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Change We Can Believe In

Every good skier understands snow.  Why should good investors not understand money?  This thought occurred to me as I listened to various reactions to the US Federal Reserve’s announcement of phase two of its “quantitative easing” program. 

No longer shrouded by the fog of crisis, “QE2” has laid bare the Fed’s dollar debasement strategy.  The government of the United States is now funding its entire $100 billion per month budget deficit through printing money to buy its own bonds.  Were it not for the necessity to ensure that Wall Street’s bonus pool stays filled, the Federal Reserve might as well cut out the New York middlemen and just dispatch trucks around the country loaded with “Benjamins.” 

The investing playbook for this era of quantitative easing is fairly straightforward.  Avoid anything that looks like a government bond and buy things like wheat and silver which represent relatively cheap, hoardable commodities. 

Figure 1:  Silver Quarters – Change We Can Believe In

  

But while hoarding is definitely the best investing play of 2010, it does strike me as a rather dubious long term economic strategy.  Can the troubles of excess debt and inflation be addressed by bringing back the gold standard?  Absolutely, I say.

Canada and the Gold Standard

Many people do not realize that this country has a long history of operating on a gold standard.  Canadian dollars were exchangeable into a specified quantity (23 grains of gold or 4.7 hundredths of a troy ounce) from the 1850's through to the outset of Word War I and also for a period following that War. 

Between 1933 and 1971, Canada ran on a kind of second-hand gold standard, under which the government committed to maintain the C$ value in a range relative to the US dollar (and the British pound in the early part of this period).  The US dollar was in turn fixed to gold at $35 per ounce.  Under the post-WWII Bretton Woods system, Canada and other countries maintained a virtual peg to the US dollar.

The beginning of the end for Canada’s gold standard came on December 23, 1966.  On that day, Mitchell Sharp, Canada’s Minister of Finance announced that coins of the 10c, 25c and 50c denominations would no longer be cast according to their long-standing mix of 80% silver and 20% copper.  Given that the price of silver had by then caused the coins’ metal value to pass through their face value, Sharp presented to Parliament an amendment to the Currency, Mint and Exchange Fund Act which would eliminate the use of precious metal.  By 1968, the deed was done.  Canada's silver coins were removed from circulation in favour of the slugs that continue to be stamped out by the Mint at the cheapest practical cost. 

By 1971, America's massive borrowing to fund the Vietnam War eventually led President Nixon to abandon gold convertibility of the US dollar in 1971.  Canada's implicit gold standard, already imperilled by the end of silver coinage, died simultaneously.  So if you ever wondered who really decided that Canada should have completely faith-based fiat currency, the answer is Richard Nixon.  Did I just hear someone say, “Only in Canada?”

Gold Standard Benefits

The benefits of a gold standard are simple, but unfortunately a significant period of time is required to demonstrate them.  For this reason many countries have been forced to learn the same lesson over and over again.  Fiat money leads to inflation, wealth destruction, and ultimately, chaos.

The most important feature of a gold standard is that the supply of money, and credit, can only grow in proportion to the speed at which total gold reserves can be expanded through the acquisition of mine output.  Given that we already have many centuries worth of production stored above the surface, this effectively limits the growth of money at most to a few percentage points per year.  With credit growth thus constrained, the emergence of debt-fuelled bubbles such as the dot-com fiasco or the various housing bubbles would have been well-nigh impossible. 

The allocation of resources in a society on a gold standard involves choices made in plain view of market participants.  In a fiat world, bankers and speculators can conspire to build huge asset valuations backed by easy credit.  When the inevitable crack-up follows, a government must choose between a prolonged deflationary recession or a bailout.  Under a bailout, all the bubble’s non-participants pay by pro-rata dilution of their monetary assets.

The hidden cost of fiat money is a long-run reduction of capital investment of any kind.  Investors, burned by confiscatory inflation, become hesitant to make long-term loans at any price.  The economic troubles of Latin America over the past three decades has its root causes in undisciplined fiat money regimes.  And as the West’s currency and sovereign debt problems now demonstrate, there is nothing fundamentally different about fiat money north of the Rio Grande.

However, if one were trying to fix the problem, as opposed to merely profit from it, there is of course a somewhat different prescription required.  Here is my best guess at how we might proceed.

Five Not So Simple Steps

The way out of the mess begins with 1) a recognition that the debts are too big.  I laid out some of my homework on that topic here.  The next step 2) would be to apply some kind of haircut to outstanding debts.  The better places to take the haircuts would be at the levels of private and sub-national debts, so that Canada as a nation might remains a somewhat creditworthy entity.  I would suggest forcing banks to take an across-the-board haircut on consumer debts and mortgages.  Other sub-national governments might also be moved to haircut their debts to the extent that they are not manageable. 

