As you know, I would not touch bonds with a barge pole, especially government bonds. After 40 years of unending fiat money expansion, the world suffers from excess levels of debt. A lot of this debt will never be repaid. My expectation is that the market will increasingly question the ability and the willingness of most states – and that, crucially, includes the big states – to control their spending and to shed their addiction to debt financing.
What happens to high-spending credit-dependent states when the market loses confidence in them has been evident in cases such as Ireland, Portugal and Greece. Among the big financial calamities of 2011 were notably government bond markets. Perversely, some of the big winners of 2011 were also government bond markets. As I explained here, market participants have so successfully been conditioned to believe in state bonds as safe assets that when some sovereigns go into fiscal meltdown it only serves as reason to buy even more bonds of the sovereigns that are still standing, even though their fiscal outlook isn’t much better. While the fate of Greek and Italian bonds should have cast serious doubt over the long-term prospect for Bunds, Gilts and Treasuries, it only propelled them to new all-time highs. Strange world.
All policy efforts are now directed toward keeping the overextended credit edifice from correcting. After decades of fiat money fuelled credit growth, the financial system is in large parts an overbuilt house of cards. What the system cannot cope with is higher yields and wider risk premiums. Those would accelerate the pressure toward deleveraging and debt deflation and default. “When they stop buying bonds, the game is over.”
They still bought bonds in 2011
2011 was another strong year for gold. Despite a brutal beating in the last month of the year, the precious metal produced again double-digit returns for the year as a whole if measured in paper dollars: up 10 percent. I believe that gold will continue to do well, as it remains the essential self-defence asset.
Amazingly, Treasuries did almost as well (+9.6%) and TIPS (inflation-protected Treasuries) did even better. German Bunds benefitted from the disaster in other euro bond markets, and they pretty much matched Treasuries in terms of total return (currency-adjusted they did less well as the euro declined slightly versus the dollar). I believe this is entirely unjustified because the EMU debt and banking woes will put considerable additional strain on Germany’s public finances. UK Gilts did better than gold and Treasuries, despite rising inflation in the UK, weak growth and a public debt load that is only ever going one way: up.
I do not believe that this can go on for long. Bonds are fixed rate investments with finite maturities. The price gains of 2011 have lowered the yields to maturity, in some cases markedly so, and thus diminished the chance of additional gain. Does that mean reversal is imminent? No. Maybe the notion, or better the myth, that the bonds of the United States, the United Kingdom and Germany are risk-free assets can somehow be maintained. Maybe yeileds can decline even further. Who knows? Personally, I doubt it.
I have long maintained that government bonds are a bad investment because the endgame for them will either be outright default or inflation. In both cases, as a bondholder, you lose. To be precise, the outcomes are either default or default. The idea that these debt loads could be elegantly inflated away is nonsense. They are already too big for that. So either you face outright default or, if authorities try to inflate, hyperinflation and currency disaster, and then default. In either case, you will not be repaid with anything of real value.
As I stressed many times, in a state fiat money systems banks must ultimately cease to be private, capitalist enterprises. Many banks have already been fully or partially nationalized. The remaining private ones are under tight, and ever tighter, regulation by the state. Should it not be easy for the state to force banks to invest more in government bonds, even at low or negative real returns? Should it not be possible to redirect whatever saving and credit there is from the private to the public sector?
Such a strategy has been outlined – not advocated- by Russell Napier of CLSA. He calls it ‘repression’. It ultimately involves rather draconian market intervention in order to continuously force the diversion of capital from private use to public use at artificially low levels of compensation. At some stage it will require capital controls. But let’s face it: most of what we have experienced over the past three years in terms of government intervention would have been simply unimaginable only five years ago. We should therefore not be surprised if market intervention becomes ever more heavy-handed and is used increasingly to favour the funding of the public sector. Gillian Tett in one of her recent Financial Times articles also discusses the strategy of ‘repression’ and predicts that we will see more of it.
‘Repression’, to the extent that it succeeds in shifting resources from the private market to the state, makes the crisis worse. It must lead to more debt, more capital misallocation and a weaker economy. We will not save our economy by trampling on the remaining bits of functioning capitalism and by confiscating more resources from the private sector. ‘Repression’ is self-defeating.
Additionally, it won’t work. Private wealth-holders will not sit on their hands forever while their hard-earned savings are being confiscated by the state. If banks become mere tools to fund the state and thus provide zero or negative real returns to shareholders and depositors, shareholders and depositors will pull their money from the banks.
But there are no alternatives for the depositors, are there? Of course, there are: Gold.
As the enemies of gold in the establishment financial press never tire of reminding us, gold pays no interest and no dividend. Because of storage and insurance costs, it is a ‘negative carry asset’. But in an environment of ‘repression’, so are government bonds and bank deposits. With zero or negative returns guaranteed on supposedly ‘safe’ government bonds and bank deposits, ever more investors, including small savers, will turn toward gold which has the additional advantage that its upside is practically unlimited – its price can double, triple or quadruple (all of which I expect) as long as paper money debasement continues, which I consider a near certainty.
Of course, a determined state will counter any evasion of controls with more controls. Maybe we will see taxes on gold investment or even restrictions on trading and owning gold. Via capital controls the country could be locked down. All of this is, of course, hugely destructive for the economy and ultimately self-defeating. I expect that we will see quite a bit of this stuff in coming years. Try and be prepared! But this will not be part of the solution. It will make matters worse. And it means that the endgame is still either voluntary default or hyperinflation and default. ‘Repression’ or ‘nationalization of money and credit’ is a policy of desperation. It is not a solution. It won’t be the endgame.
The greater fool theory
At the present juncture, any investment in government bonds requires that you adopt the ‘greater fool theory’. You must believe that there is always some greater fool out there to buy the bonds of you when you want to get out.
The government bond market is still skating on thin ice – and so is the entire financial system.
In the meantime, the debasement of paper money continues.