February 13, 2008
In January of 2007, I wrote an article called “Ten Reasons Why Dollar Denominated Bonds Aren’t as Safe as You Think.” Here, I’m updating that same article, taking into account what has happened in the past year. Many people think of any type of dollar denominated bonds, whether they are U.S. corporate bonds or U.S. Treasury bonds as a safe place to park your money for reliable sources of income stream. In fact, the U.S. Treasury Department on their own website, even tout U.S. Treasury Securities as a “great way to invest and save for the future.” Many people believe this rubbish because they are advised of this by a horde of financial consultants that provide poor advice. Even today, I still read articles of money being moving into U.S. bonds as a “safe haven” given the continuing volatility in global markets. Many people think of U.S. Treasury bonds as safe because of the “federal guarantee”. The ten reasons below render that federal guarantee irrelevant.
(1) The often repeated financial consultant statement that bonds are a “safe place” to park your money, especially if you are older, is a myth.
Think of the losses of the U.S. dollar versus other major global currencies in the past two years. A greater than 8% decline against the yen (which is amazing given that the Bank of Japan had set interest rates between 0% and 0.50% during this time), an 11% decline versus the Pound Sterling; a whopping 19% decline against the Euro. If we look at emerging market currencies, the losses are just as pronounced. In just the past two years, the dollar has lost an incredulous 19% against the Thai Baht and almost 23% against the New Zealand dollar (I mention the New Zealand dollar and Thai baht because these currencies are commonly held currencies in Asian currency baskets offered by major banks as a hedge against the falling dollar). If you hold dollar denominated bonds with a 5% income stream and your dollars have lost 20% of purchasing power, are you really happy with a net 15% loss?
(2) Many of those in the retirement phase of their lives are convinced to invest in longer maturity bonds because of poorer yields of short-term bonds. As the Euro gradually replaces the U.S. dollar as the international currency of choice, the longer maturity necessary to ensure a return of face value on bonds presents a significantly greater risk.
(3) As interest rates go up, the face value of bonds go down, and vice versa. Right now, Wall Street strongly expects the U.S. Federal Reserve to continue slashing interest rates to try to save the faltering U.S. economy. Thus, the face value of bonds should rise, but so what? Despite the release of retail sales statistics yesterday that illustrated that Americans are continuing to spend money, I’ll tell you why this news is highly negative and not “positive” as it was spun by the investment industry.
Fact: According to the U.S. Department of Commerce, the savings rate in the U.S. was -.0.4% in 2005. The savings rate in the U.S. was -1.0% in 2006. The figures are not yet out for FY2007, but you can bet the bank that they are negative and look worse than the 2006 figures. The only other two years in American history when savings rates were negative were 1932 and 1933 during the Great Depression.
So this is why yesterday’s market rally will be short lived. Yes the rally may continue a little bit longer, but if it does, it will only continue because the thundering sheep herd is being misled by the spin doctors. The odds greatly favor U.S. markets continuing to pullback further this year and also dragging other global markets down with it. Retail figures were reported yesterday that Americans are continuing to spend, which given the reports above, can only be interpreted one way: Americans are going deeper into debt. This should have been a HUGE red flag, but instead, the markets rallied almost 200 points. The stock market cheerleaders came out in mass yesterday. RAH RAH RAH, Americans are still spending, despite being broke. This is GREAT news, they cheered! Yes, if it’s unbelievable to you that the investment industry believes this, it’s unbelievable to me as well. But this foolish media “spin” can not prevent a greater economic crisis that is firmly on its way from unfolding.
Furthermore, at some point and time, the U.S. Federal Reserve will try to block global flight from the U.S. dollar by propping up interest rates, not cutting them. Here you suffer twice. Once from a loss of purchasing power and twice, from a devaluation of the face value. See number (2) why holding a long term bond until maturity may not be an option. And even if the Federal Reserve keeps in line with Wall Street expectations, that’s bad news too.
4) As the dollar loses value over time, banks and other financial institutions will increase interest rates on loans and other financial instruments to compensate for the heavy losses they are incurring on a weakening dollar. As your costs of doing business and living rise, yields from bonds won’t cut it anymore.