What cannot be achieved through debt writedowns could also be achieved through step 3) a co-ordinated, one-time emission of fiat cash.  If we want to extinguish the provincial debt of Quebec, for instance, it could be bought back with a load of freshly printed fiat cash.  It would be important that the emission of fiat cash be a one-time measure.  Another key step in the process 4) would be in the significant reduction in unfunded entitlement programs that would put Canada on a more sustainable go-forward fiscal footing.  Finally, we would reach step 5) the critical part of this process, which would be a permanent fixing of the currency of a newly solvent Canada against gold.  What the exchange level might be would depend on circumstances at the time.  If it were to be done today, the fix might be applied at C$2500 per gold ounce.

Harsh medicine, indeed.  It would make the imposition of the Goods and Services Tax look like a walk in the park.  Yet the alternative, to do nothing and twist into inevitable chaos, seems far worse.  As an investor, my bets are placed squarely on the do nothing option.  But as a citizen, I recognize that there is a plan that could pull this country from the chaos of a broken fiat money system.  Can we really leave this purgatory of excess debts and phoney cash for “change we can believe in?”  The answer is obvious.  Yes we can. 

The Crowded Room

The most crowded investor meeting I ever attended was held in a very large hotel ballroom in Boston.  As the event began, the lights dimmed, and the hundreds of analysts and bankers in attendance were treated to a colourful laser show with blaring rock music.  Finally, from behind a curtain, a triumphant executive team emerged to a round of applause.  The CEO’s name was John Roth.  His company – Nortel Networks.  The date stamped in my passport was November 21, 2000, mere weeks after now-worthless Nortel’s quoted value had reached its $366 billion apex.

  

That experience introduced me to one of the investing world’s most dangerous situations, the crowded room.  I’ve seen a few crowded rooms since then:  one that feted a bearish fund manager as he toured this country promoting an equity fund loaded with over 90% cash (right before a massive commodities and equities rally); and another whose guest of honour touted global base metal demand just as copper and zinc prices began to melt down.  And let us not forget the rooms that filled for “peak oil.”

  

Figure 1:  The Plaza: Host to 2010’s Crowded Room?

 
  

  

I do not blame the shining lights of finance for burning a few moths along the way.   Each crowded room phenomenon started years before with a plausible, often excellent idea.  And early followers who got into a trade in advance of “standing room only” signs and fire code contraventions generally made out quite well.   But the thinking investor should always be on guard against the perils of a well-loaded bandwagon.

  

 The Crowded Room of 2010

  

Surveying the investing scene of 2010, there appear to be as least as many “crowded rooms” today as there were ten years ago.   I will ignore for the moment the mere swarms surrounding Canadian bank equities and long-dated corporate bonds in favour of addressing the greatest crowded room of them all – a veritable Lollapalooza – that supports the obscene valuation of United States government bonds.  From this great insanity, all the little bubbles draw their courage.

  

The US bond market’s crowded room moment may be coming soon.  My guess at its precise physical location would be New York City’s Plaza Hotel, which hosts the upcoming Bank Credit Analyst conference.  Topping the bill at that meeting is a much heralded “debate” between two institutionally-approved hot hands, Gluskin Sheff’s David Rosenberg and Oppenheimer’s Brian Belski.  Rosenberg is a leading cheerleader for long-dated US Treasuries who has insisted recently that the United States will never default.  As a consequence, “Rosie” is convinced that the currently tiny yields on US Treasuries are juicy given the coming deflation.  His “opponent” in this event, Brian Belski is expecting the gold “bubble” to burst any day and projects an increasingly strong US dollar and a continuing economic rebound. 

 

Who am I, a humble analyst from a small Canadian city where business lunches generally involve ketchup, to question such financial luminaries?  And yet, it does appear to me that the supporters of US dollars and low-interest US dollar bonds neglect certain key questions.

 

If it is generally true that people and companies with heavy debtloads pay higher interest rates than people with less debt, why does the United States pay a lower interest rate with debt/GDP at 100% and deficits/GDP of 10% than in any other year in the past forty, when US debts were far lower?

 

What is the effect of “open market” operations whereby the US Federal Reserve and the Bank of China buy US bonds in the market with freshly created cash?  What would American interest rates be without such activity?

 

How is it that money supply (M2), as measured by the US Federal Reserve can grow at a rate of 7 to 8% per year for the past decade and yet ten year US bonds can yield 2.7%?  And if US interest rates actually paid investors fair compensation for money supply dilution (yields of 10%, say), how could America possibly service its massive debt?

  

Now I recognize that these are not the type of questions that earn one invitations to address a crowded room circa 2010.  Perhaps we should check in again ten years from now.

 

This Curve Also Rises

A few months ago I posted a piece that highlighted the difference between the hedgehogs and foxes of the investing world.  It is still a cult hit amongst animal lovers cruising for pictures of hedgehogs.  But the key point was that there are two different kind of investors.  There are foxes who chase every bit of news in the hopes of outwitting the market in the near term, and hedgehogs, who have one big idea that if correct will more than compensate for the lack of near term detailed information.  In the animal world, the hedgehog’s big idea is that no predator, howsoever hungry, wants a mouthful of quills.

