FIGURE 7.3 The United States’ Cumulative Debt Is Below Historical Highs
Sources: Office of Management and Budget, Congressional Budget Office
The three years shown in Figure 7.3 are the extreme points of their eras. During World War II, the United States ran up enormous debts. By 1946, just after the end of World War II, the U.S. federal debt had risen to 122% of the overall economy. Using the current projections, the most extreme figure over the next decade will occur in 2011 when the U.S. federal debt is projected to reach 74% of the size of the overall economy. Not only is this figure far below World War II levels, it is not substantially different from where we stood in 1996.
When we move from the cumulative federal debt to the annual budget deficit, the current projections look even better. While $600 billion is an enormous sum, when scaled against the size of the economy, our current deficits are tiny compared with those during World War II. Figure 7.4 shows the annual deficit as a percentage of the overall size of the economy for a few selected years.
In 1943, the government’s one-year deficit exceeded 30% of the overall economy! The CBO projects that over the next decade, 2004 will have the largest deficit when measured against the size of the economy. The projected 2004 figure of 5.6% of GDP is smaller than the 6.0% of GDP figure that occurred in 1983 (the largest of the Reagan era deficits).
FIGURE 7.4 The U.S. Annual Deficit Is below Historical Highs
Sources: Office of Management and Budget, Congressional Budget Office
Is it possible to have $500 billion deficits as far as the eye can see without harming the economy? The answer appears to be a resounding yes. In fact, throughout the early 1980s, the United States ran large deficits every year while the economy prospered. Specifically, in spite of large deficits, interest rates fell during the 1980s. While we can’t know what would have happened in the 1980s with smaller deficits, the U.S. economy seems able to handle deficits in the range of 5% of the size of its economy.
So what is the likely effect of deficits on interest rates? With current projections, the deficits look to provide some upward pressure on interest rates but with no cause for panic. The projected U.S. federal deficits and debt are well within historic ranges. The key will be to watch as the deficit and debt figures change. If annual deficits and cumulative debt swell beyond current projections, they could cause interest rates to rise substantially.
Three Ways to Lose Money in Ultra-Safe U.S. Government Bonds
The federal government deficit, as currently projected, does not seem to spell doom for bonds. Those who argue that the deficit will cause problems have been making their bearish case for decades. In fact, Professor Tobin’s quote regarding the crowding out effect was made in 1986. Eighteen years later, Alan Greenspan said, “One issue that concerns most analysts, especially in the context of a widening structural federal deficit, is inadequate national saving.”5 Those who fear that the large U.S. federal deficits will eat up all the available savings might eventually be proven right, but there is no evidence of a problem yet.
Even though U.S. government bonds are among the safest investments in the world and there is no imminent risk from deficits, there are three ways investors can lose money: (1) You never get your money back, (2) you get worthless money back, or (3) you get much less money back than alternative investments.
Bond Risk #1: Government Default
The most extreme risk is that the U.S. government defaults on its bonds. Many corporations and other countries have defaulted on their bonds. It is almost impossible to imagine the U.S. federal government defaulting. In the most extreme circumstances, annual U.S. government deficits could reach trillions of dollars. Even in such circumstances, the government has unlimited ability to create dollars so there is essentially no risk of default.
A U.S. government default is almost impossible. Those who worry about such a default ought to be investing heavily in items such as guns and food. I am not saying that it is impossible for the U.S. government to default on its bonds, just that this is extremely unlikely, and if it happens we will have much more to worry about than our investments.
Bond Risk #2: Inflation
The second risk to bondholders is that they will be repaid but that the dollars they are repaid with might be able to buy very little. On this subject, the science fiction legend Robert Heinlein (author of Starship Troopers, Stranger in a Strange Land, and many other classics) wrote, “$100 placed at 7 percent interest compounded quarterly for 200 years will increase to more than $100,000,000—by which time it will be worth nothing.”
We already covered the risk of repayment with worthless dollars in the inflation discussion. As of right now, there is no sign of dangerous levels of inflation in the United States. Nevertheless, the risk exists and is one of the most serious risks for bondholders.
In most circumstances the interest rate on government bonds exceeds the inflation rate. While this has almost always been the case in the United States, the amount of cushion—the difference between interest rates and inflation—has varied dramatically. Figure 7.5 shows the interest rate on the 10-year U.S. Treasury bond minus the rate of inflation.
FIGURE 7.5 Interest Rates Adjusted for Inflation Are Extremely Low
Source: Federal Reserve, Bureau of Labor Statistics
The extra return on bonds above inflation has been decreasing for the last 20 years. The 1983 bond investor received 7% above inflation while the 2003 investor received only 1% above inflation.
In comparison to current inflation, bond buyers today are getting the worst deal they have had in decades.
