What We Don't Learn From History… IS THAT WE DON’T LEARN FROM HISTORY!

Take One:
By Troy Flowers

 WHAT WE DON’T LEARN FROM HISTORY… IS THAT WE DON’T LEARN FROM HISTORY
 
This profound quote is from none other than famed investor Warren Buffet.  What we have here in the US is that we have not learned the dangers of trying to tamper with the bond market.
 
The question is what is the “bond market?” Affluent investors tend to own individual bonds. Most average investors have bonds in their portfolios via bond funds.  But most really do not have an idea what bonds do. I will give you a very brief introduction to bonds - specifically government bonds.
 
When the government wants to fund a project but doesn't have the political courage to raise taxes on the citizens - it issues bonds (another word for debt). They basically borrow the money that it needs to pay back (eventually). There are a couple of important aspects of bonds:  the bond price and bond yield. Very simply bond prices are how much you pay to purchase a bond.  Bond Yields are the rate of return an investor gets from investing in a bond. They are inversely related, which means when the bond prices go up then yields go down and vice versus. Even though the stock market and the Dow often command more attention from the media, the bond market is actually many times bigger and is more vital to the ongoing operation of the public and private sector. Thus, when a country’s bond market falters then that the country can go bankrupt. The bond market debacle in Russia is an excellent example of this.

This crisis occurred in August of 1998. What were some of the the root causes? Declining Productivity and the cost of the first war in Chechyna (approximately $5.5 billion). More importantly, Russia  had chronic fiscal deficit problems and artificially high fixed exchange rate. One of the key points is that they had an “artificially high fixed exchange rate.” This means that the Russians thought they had to prop up the currency or keep the value of their currency high to keep investors from taking their money elsewhere .  The Russian finance minister actually hiked rates to 150%!  The problem was that they had to pay interest payments at 150% to the debt holders who held Russian paper. It got so bad that the IMF and the World Bank was forced to step in and issue a $22.6 billion bailout. It was helped but the Russians did not want to abandon its support for the Ruble. The Russians then adopted a floating peg. Which meant if the Ruble fell below a certain range then the central bank would step in and buy the Ruble keeping it propped up.  If the Ruble got too strong then the central bank would sell the Euro.

This resulted in an erosion crisis and investors dumped the Ruble and Russian securities.  This drove the value of the Ruble down. The central bank then tried to spend its reserves to defend the Ruble but that just made matters worse and further eroded investor confidence.

Eventually, on the 13th August 1998 the Russian stock, bond and currency markets collapsed!  From January to August 1998 their stock market lost 75%+ of its value.
 
So what does that have to do with us? A whole lot...
 
Our Federal Reserve is trying to do what the Russians did BUT in reverse. Instead of trying to prop up our currency, the Fed is trying to purposely devalue the US dollar ( i.e. QE 1, QE 2 and Operation Twist) by holding interest rates down. The problem is that very soon US bond investors will realize inflation is NOT 2% like the Fed wants us to believe.  Right now bond yields are at a dangerous low rate of  1.7%.  According to famed economist and author Peter Schiff, interest rates over the last 40 years have averaged 7%.
 
Investors will soon be unwilling to accept a 1.7% rate (or less) anymore and they will demand a higher rate of return for us to use their money. This means the US government will have 7% (for example) interest on +$14 Trillion dollar debt. In addition, investors who hold US paper will see the value of their bond holdings drop like a bad habit as interest rates soar.  As a result, those investors will take (as Wall Street insiders like to call) a severe “haircut.”  This is the problem in countries like Greece, Italy, Portugal and Spain.
 
In the last 13 years let us see what financial history has shown us…:
 
The Russians tried to manipulate the bond market in the late 90’s and it not only didn’t work they nearly went bankrupt. 
 
The US tried to control the bond market/interest rates and artificially pushed interest rates to low levels from 2002 to 2008.  We created a housing bubble that imploded in 2007-2008 and our economy nearly collapsed.
 
So now what’s the new solution to get our economy back on track?  Drum roll please…
 
Drive interest rates EVEN lower?? Really?? (Scratching my head)
 
Didn’t Albert Einstein once say the definition of insanity is doing the same thing over and over again and expecting different results? But hey, what does Einstein know?

So what do we think will happen when this bond bubble collapses? Well, to borrow a great line from the movie 300: “This will not be over quickly. We will not enjoy this.”