You’ve seen the recent news about inflation, right?
If so, you know that the Consumer Price Index jumped by 0.6% in January. You know that it was the sharpest jump in three years. And of course you can do the math; if it continues at that pace, it would imply an annual inflation rate of 7.2%.
Meanwhile, I assume you’ve also been paying attention to what’s going on in the bond market.
If so, you know that the 10-year Treasury yield has risen by 73% since July of last year … has plowed past its critical peak levels of 2015 … and would still need to triple from current levels to reach 7.2%.
What you may not realize is that this kind of interest-rate upsurge has happened before. Ultimately, it nearly bankrupted the U.S. government. It drove the Fed to take drastic steps that no one ever dreamed possible. And it forced a Democratic president, in an election year, to deliberately precipitate a sudden contraction in the entire U.S. economy.
Hard to believe? Then read my diary of those exact events as I witnessed them in real time. Then, be sure to glean from them some of the most critical investor lessons of all.
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We pick up the story from last week, but first a quick recap. On August 15, 1971, President Richard Nixon announced a series of executive orders designed to reset global trade relations and create more jobs in America. At the time, however, he had no clue regarding the unintended consequences that played out over the ensuing years: The 13-fold surge in the price of oil. The 20-fold explosion in the price of gold. The worst consumer price inflation in U.S. history unrelated to a major war. And to our point today, the greatest-ever jump in bond yields of all time.
As you know, when bond yields are rising it means that bond prices are falling. Let’s say, for example, that you buy a $10,000 Treasury bond at par (price = 100), and that the bond pays you fixed interest of $300, or 3% per year. And let’s say that, after a big rise in interest rates, the Treasury offers new bonds that pay double the rate you’re getting — $600, or 6% year. If you want to sell off your old bond, how much will you get for it? Probably half of what you paid, or around $5,000 (price = 50). It’s logical. Because that’s what it will take for the $300 interest payment to give the new owner the same 6% yield being offered on new bonds.
This preamble is important because, when I recorded my diary, I refer to interest rate surges and bond price collapses interchangeably.
Back in the 1970s, why did rates rise and bond prices fall? Inflation was the most obvious culprit, and everyone who lived through those days remembers it as the cause of the bond market collapse. What most people didn’t realize then — and still don’t understand today — is this:
- Like in recent years, the Federal Reserve had been artificially suppressing interest rates below normal levels for most of the 1970s.
- Like in recent years, this Fed policy provided tremendous support to bond prices and created a big speculative bubble in bonds.
- Like now, as inflation rose, the Fed came under pressure to let rates rise; and as the decade of the 1970s progressed, that pressure intensified.
- Like now, despite the higher interest rates, life went on. Stocks rose. The economy grew. And investors made a lot of money. “As long as my stocks are going up,” they said, “who gives a damn?”
As the decade was coming to a close, however, bond investors began to take the bull by the horns. Unlike lobbyists, bond investors didn’t have to rush down to Washington and bang their fists on the desk of some faceless bureaucrat. Unlike PACs or super PACS, they didn’t have to spend billions on advertising to make their voice heard. To bring about a major reversal in government policy, all they had to do was pursue their own financial self-interest by uttering a single four-letter word: “SELL.” Sure enough, slowly at first, but with growing momentum as the years progressed, investors all over the world stepped up their selling of U.S. Treasury bonds and dollars.
That’s where my diary begins …
My Diary of the Biggest Bond
Market Debacle in U.S. History
Belgrade, October 1, 1979. Newly appointed Fed Chairman Paul Volcker has flown here to the annual convention of the International Monetary Fund. He has already made up his mind that, to persuade investors he’s serious about inflation, he must do something drastic. He will fight fire with fire. He will hike interest rates sharply. And most important, he will end the Fed’s practice of suppressing interest rates below normal market levels.
In Belgrade, he’s seeking support from West European central bankers to go forward with those dramatic actions, and they are 100% behind him. Their big concern is the plunging U.S. dollar. But it’s all part of the same story. The only way to support the U.S. dollar is to jack-up U.S. interest rates.
“No more half measures,” they say to Volcker. “No more tinkering here and there like your predecessors at the Fed. Unless you go all the way, we could see a dollar collapse that will make the 1977-78 debacle look like a picnic.”
Washington, October 6, 1979. After a sudden departure from the IMF meeting on Tuesday, Chairman Volcker has just announced a series of “Draconian bombshells.” He’s hiking the discount rate by a full percent. He’s imposing stiffer controls on short-term borrowings by U.S. banks. And most important, he’s shifting to an entirely new approach to monetary policy. Instead of focusing on controlling the price of money (interest rates), the Fed will focus on controlling the supply of money, and let interest rates rise as they may. In other words, he’ll let market forces — the supply and demand for money — determine what the appropriate interest-rate level should be. And at this juncture, that’s going to be much, much higher.
New York City, October 11, 1979. Eight years and two months after the Nixon Shock of August 1971, the true repercussions are now finally hitting home — and hard! Interest rates were like a pressure cooker, with the Fed holding down the lid tightly. Now, Volcker has released the lid and interest rates are exploding higher. Of course, when interest rates surge, the prices on older, lower-yielding bonds plunge. That’s why the price on 30-year Treasury bonds has cratered by 4% just in the last four days, a decline that’s being called the “Great October Bond Debacle.”
Teheran, November 4, 1979. A group of Iranian students, calling themselves the “Muslim Student Followers of the Imam’s Line,” have invaded the U.S. Embassy, taking 52 Americans hostage. Fears of another oil shock are sweeping the globe.
Kabul, Afghanistan, Christmas Eve, 1979. The Soviets have invaded Afghanistan. Washington responds with round-the-clock deliberations about rapidly ramping up defense spending and financing it with more bond sales.
