T H E B R O Y H I L L L E T T E R
“Historical experience tends to support the proposition that a suf
fi
ciently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to
fi
x yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade . . . The Fed was able to achieve these low interest rates despite a level of outstanding gov- ernment debt (relative to GDP) signi
fi
cantly greater than we have today, as well as in
fl
ation rates substantially more variable . . . Interestingly,though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long- maturity bonds outstanding.” – Ben Bernanke, De
fl
ation: Making Sure “It” Doesn’t Happen Here (2002)“The rare occasions of liquidity traps are very different from typical economic recessions. Consequently, they require a unique monetary policy response. Economic theory tells us that in such circumstances monetary policy should aim to lower the real, or in
fl
ation-adjusted, rate of inter- est by temporarily allowing in
fl
ation to rise above its long-run path . . . The higher in
fl
ation would decrease the real interest rate, raising the opportunity cost of holding money. This would provide an incentive for banks and corporations to release funds for investment and in the pro- cess spur job creation.” – Chicago Fed President Charles Evans (2010)
Executive Summary
Policymakers have put all their eggs in a basket that has never been “stress tested,” hatched from a chicken that no one hasseen for a century. Unconventional has become conventional, especially in terms of monetary policy. But current policy isunlikely to be as effective in supporting aggregate demand as “economic theory” would suggest. The transmission mecha-nism to the real economy is broken. In a
Balance Sheet Recession
, monetary policy is hopeless, so
fi
scal policy is requiredto
fi
ll the gap in private sector demand. De
fi
cit spending is harmful when it fails to enhance long term productivity or toproduce a future stream of cash
fl
ows capable of servicing the increased debt load. But an intelligent
fi
scal response is oneof the few weapons in our arsenal for dealing with a protracted downturn. Needless to say,
Cash for Clunkers
does not
fi
tour de
fi
nition of “intelligent.” We need smart policies from strong leaders such as investment in infrastructure, incentivesfor research and development, a simpli
fi
ed and predictable tax policy, and heaven forbid someone actually address ourlong term entitlement liabilities! While consumers’ desire to pay down debt is positive for the long term health of the economy, the lack of new credit ham-pers the economy’s ability to recover through the normal post-recession cyclical channels. As such, government spending is required to arti
fi
cially support economic growth while the private sector rebuilds its balance sheet and is once againable to support healthy levels of credit creation. Fiscal policy is the only way to deal with a large output gap.
Frontloaded Fiscal Austerity
is counterproductive and would only serve as a de
fl
ationary shock to aggregate demand - especially if thedeveloped world’s economies pursue it at the same time (don’t look now, but this is exactly the policy being jammed downEurope’s throat today). History warns that when governments stop stimulus too soon, recessionary forces reassert them-selves. Poorly timed de
fi
cit reductions can reduce GDP and prompt a drop in tax revenues, translating into bigger de
fi
cits,more cuts, less taxes, etc. (i.e. Southern Europe). This is the type of self-reinforcing cycle policy makers have nightmaresabout. Unfortunately, maintaining
fi
scal stimulus for the entire duration of a
Balance Sheet Recession
is politically impossible. There are many, many years of deleveraging ahead of us.