Bond Risk #3: Opportunity Cost
In 1989, I was the chief financial officer of Progenics Pharmaceuticals, a start-up biotech company (now publicly traded with the stock symbol PGNX). For no good reason related to my job, I wrote an analysis of the RJR-Nabisco leveraged buyout. The Wall Street Journal published a short version of my analysis as an editorial.6
One of the consequences of this article was an invitation to give my first lecture at Harvard. I was honored by the request so I flew to Cambridge to present my analysis. How did my first Harvard lecture go? The short answer is that it went amazingly poorly. Early in the lecture, I asserted that RJR-Nabisco bondholders had lost $1 billion because of the leveraged buyout. My calculation simply added up the loss on all RJR-Nabisco bonds as quoted on bond markets on the day the deal was announced. (These bonds traded actively so it was easy to get an accurate measure of how much the price dropped because of the buyout announcement.)
A student objected by saying that the bondholders had lost nothing. She argued that the RJR-Nabisco bondholders were still going to get all their money back. Accordingly, she said that the current price of the bonds was irrelevant. I tried to argue against this view, but it was shared by most of the students. After about 20 minutes of incoherent verbal flailing, the professor had to intervene and say, “Please, let’s just assume that Terry is right and move on.” This intervention allowed the lecture to continue, but obviously I had lost all credibility.
Let’s view this issue in the context of a $1,000 investment into a 10-year U.S. Treasury bond. Assume that the bond is bought with an interest rate of 4%. The purchaser gives the government $1,000. In return, the government promises to pay $40 a year for 10 years, plus return the original $1,000 at the end of the tenth year.
Now let’s consider what would happen if, soon after the purchase, interest rates on 10-year treasuries jumped from 4% to 6%. What would happen to our investor? The investor owns a bond that still promises to pay $40 a year for 10 years and to return the $1,000 upon maturity. From this perspective, the bondholder doesn’t appear to have lost any money (this is the student’s argument from my lecture). On the other hand, the rise in interest rates means that the market price of the bond would have dropped by $150.
So how much money would our bondholder lose? Is it $0 or $150 or something else?
The economist’s answer is that the bondholder
would lose the full $150 even if the government makes all the payments as promised. Where does the loss come from? The loss is caused by the change in the “opportunity cost.” By investing at 4%, the bondholder has lost the opportunity to earn 6% on the $1,000. And these are not simply losses on paper, these are real dollars that the investor could have in his pocket but never will.
In my first Harvard lecture, and many since then, I have learned that opportunity cost is a difficult concept to grasp. Even highly trained people who understand the idea tend to overlook opportunity costs.
While the opportunity cost in financial terms is often misunderstood, in other areas of life it is clear. A famous—and almost certainly fake—wedding toast goes as follows: “Sometimes at rare moments in human history, two people meet who are meant to be together forever. When such romantic lightning strikes, I hope that the bride and groom have the strength to say, ‘I am sorry, I’m already married.’ ”
For those who are unwilling to divorce, the opportunity cost of marriage is the forgone opportunities with other potential mates. A similar theme is revealed in stories of a mythical culture where women were allowed to have up to three husbands, but where divorce was banned. It was said that women in this culture almost never had a third husband, and when they did, he tended to be extremely handsome. By some calculations, the third husband has the highest opportunity cost in this marriage system because he rules out all future possibilities.
So the bondholder who locks in a 4% interest rate for 10 years loses when the world changes to provide opportunities for 6% investments.
How Low Can Interest Rates Go?
U.S. bonds have had a 20-year run. When will interest rates begin to rise, thus ending the bull market in bonds?
Predictions, particularly of the future, are tough. (Economists have a nearly unblemished record for predicting the past.) The most famous wrong prediction of an economist is probably Yale Professor Irving Fisher’s quote that “Stocks have reached what looks like a permanently high plateau.” Professor Fisher made this sanguine statement in October 1929 just before the stock market collapsed by 90% and the Great Depression began.
Professor Fisher was, by some accounts, the world’s most famous economist and he made his remarks at precisely the wrong time. This is amazing, but not too different from the record of many economists.
One of my neighbors is a meteorologist (and don’t call her a weather lady) for one of the Boston TV networks. She’s a bit of a celebrity in the area. I see her from time to time in our building’s elevator, and my running joke with her has two themes (neither of them are at all funny). First, I blame her for bad weather and thank her for the occasional nice day. Second, I tease her for forecasts that often miss the mark. Actually, I used to tease her; once she found out that I am an economist, the teasing had to end.
Although their failures are usually less spectacular than those of Professor Fisher, many seers in many fields have missed the mark by similarly wide amounts. Some decades ago I read an article arguing against immigration into the United States. The article said, look we’re all immigrants here in the United States (even Native Americans arrived only 15,000 years ago), but enough is enough. The country is finite and filling up. It’s just common sense that the United States can no longer accept huddled masses upon its teeming shore.
The punch line was that this anti-immigration piece had been written hundreds of years ago when the country was empty by modern standards. By reprinting the article the newspaper was arguing in favor of immigration.
