"Risky Business"
We're in Maximum Safety Mode: Here's why...
By Bill Bonner
Dublin, Ireland - "The US Empire can withstand moron presidents, a jackass Congress, and dumbbell Fed chiefs…but can it survive 5% interest rates?
We’re in Maximum Safety Mode. Here’s why. By our reckoning, the big sea change came in the summer of 2020. That is when the Primary Trend in the credit market – that is, the most primary of all trends in the financial world – changed direction. After a 40-year spell of rising bond prices (along with falling yields), the yield on the US 10-year bond finally hit bottom in July, 2020. Since then, bond yields are up…bond prices are down. In fact, it is the worst sell-off in the bond market ever seen. And it’s the strongest upswing in yields ever recorded.
Risky Business: The US 2-year note, for example, is the benchmark for short-term finance. On the last day of July, 2020, the yield was only 0.11% – barely one tenth of one percent. Today, it is over 5% – or 45 times higher.
When you can get 5% on two-year loans, it puts other investments in a new light. Adjusted for inflation, stocks are down 20% to 30% over the last two years. Why buy them? Who wants to risk another 25% loss? A five percent gain, guaranteed, takes the wind out of their sails…and sucks the credit out of their balance sheets.
Remember, the whole idea of lowering interest rates to absurd lows was to encourage investors not to save…but instead to put their money into risky ‘investments.’ Trouble was, with the real cost of capital thus obscured, the markets no longer imposed any discipline. A real interest rate – set by willing buyers and sellers of credit (lenders and borrowers) – is the only way to know whether you are making money or losing it. That interest rate – the going rate to borrow capital – is known as the “hurdle rate.” If your investment earns enough to pay the interest, it clears the hurdle. All is well. You, and by extension the whole world, get richer. But if you don’t clear the hurdle, you stumble…fall on your face…and real capital is consumed…used up…and lost.
When the Fed falsified the interest rate – in its crackpot effort to ‘stimulate’ the economy with fake money lent out at fake interest rates – it effectively knocked down the hurdle. Without it, there was no way to tell whether you were making money or losing it. The result? Money was wasted – on cryptos of no productive value…buybacks that only enriched shareholders while adding no productive capacity…zombie companies…and worst of all, on government “investments” that not only destroyed capital but also warped the whole economy, twisting it towards disastrous wars and economic meddling.
A Credit Crisis: You may say, ‘well…so what…the money wasn’t real anyway.’ True. But it was used to buy real resources…time…skills…that were squandered on silly projects. And these precious resources are, by the way, irreplaceable. Once you have used a gallon of gasoline…eaten a hamburger…or spent an hour of time…it is gone forever.
Now that interest rates are (barely) positive in real terms (after inflation) savers are once-again being rewarded and a hurdle, however modest, is back in place. But how do the zombies stay in business? They need to borrow just to keep the lights on. And what about the banks? They lent money at low rates…now, they’re being repaid at low rates, while customers expect to earn higher rates of interest on their deposits. US banks are said to be sitting on as much as $200 billion in losses. Four major banks have already gone broke. What about the rest of them?
It may be true – you never know! – that the economy can somehow muddle along towards higher interest rates and lower inflation. We doubt it. There is $307 trillion of debt in the world. Every penny represents a commitment by somebody to pay somebody else. And all of them made plans…and other commitments…based on assumptions that are no longer correct. They planned to refinance at 3%. Now, they must pay 6%...or 10%...or more.
We are describing a ‘credit crisis.’ When they changed the US dollar in 1971, the economy gradually became dependent on credit. Instead of paying for things with money they had already earned, people began to finance their houses, their cars, their dinners at TGIF, their corporate takeovers, their wars – everything – on credit. And when credit becomes harder to get and more expensive, there is a ‘crisis.’ And when investments go bad, the losses are not taken from past output…but from the future.
The Worsening Decline: Mortgages at 8% interest…cars at 10%...and business borrowing has shot up too; the Bank of America’s high yield index has more than doubled in the last two years. Bloomberg: "Junk Bonds Yielding Over 10% Hit $325 Billion, Tempting Investors."
The amount of double-digit yielding debt for investors to choose from in the US junk bond market has swelled over the last six months as higher borrowing costs and a weakening economy weigh on credit quality. Meanwhile, under the weight of higher interest rates, the whole capital structure begins to creak and wobble. Housing starts this year are at the same level they were in 1959. Business start-ups, too, are slipping. Bloomberg: "Venture Slowdown Hits the Earliest Stages of Investing, Signaling Worsening Decline."
The slowdown afflicting the venture capital and startup sector has hit the worst point of the last 18 months, new third-quarter data shows. Financings at the seed stage—the earliest chapter of startup investing and one previously insulated from the choppy environment—are slowing, a sign that the downturn is deepening."
And what about the biggest borrower of all – the US government? It is borrowing at the rate of $2 trillion per year. Three years ago, it would have paid less than 1% on a 10-year bond. Now, it’s 4.7%. For every debit, there is a credit. But not necessarily enough collateral. That is why we are in Maximum Safety Mode. We don’t know what will fail, or when – a bank, a company, a household? But we don’t want to be holding its I.O.U. when we find out."
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Joel’s Note: "We asked BPR’s investment director, Tom Dyson, to explain Maximum Safety Mode in simple terms in a recent Private Briefing. Here’s what he said…"That's a shorthand way of saying that we're on the sidelines. I was just thinking about 2020 and 2021 and just looking back over some of the things that we were talking about and that were in the news back then. It's easy to forget how crazy the markets got back then with blank check companies, for example. To think that people were propositioning investors with this pitch. “We don't know what we're going to invest in, but we're going to invest in something cool. Why don't you give us our money now and we'll take care of it?”
That was even a thing. Loans with negative interest rates and images of rocks selling for hundreds of thousands or whatever. So it was crazy. It was a true bubble. And then you overlay on to that, they've just jacked up interest rates the fastest that any of us have ever seen in our lifetimes. I'm not going to say the fastest ever, but who knows? I don't know what's going to happen. I'm not saying that there's going to be a market crash or that bad things are going to happen. I'm not saying that. I don't know that. I don't have a crystal ball. What I'm saying is I don't want to participate in this right now. I just don't want to. I want to be on the sidelines and I'm happy to watch. It's fun to watch, I love it, but I don't want to be on the field.
By the way, we're getting paid to watch. For the first time in many years there's actually a real interest rate on risk-free securities. So why not? Why not watch? To me, that's just a sensible position. And I'm a gambler. I'm into asymmetric risks and making... We weigh up all the probabilities of all the potential outcomes and then you try and figure out what's the best thing to do. I just can't get away from this that the best place right now is on the sidelines watching.
Let's just see how this new interest rate regime goes, this new inflation burst that we've just had. Again, for the first time in a long time, no one is making us invest. Why don't we just chill? I guess that's my main message and that's the main position and that's what setting the dial to maximum safety means. It's like, "Let's not take any risk just for the moment. Let's just wait." And so that's what I mean by that. It's a philosophical position of “let's wait and see.”