 

The hedgehog-ish investing idea I posted on back in June was that investments made at low prices tend to result in superior returns.  To this rather simple insight, I add a corollary: investments acquired at high prices tend to result in inferior returns.  It is this second point that I comment on today.  I sit as a prickly hedgehog type observing the big bubble of our era – the bond market – and ask myself, what can possibly stop long-term interest rates rising?

 

Figure 1: The Sun Rises over Vancouver – Will Rates Follow?

 

 

The Interest Rate Cycle

 

Changes in the 10-year Treasury yield have been the pre-eminent driver of our economic lives.  What has the trend been in Canadian interest rates, Swiss equity multiples, Seoul house prices, or even global business school enrolments?  Generally speaking, these values are mere derivative functions of the US Treasury yield curve.  As rates have fallen, asset prices became pumped up.

 

The most telling picture with respect to the rate cycle is the 50-year chart depicting the yield-to-maturity of the 10-year US Treasury bond (arguably the world’s most important interest rate).  Here we observe a parabolic increase in rates that started gently in the 1960’s and culminated with spikes in the early 1980’s.  This uptrend was followed by a rapid decline in rates that began during the early years of the Reagan presidency and continued with a moderating decline to December 2008, where a low of 2.1% was hit in aftermath of the Lehman collapse.

 

 

Figure 2:  US 10-Year Treasury Bond Yield 1960-2010

 
 

I offer a few observations on this chart above.  First, it appears to the hedgehog in me that there is not very much room on the chart for rates to continue to fall towards the x-axis.   If I knew nothing about the fundamental drivers of government borrowing costs (OK – I hear you, but I can’t stop now) then I would be inclined to believe that mere mean reversion might apply.  And mean reversion would suggest that over the next several years the US government may come to pay an interest rate two or three times higher than it does today.

 

The second observation I make is more technical in nature.  If you look very closely, one can see that the trendline over the past five years is essentially flat.  The great James Grant, whom I would follow into battle even if he were wrong just because he is such a great read, emphatically called a bottom on this curve in 2003 when the 10-year yield hit 3.1%.  Clearly he was wrong.  But a good market – and US treasuries were a good market – often gives you a long time to get out.  Let me follow up Mr. Grant by calling the post-Lehman 2.1% yield the second part of the yield curve’s “double bottom.”

 

The third observation is more fundamental in nature.  I am at a loss to explain why government bond prices are so high when the likelihood of eventual repayment (in real inflation-adjusted value terms) has rarely been as low.  The internet offers no shortage of treatises on the unsustainable debt of the United States and I shall not add to these here.  But my investigations into sovereign credit quality of Japan and Canada suggests that the other major sovereigns aren’t much better.  Add to this equation the fact that the largest purchasers of government bonds are not profit-seeking individuals but the governments themselves and it is hard to see how today’s bond market differs at a conceptual level from the sort of scheme being run by Bernie Madoff.

 

 

Figure 3: US 10-year Treasury Yield

Date	Yield to Maturity
Jan 1, 1960	4.72%
Jan 1, 1970	7.08%
Jan 1, 1980	12.64%
Jan 1, 1990	8.65%
Jan 1, 2000	6.02%
Jan 1, 2010	3.81%
Average during period	6.78%

 

 

Practically speaking, central bankers are equipped with the full policy arsenal available to a modern state.  Therefore, I doubt we will soon fall into a real take-to-the-streets economic crisis.  But playing Ben Bernanke’s role looks to me like trying to win a chess game against Bobby Fisher with only king and a pawn at one’s disposal.  We know what the outcome will be – rates will rise – the only question is when?

 

 

Investing Themes for Rising Rates

 

And what do we do as rates rise?  A rising interest rate environment is a different kind of investing landscape, but one with many identifiable opportunities that investors can exploit.

 

The first opportunity arises from the increased volatility that occurs in a rising rate environment.  The debts that get piled up when interest rates are low are harder for companies and their customers to bear when rates turn the other way.  For this reason it is worthwhile opening up long/short and option eligible accounts and being prepared to take significant short positions following rallies such as the one which has lasted from March to December of 2009.

 

The second opportunity is in long-term ownership of asset classes which perform well in a rising interest rate environment.  I have noted silver as a particular favourite, but commodities as a group possess characteristics which make them resilient in such circumstances.   Growth-type equities which, like commodities, are not valued off current yields should outperform equity indices now dominated by dividend payers.  I would not buy too many now, but these might be great investments to make in moments of turmoil.

 

Another successful strategy for a world with rising rates has simply been rolling over short-term deposits.  Remember, to win in investing, you don’t need to put up big numbers if others are making losses.  Short term paper will outperform long-bonds in a rising rate world and will also provide the flexibility with which to buy assets at opportune moments.

I recognize that the foregoing list contains very few of the well-loved and traditional components of most investor portfolios.  But in investing there are no permanent friends or enemies, just a persistent imperative to grow capital.  The music of interest rates appears to be changing.  Therefore, it is time for all good hedgehogs to adjust their dance steps.