There are two ways to be wrong in making predictions. Irving Fisher was wrong to predict no end to the trend that prevailed in the roaring stock market of the 1920s. In my experience, it is even harder to predict turning points in powerful trends. This was the mistake of the original author of the anti-immigration piece who thought America was overpopulated hundreds of years ago.
When will the bull market in bonds end? In spite of the hazards of predicting market turns, I have a clear answer: The bull market in bonds will end soon, maybe not today, maybe not tomorrow, but soon and for the rest of your life. Actually, that’s Humphrey Bogart’s line as Rick near the end of Casablanca. While prospects are not quite so bleak for bonds, the bull market has largely run its course.
How low can interest rates go? The historical answer is that interest rates can move substantially lower. In the Great Depression, the interest rate on some U.S. Treasury debt fell to 2 basis points (that’s 0.02%!). At this rate, a year’s interest on $100 is two cents! At around the same time, the interest rate on 3- to 5-year Treasury notes was under 1%.7 Similarly, Japan has had interest rates below 1% on some of its government debt in recent years.
Even the current low interest rate on U.S. treasuries isn’t the lowest possible. Rates can go significantly lower. They cannot, however, go below zero. That may seem obvious, but the proof is actually a bit subtle. Would you give the U.S. government $100 in order to receive $99 back in a year? The obvious answer is no. A far better alternative would be to put the $100 in a safety deposit box and thus still have $100 in a year.
The cost of storage is the key to understanding the lower bound on interest rates. In our society we can store money safely at very low cost. Thus, we can always get at least $100 back in the future for $100 stored away today.
Consider the very different storage world of a squirrel. Squirrels bury food in good times and hope to retrieve some of it in bad times. On their acorn investments, squirrels always accept negative interest rates. When a squirrel saves 100 acorns by burying them, it always receives fewer than 100 acorns back upon retrieval because some have decayed or been eaten by other animals. If a squirrel buries 100 acorns and later eats only 80, it has just accepted an interest rate of negative 20%. Squirrels must accept negative interest rates because they have no better storage options.
Modern industrial societies have highly secure, low-cost storage options for money. A safety deposit box that is rented for a few dollars a year can hold a lot of cash. Thus, unless one fears a breakdown of civilization, interest rates cannot go below zero. No one is going to accept a promise of less than $100 for an investment of $100. The fact that interest rates cannot go below zero means that the majority of the bull market in bonds has already occurred. To be precise, interest rates have gone from above 12% to below 4% in the last 20 years. That means we’ve already seen at least two-thirds of the entire bull market in bonds.
Buying Bonds at the Wrong Time
The bull market in bonds that began in the early 1980s has largely run its course. The majority of possible profits has already been made. This does not mean that bonds are bad investments now, but it does mean that they cannot be fantastic investments.
It is easy to calculate the maximum returns on bonds. Consider our $1,000 investment in a 10-year Treasury bond at 4% per year. How much can our bond buyer make? If interest rates went to their theoretical minimum of zero, the bond would jump in price from $1,000 to $1,400. So the absolute maximum gain on the 10-year Treasury bond is 40%.
Recall that in the early 1980s, I ignored the advice to buy the Reagan bonds. Other investors apparently shared my view. The data on investments into bond mutual funds reveal that investors really started loving bonds only when the stock market tanked in the last few years. In fact, bond mutual funds took in all-time record amounts in 2002.8 This appears to be another example of investors being completely out of sync with investment opportunities. Bonds were an amazing opportunity in the early 1980s, but by the time investors got really excited about bonds, the majority of the bull market in bonds was over.
In the mockumentary This Is Spinal Tap, Rob Reiner plays Marti DiBergi, a filmmaker touring with the world’s loudest band. In perhaps the most famous scene of the movie, Nigel Tufnel (played by Christopher Guest) reveals the band’s secret. Spinal Tap is the world’s loudest band because their amplifier “goes to eleven” and not just to 10.
DiBergi asks, “Does that mean it’s louder? I
s it any louder?”
Nigel responds, “Well it’s one louder. Isn’t it? It’s not 10. You see, most blokes are going to be playing at 10. You’re on 10, here all the way up, all the way up, all the way up. You’re on 10 on your guitar. Where can you go from there? Where? . . . Nowhere. Exactly. What we do, if we need that extra push over the cliff, you know what we do?”
DiBergi offers, “You put it up to 11?” to which Nigel responds, “Eleven, exactly, one louder.” Puzzled, DiBergi asks, “Why don’t you just make 10 louder and make 10 be the top number, and make that a little louder?” After a stunned silence, the scene ends with Nigel saying, “These go to 11.”
The new version of the Oxford English Dictionary includes “goes to eleven” to mean to put to the maximum volume. The majority of the bull market in bonds is over because, metaphorically, bonds cannot go to eleven. Where can you go from a 4% interest rate on the 10-year Treasury bond? Nigel Tufnel would respond with “nowhere.” So perhaps bonds in this environment are not for wimps, but rather for risk-takers.
Mean Markets and Lizard Brains Page 17