Last week, I told you about my father’s success in buying and recommending gold bullion and shares in the early 1930s, just months before one of their greatest rises of all time.
This week, he tells you, posthumously, about one of his failures — he missed a major move in a market that most people don’t pay enough attention to …
The Interest Rate Explosion of the Early 1930s —
Why It Took Me Completely by Surprise
by Irving Weiss (1908 – 1997)
When I first studied interest rates in the late 1930s, the going theory was that they were tied to inflation. When we had more inflation, interest rates would go up. When we had less inflation or actual deflation, interest rates would fall.
True most of the time? Perhaps.
But nobody looked at interest rates as being separate from inflation, and neither did I.
Boy, was I in for a big surprise! In fact, just as I began to watch interest rates more carefully, every single thing I had read about interest rates went by the wayside.
Interest rates had fallen sharply during the stock market crash of 1929, which was to be expected. Then something absolutely astounding happened. Although we were still experiencing deflation, although the economy was still sinking, interest rates began to surge dramatically.
The immediate reason: Bond markets collapsed.
To understand why, consider this example: In 1929, an investor puts $1,000 in a General Motors bond paying 3 percent per year, or $30 interest. But after the crash, fearing that GM might go broke, he sells the bond for $500. Since it’s still paying 3 percent a year, the new buyer now is making $30 per year on a $500 investment, or 6 percent! So as the bond price fell in half, the current yield doubled!
But when I saw interest rates surging, I didn’t understand the cause. Was it inflation coming back? Did I read the textbooks upside down? That’s when I began to look at interest rates as a powerful fundamental force in their own right.
The yields on low‑grade corporate bonds were the first to surge as their prices plunged. It was like an aftershock from the stock market crash, but with a long lag.
This made sense because these were bad bonds. They were issued by companies defaulting on their payments. A lot of the companies simply ceased to exist. So it was natural that their bonds should become worthless.
Their yields went to 15 percent, 20 percent, 30 percent. But what good was it if you lost your principal?
Then high‑grade corporate bonds also got hit hard. Investors feared that any company — regardless of rating — could go belly up, and they were right!
At some companies, finances deteriorated so quickly that, by the time the analysts got around to downgrading them, it was too late. Amazingly, high‑grade corporate bond yields surged past their pre‑crash highs as their prices crashed.
Someone was selling the hell out of them. But who?
You’d think that at least Treasury bonds would be protected from this selling panic. They weren’t. Investors sold them aggressively, driving their prices to new lows, just like the corporate bonds. Yields surged.
Where was all the selling coming from? What drove interest rates up when every textbook in existence said they should be going down?
It wasn’t until years later that my brother Al and I began to put it all together. To understand what was going on, we had to throw all the traditional theories about interest rates into the trash can. We had to forget about inflation, deflation, money supply and the Federal Reserve.
Instead, we looked at bonds like any other kind of investment — no different from stocks or commodities. When investors sold them, they went down in price. When investors bought them, they went up.
These investors didn’t give a hoot about textbooks. All they cared about was the fact that they needed cash. The banks needed cash to meet huge demands for withdrawals. Businesses needed cash to pay bills. Insurance companies needed cash to pay claims. So they went to their financial VPs to dig up something they could sell off for cash.
“What’s this?” they asked.
“They’re bonds, sir,” came the answer.” They’re solid investments — not like stocks.”
“Can you sell ’em?”
“Sure we can. But bonds are good for bad times. You shouldn’t be selling them now because …”
“I don’t give a damn if they’re good, bad or in‑between. Sell ’em. Raise cash!”
Thus, tremendous amounts of bonds were dumped on the market. High‑grade bonds. Low‑grade bonds. Muni bonds. Treasury bonds. It didn’t matter what color or denomination. Everywhere, financial institutions and businesses were getting rid of their bonds.
If they were low grade or on the verge of default, they got no more than pennies on the dollar. And even with higher grade bonds, many investors were simply throwing the baby out with the bath water, driving prices to new lows (yields to new highs).
I asked some of my business clients why they wanted to sell bonds. They talked about “inflation coming back,” about the danger of “reflation,” as they called it.
But later, I realized that inflation was just an excuse. The real reason they sold the bonds was because they needed the cash.
Everyone was scared of bonds, including myself. I hadn’t yet figured out why it was happening, so I just stayed away. How unfortunate, because that turned out to be one of the best possible times to buy bonds.
Fast Forward to the 1970s
Throughout most of the 1970s, I waited for someone in Washington to tame the nation’s growing debt and tackle inflation. Nothing was done.
The dollar continued to sag. Then it collapsed. Between early 1977 and late 1978 — within less than twenty‑four months — the dollar plunged from nearly 300 to 175 against the Japanese yen, from 2.4 to 1.8 versus the West German mark, and from 2.5 to 1.5 vis‑à‑vis the Swiss franc.
It was the sharpest drop in American currency since the collapse of the Continental Currency precisely two hundred years earlier.
Still, most people in Washington didn’t seem to care. They just didn’t understand how vital it was to maintain a strong currency, how dangerous it was to let it fall.
