridiculous risk-to-reward ratio.

But the mother of all cognitive dissonances is not the German bond market but the Japanese. Bloomberg’s William Pesek highlights the tortured logic plaguing Bank of Japan Governor Haruhiko Kuroda as he attempts to escape from the corner of the bond market he has painted himself into:

“Aside from the debt binge’s many failures to date, Japan’s financial markets are now struggling with a lack of liquidity. Major traders like Royal Bank of Scotland are beginning to leave Japan. And Japan’s bizarrely low 10-year yields, which are currently at 0.32 percent, also suggest something’s amiss in the country’s markets. It defies the basic tenets of economics for the nation with the largest total debt, largest ratio of geriatrics and low rates of immigration to have lower bond yields than countries like Singapore, Sweden or Switzerland.”

When one of the world’s government bond markets finally blows up (Japan still looks like the primary candidate, but stranger things have happened), economists will scratch their heads and wonder where it all went wrong. Wiser souls will wonder how economists could ever have thought that money printing was the answer to anything. Quantitative easing is, fundamentally, simply a flashy coinage to disguise a blatant attempt to control government bond prices. In his introduction to Schuettinger and Butler’s book, David Meiselman asks:

“What, then, have price controls achieved in the recurrent struggle to restrain inflation and overcome shortages ? The historical record is a grimly uniform sequence of repeated failure. Indeed, there is not a single episode where price controls have worked to stop inflation or cure shortages. Instead of curbing inflation, price controls add other complications to the inflation disease, such as black markets and shortages that reflect the waste and misallocation of resources caused by the price controls themselves. Instead of eliminating shortages, price controls cause or worsen shortages. By giving producers and consumers the wrong signals because “low” prices to producers limit supply and “low” prices to consumers stimulate demand, price controls widen the gap between supply and demand.

“Despite the clear lessons of history, many governments and public officials still hold the erroneous belief that price controls can and do control inflation. They thereby pursue monetary and fiscal policies that cause inflation, convinced that the inevitable cannot happen. When the inevitable does happen, public policy fails and hopes are dashed. Blunders mount, and faith in governments and government officials whose policies caused the mess declines. Political and economic freedoms are impaired and general civility suffers.”

This week, the UK electorate goes to the polls. The country is still bankrupt. The campaigning has been long, tiresome and utterly uneventful. Judging from the leaders’ debate last week, Labour remains in complete denial about the chronic overspending of its last term in office. But the current coalition government has barely been more honest about the success of its own debt reduction programme, during which the UK Chancellor has added more to the public debt in five years than the previous government did in 13.

Quantitative easing is a squalid little lie. It appeals to economists with no grasp of history. It pretends that too much debt can be simply resolved through futile attempts at price controls and money printing. The practical outcome of QE is that it turns the bond market into a no-go area for any rational investor. We are now in the terminal stages of QE, during which the practical limitations of this fatuous and discredited policy are being revealed. When you devalue money and distort the supposed risk-free rate, you devalue every aspect of the capital structure. The solution is to avoid bond markets almost entirely, and seek shelter in either cash or productive equity assets offering a genuine ‘margin of safety’ amid a world made mad by demented financial engineers.

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