(5) As the massive yen carry trade continues to unwind, which might not happen soon because the Bank of Japan is expected to keep its benchmark interest rate at 0.5%. Again, the fact that the dollar has lost value to the yen despite the “free yen” policy of the BOJ is downright scary. Last year, I wrote, “as every single major world currency pounded the dollar, the Yen was just about flat against the dollar. In the coming year to eighteen months, it will be the Yen’s turn to pound the dollar.” Despite the fact that the BOJ maintains a free yen policy and primarily due to an unwinding yen carry trade, the yen appreciated from 125 yen to the dollar to about 108 to the dollar today. A 14% increase in strength. Again, scary.
(6) While most people think that there has been no further attack on the U.S. by terrorists since 9/11, there has been a far more devastating ongoing attack – an ongoing economic war. Though this fact is not discussed at all in the mainstream media, Osama bin Laden has repeatedly stated that his number one goal is to topple the U.S. as an economic power. The attacks on the Twin Towers were symbolic of that goal. However, if he achieves his goal of debilitating the U.S. economy through the draining of U.S. resources in the current prolonged war in Iraq, this would make him far happier than any overt attack he could accomplish.
So far in this economic war, the Iraq war has been estimated to cost U.S. taxpayers as much as $2 trillion dollars with at least another $1 trillion in expenditures before any troop withdrawal can realistically happen.
(7) In response to (6), the U.S. Federal Reserve has expanded the dollar money supply to provide funding for the war. With no end in sight to this war, we can expect the dollar money supply to continue to expand, therefore placing more downward pressure on the dollar.
(8) The U.S. has no powerful allies to keep the dollar strong. With protectionism sentiment stronger among the newly elected Democratic U.S. Congress in 2007, the U.S. certainly has no friends in China, the largest holder of dollar denominated debt at over $1 trillion. Certainly when the U.S. Congress moved to block the Chinese state-sponsored bid for U.S. oil giant Unocal because they viewed such an acquisition as a threat to national security, the Chinese government certainly viewed this action as hostile to their business interests. Now, the Chinese government is moving lots of money from their central bank reserves into a much more private Sovereign Wealth Fund, in chunks of $200 billion at a time. This I believe is an effort to keep quiet their continuing efforts to convert devaluing dollars into real hard assets. Yes, the “nuclear option” as China’s dollar policy decisions are referred to, is still on the table.
(9) The largest holders of Petrodollar reserves include Russia, Venezuela, Iran and other Middle Eastern countries. Read that list again. There is not a single nation strongly friendly to the U.S. on that list. Officially, the Gulf Nations pledged at the end of 2007 not to decouple their currencies from the dollar. If you are as naïve as to believe that “official” pledge, go graph the currencies of the Gulf Nation against the U.S. dollar. In the past two months, you will observe radical strengthening of some Gulf Nation currencies against the dollar. If they were really keeping their currencies pegged to the dollar that means that their central banks would be slashing interest rates in line with the U.S. Federal Reserve. These FX charts show a different story.
(10) When people finally realize that (1) through (9) are true, there may be a flight from the bond market, causing bond prices to tumble.
Lastly consider this. I expect all major currencies to fall this year. The ECB eventually has to cut interest rates as the U.S. Feds large interest rate cuts has forced their hand. The intrinsic value of all paper currencies is zero. If the dollar is reported as rallying against the Euro, it will only mean that the Euro is devaluing faster than the dollar for the time period that is being reported, or vice versa. In the past two years. Despite the enormous appreciation of other major currencies against the U.S. dollar, the performance of gold and silver has blown the performance of all fiat currencies out of the water. Gold has appreciated by 71%, and silver by 91% against the dollar in just the past two years. This is because gold and silver are real currencies while all paper currencies are backed by nothing and have intrinsic values of nothing. So yes, I will continue to view money that pours into dollar denominated bonds as the “stupid” money and not as money that has found a “safe haven”.
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J.S. Kim is the founder and Managing Director of maalamalama, an investment consultation company that teaches investors how to make a fortune from the coming global economic crisis.[tags]gold,silver, U.S. Treasury bonds,currency trading,dollar crash, dollar crisis[/tags]