Lower for Longer
We have long believed that the path of least resistance for interest rates is down, at least until the deleveraging processhas run its course. In other words, demand for credit will remain muted until the private sector reduces its debt to moremanageable levels. Fiscal de
fi
cits are not crowding out private sector borrowing because the private sector doesn’t want
SECOND QUARTER 2011
to borrow. Rather,
fi
scal de
fi
cits are facilitating the private sector’s desire to save more, deleverag-ing their balance sheets. The private sector in thedeveloped world needs to get its
fi
nancial housein order. And the only way that can happen in thenear term, without increasing the risk of a de
fl
a-tionary depression, is for the governments of thedeveloped world to run large de
fi
cits.One gauge we are monitoring for progress is the
Household Financial Obligations Ratio
(FOR), a broadmeasure of debt payments relative to disposablepersonal income. While the FOR has fallen fromits Q1-08 peak, a move towards its early 80s low would be more indicative of a secular low. Unfortunately, a big slug of the improvement in the ratio to date has come fromgovernment transfer payments, which have temporarily boosted disposal personal income. Excluding transfer payments,the FOR has declined by a fraction of the magnitude illustrated above and remains well above both its long term averageand prior lows. Much lower levels are needed to provide a base to build upon.Understanding the mechanics of a
Balance Sheet Re- cession
is critical to understanding why large govern-ment debts can coexist with low interest rates. Putsimply, the amount of money borrowed by the gov-ernment to offset the contraction in private sectorcredit is by de
fi
nition equivalent to the excess sav-ings in the system. Yields on government debt arelikely to stay
Lower for Longer
. The greatest irony in all of this hysteria is that those who are shrieking the loudest about the prospectfor rising yields fail to understand why interest ratesmight rise in the current environment. Despite mas-sive debt levels, private sector deleveraging, de
fl
ationrisks, etc., the only thing that got interest rates mov-ing higher in the 1940
′
s was an economic recovery! Budget de
fi
cits have a meager 40% correlation to bond yields, whileFed policy and in
fl
ation command 80% to 90% correlations with the treasury market. And the Fed has repeatedly told usthey have no intention of raising rates for a long, long time. Interestingly, when “Heli-Ben” gave his “What If” speech inNovember 2002, he mentioned that in a 0% world, he would target long term rates to mitigate de
fl
ation risks. He speci
fi
-cally cited how the Fed established an explicit ceiling on the long bond yield of 2.5% in the decade to 1951. Interesting.Interest rates are best explained by the ebb and
fl
ow of economic data and have a positive correlation with LEIs whichgrows still stronger when in
fl
ation pressures are subdued. Yields are falling because the outlook for growth is deteriorat-ing. Bond yields surged in 2009 alongside rising LEIs and hopes of a sustainable recovery. Bond yields plummeted in thespring of 2010, as those hopes were shattered. Beyond the short term cyclical
fl
ow of economic data, interest rates shouldtrend lower for the next few years as experience supports the view that recessions are de
fl
ationary by nature. In the 11recessions since 1950, CPI declined on average for roughly 29 months after the recession ended. Considering the structuraldifferences inherent in an extended deleveraging process, we’d expect a much more extended decline this time around.
SECOND QUARTER 2011
2
Size Matters
Given our massive debt bubble, even minor rises in interest rates create enormous dif
fi
culties in debt service. The resultis a global economy much more sensitive to changes in interest rates. Because debt burdens are a function of the rate of interest and the quantity of debt, when debt levels are high, smaller changes in interest rates have a larger impact on debtservice burdens and on the economy. The “choking point” of rising rates on the economy has become lower and lowerover time. In other words, greater and greater levels of debt act as larger and larger speed bumps for economic growth.Put simply, with an ever increasing weight of debt on our shoulders it takes successively smaller hiccups in yields, to break the economy’s back. In 1989, when rates rose to 9.5%, they popped the commercial real estate bubble and caused the S&Lcrisis. In 1999, the tech bubble burst as rates approached 6.5%. And in June of 2006, interest rates at 5.25% triggered acollapse of the residential property market and brought about the Great Recession. We believe the next “choking point”for the economy is likely to be signi
fi
cantly lower than the previous ones, given the massive surge in public and privatesector debt loads and the looming threat of debt de
fl
ation.De
fl
ation, deleveraging, and risk-aversion will likely continue for longer than most expect. This toxic mix, combined withBernanke’s desire to keep rates low, should result in progressively lower yields down the road and bodes very well for long term bonds. The average long term Treasury rate from 1870 is 4.3% while the average annual in
fl
ation rate over this periodis 2.1%. If in
fl
ation goes to zero (or negative), then the long term bond yield should fall toward 2% (or lower). At currentyields, we believe long term bonds offer an attractive hedge against continued deleveraging. After falling dramatically during the recession, nominal GDP ended the 30s where it started, so there was no growth forthe entire period. Long term US Treasury rates dropped from 3.6% in 1929 to 1.9% in 1941 and the US stock marketdeclined 62% over the entire period. In Japan, nominal GDP remained
fl
at for 20 years, even though debt as a percentageof GDP went from 50% to 200%. During this time, interest rates fell from 5.7% in 1989 to below 1% last year and theNikkei was down over 77% over this period. The US situation today is not too different from Japan’s in 1990 – yes thereare differences, but many similarities, and most importantly, our “solutions” are nearly identical to what Japan tried. Japanhas wound up with 2 decades of de
fl
ation and a 10 year yield that hit 1% for the
fi
rst time in 1998.
3
SECOND QUARTER 2011
Source: Bienville Capital Management
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