They didn’t understand its potential impact on the bond market, the stock market and even our national security. Years earlier, I would have done something about it. I would have organized a grassroots campaign.
But now, I could do nothing. This was frustrating to me. I just watched with great angst as the dollar was totally neglected.
It wasn’t long before the consequences began to hit home.
In 1979, OPEC threatened to refuse payment for its oil in dollars. Commodity prices were surging. Inflation was about to take off into high double‑digit territory. Unless something was done immediately, our country was on its way to becoming the equivalent of a banana republic.
At the 11th hour, on October 6, 1979, the newly appointed Fed Chairman, Paul Volcker, stepped in to put a stop to the nonsense.
He couldn’t do much about the deficit. That was too far gone. Nor could he help the bond markets. It was too late for that too. All he could do was freeze the money pumps and hope that nature would eventually take its course.
Volcker raised the discount rate two full percentage points. He imposed stiffer controls on borrowings by America’s banks. Most important, he gave up trying to hold interest rates down and let them rise to whatever level was necessary in order to balance the forces of supply and demand for money.
For months, interest rates had been bottled up, held down artificially. Now, Volcker’s actions were like yanking off the lid from a pressure cooker.
Interest rates exploded!
In the first 10 days of October 1979, the yields on 30‑year government bonds surged as their price plunged four points in four days.
A $1 billion IBM issue — hailed weeks earlier as a “brilliant piece of corporate finance” — was now being described as the “greatest underwriting fiasco of all time.”
In January 1980, the month‑to‑month consumer price inflation surged to an annual rate of some 18 percent, sending interest rates further into the stratosphere. Then in early February, an infamous landmark was surpassed: The yields on 30‑year Treasury bonds rose above 11 percent.
Most people didn’t understand how important that was. I did. I studied the history of interest rates in America as far back as the 18th century. I knew exactly where the critical peaks were and what they meant.
The last time Treasury bond yields hit 11 percent, our country was divided in two as the Civil War raged. “Isn’t it ironic,” I thought to myself, “that so many millions died back then, only to let greed undermine our country again a century later?”
By mid‑February, the bond market approached a doomsday scenario. Now, no matter what the yield, the Treasury could not find enough buyers willing to buy its bonds. Investors had losses totaling at least 25 percent of the market value of their bond holdings, or more than $400 billion. So they were scared. They were absolutely terrified.
The Wall Street Journal quoted a banker in the East who said that, if he had to liquidate his Treasury notes, the loss would amount to more than $225 million, wiping out the bank’s capital.
Ten years earlier, Nixon tried to control interest rates — in what I believe was the wrong way and for the wrong reasons. This was the market’s revenge.
Finally, some people on Wall Street were beginning to wake up to the problems I had warned of as far back as the Eisenhower Administration. One analyst quoted in The Wall Street Journal put it this way:
“Unless those that brought us this disgusting inflation want to see a government, corporate and tax‑exempt market worth $3.5 trillion, along with a mortgage market worth $2.5 trillion, wiped out, it is clear they are going to have to do something. If that includes taking away the money that has made this sickening inflationary party possible, then we could have an awesome hangover.”
The bond market collapse continued as interest rates surged. Treasury bills hit 16 percent. Bonds hit 13 percent.
However, it was much more than just a collapse in the price of bonds. We began to see a collapse in the bond market mechanism itself.
The plunge in prices caused huge losses to the Wall Street bond dealers who acted as middlemen between the United States Treasury and the public. Many of the dealers were on the verge of running out of capital. So they were forced to cease their bond operations. They closed up shop.
Only a couple of larger dealers, such as Merrill Lynch and Salomon Brothers, continued doing business. “If the plunge continues,” the press commentators said, “the bond market will have to close down completely.”
In that scenario, there would be no money for government paychecks, no money for Social Security checks and no money to run the government.
I called Martin, who was in Japan at the time, to get his opinion. “Either Carter deflates the economy or he shuts down the government,” he said.
“There are no other choices. It doesn’t matter that he’s a Democrat, that this is an election year, that it will kill his chances for re‑election. This isn’t politics. It’s national survival.”
Martin was right. The politicians knew that it was the Treasury’s borrowing power which guaranteed that their own paychecks wouldn’t bounce. They had a personal, vested interest in protecting it. Besides, what good is it to be re‑elected to a government if there is no government left?
Sure enough, on April 15, 1980, Carter did the unthinkable. He imposed a rigid series of credit controls. He shut down the life blood that fed the economy — credit. For the first time in history, a Democratic President, in an election year, took steps to deliberately force the economy on a downward path.
This event, above all, demonstrated the enormous power of exploding interest rates.
Credit controls didn’t last very long. But just as soon as they were lifted, interest rates surged to new highs again. And again, Fed Chairman Volcker clamped down.
In the years that followed, I thought that America’s leaders had learned something from their mistakes of the 1970s and 1980s. But, as it turned out, they didn’t learn a darn thing.
Back to the Present
Those were Dad’s stories of the 1930s and 1980s.
Sound familiar? See some uncanny similarities with today? What about differences?
Hop over to my blog and let me know what you think.
Good luck and God bless!