New York, January 1980. Talk of a new cold-war economy, plus month-to-month price inflation running at an annual rate of some 18% are sending interest rates through the roof again as bond prices collapse even further. Will it be as bad as the Great October Bond Debacle that we saw last year in response to Volcker’s shock treatment?
New York, February 5, 1980. Yields on the longest-term U.S. Treasury bonds have just broken through the 11-percent level, the all-time peak last reached when our country was split in two, fighting the Civil War. Treasury bonds have lost 2.5% of their face value today alone. Traders are calling it “Black Tuesday.”
New York, February 6, 1980. Some panicky holders of bonds are willing to unload at almost any price, but there are few takers. Today, the flood of sell orders prompted all except four or five of the largest, best-capitalized Wall Street bond dealers to effectively “abandon their market-making role.”
New York, February 11, 1980. According to bond market pros, the most important interest-rate market in the world, the market for U.S. government securities, is perilously close to a meltdown. This is no longer just a collapse in prices. It’s a collapse in the market institution itself. The only two bond dealers that are still trading are Salomon Brothers and Merrill Lynch. Most of the others lack the capital to risk the losses they’re taking just by holding U.S. government bonds in their inventory. So they’ve effectively packed up and gone home. This is supposed to be the most-liquid market in the world. But everyone wants to sell. So there’s no liquidity. Dealers can’t even find buyers for lots as small as $5 million in Treasury bonds. If this continues, the government won’t be able to roll over its maturing Treasury notes and bonds, finance its deficit or even meet its weekly payroll.
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New York, February 14, 1980. The pressures on the U.S. government to take massive, further anti-inflationary actions are mounting by the minute. If Uncle Sam cannot find buyers for his bonds, he will have to declare bankruptcy, close up shop, and start a new government. Meanwhile, by some estimates, investors have suffered losses of at least 25%, or more than $400 billion. One source from a bank in the East says that, if he had to liquidate his holdings of Treasury securities, the loss would amount to more than $225 million, wiping out the bank’s capital.
Another source quoted in The Wall Street Journal puts it this way: “Unless those that brought us this disgusting inflation want to see a government, corporate and tax-exempt market worth $3.1 trillion and a mortgage market worth $1.1 trillion wiped out, it is clear they are going to have to do something such as much tighter monetary and fiscal policy. If that includes taking away the money that has made this sickening inflationary party possible, then we could have an awesome hangover.”
New York, February 19, 1980. The collapse continues to gain momentum, with the bond market reeling through “an even blacker Tuesday” as Treasury bonds lose about 4% of their face value in just one day alone. That surpasses the 2.5% plunge, which caused traders to refer to February 5th as “Black Tuesday.”
New York, February 21, 1980. Henry Kaufman, of Salomon Brothers, speaking before the American Bankers Association in Los Angeles, has just called for the declaration of “a national emergency.” On Wall Street, bond prices were initially a bit higher until, as one dealer explained it, “Henry K. at the A.B.A in L.A. touched off another steep market slide.”
New York, February 24, 1980. The bond market collapse is now three times worse than last year’s “Great October Bond Debacle,” and some bond experts are doubting our nation can survive it. Strangely, few Americans even know it’s happening.
Washington, March 14, 1980. If Fed Chairman Volcker thought his first round of Draconian measures would do the trick to end inflation, the last five months of bond market collapses have been a rude awakening. The markets have been sending the message that the cancer of inflation is far too advanced to be cured with a single treatment. So they’re demanding more.
In response, Chairman Volcker and President Jimmy Carter have teamed up to fight inflation with even bigger guns. He’s clamping down on credit cards. He’s imposing stiff reserve requirements on nonmember banks. He’s slapping all banks with a special 3-percent rate surcharge. He’s freezing all new money flowing into existing money-market funds. Plus more.
They’re calling this new package of super-Draconian measures “credit controls,” but it’s more than that. It’s a near-shutdown of the nation’s credit machine.
There ends my diary, but the drama continued. In the days after credit controls were announced, bond investors cheered. Bond prices enjoyed their sharpest rally of all time, as long-term bond yields plunged.
Meanwhile, short-term interest rates, which are the most sensitive to dramatic policy reversals, fell even more sharply; the interest rate on 3-month Treasury bills nosedived from 16% to 6% in a matter of weeks, its deepest and sharpest decline of all time.
Credit starvation was obviously great for bonds and interest rates. Trouble is, it was horrible for the economy, as GDP suffered one of its sharpest contractions of all time, dooming President Carter’s chances for re-election that year.
April 12th Crisis at White House
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But then, it was bond investors who got spooked, fearing that inflation would suddenly roar back. So they again dumped bonds in a panic and drove bond prices all the way back down to their all-time lows, while the 3-month T-bill rate zoomed right back up to 16% and beyond, its steepest and sharpest rise of all time.
Lessons for President Trump and Investors
Lesson #1. Thanks to the Fed’s continuing efforts to slow things down, the initial period of rising interest rates may not pose an immediate threat to stocks or the economy. Consumers can continue to spend. GDP can continue to expand. And stock investors can make a lot of money.
Lesson #2. Looking ahead, however, there’s one sobering fact of life that must never be forgotten: The longer the Fed suppresses interest rates below normal levels, the greater the ultimate interest-rate explosion.
Lesson #3. The Fed’s efforts to hold down interest rates since 2008 — with the largest money printing binge in U.S. history — makes the Fed’s “easy money” of 1970s seem ultra-conservative by comparison.
Lesson #4. Likewise, the bond market bubble that the Fed created in the 1970s was minuscule in comparison to the speculative bubble in bonds today. The full consequences may not be known until it’s too late to turn back the clock.
Good luck and God bless!