The Free Market 20, no. 4 (April 2002)
It has been said that the stock market is not an actuarial table. The same can be said of the bond market. Rather than an infallible guide to the future, the bond market embodies the best guesses, hopes, dreams, and fears of many investors. Hence, the bond market can be fallible and, in fact, has been so—in spectacular fashion—in the past.
People commonly look to the bond market to gain some insight into what the future might hold, particularly when looking for signs of inflation (or generally rising prices). They watch the yields on the long bond or the ten-year Treasury note. If yields rise, the bond vigilantes are said to be worried about inflation and thus are demanding higher yields to tie up their money for any length of time. Bond market commentary is peppered with such interpretations of the day’s or week’s action. Besides the CPI and PPI, the behavior of the longer-term bond yields is perhaps the most common source of inflationary prognostication.
It is certainly true that during times of generally rising prices (commonly referred to as inflation), the yields or interest rates on debts will also rise. It was not that long ago that the prime rate was 18 percent (in 1981), compared to only 4.75 percent today. As Sidney Homer observed in his invaluable History of Interest Rates, the very peak of bond yields occurred in the fall of 1981.
The US government “borrowed money for twenty years by issuing 15 3/4 percent bonds, which sold at just under par to yield 15 7/8 percent. This stands as the highest bond yield the government had to pay in the two-century history of the republic.” These interest rates reflected the recent economic experience with rising prices, and investors can hardly be blamed for demanding such historically high yields.
However, it is another thing altogether to depend on bond yields as a predictor of things to come.
The Great Bear Market for Bonds
The greatest bear market for bonds began, as you would expect, with very low interest rates. World War II was financed at 2.5 percent interest rates for terms between ten and twenty years in length. Thus, on the eve of the greatest run of inflation the republic has ever seen, investors were committing themselves to a 2.5-percent return on their money.
Again, these interest rates reflected investors’ most recent experiences. Investors were still recovering from the Great Depression, and perhaps they were looking for safety and thought that government bonds would give them that. Many people thought that the depression would return once the war ended. And from the vantage point of someone living at the time, perhaps there were few alternatives deemed safe enough for one’s savings. Maybe.
But not everyone took that approach. John Rothchild, in his latest book, The Davis Dynasty, quoted anti-bond hero Shelby Davis, who “saw the threat in the ‘sea of money on which the US Treasury has floated this costliest of wars.’ “ Shelby focused on supply of money and credit, as best he could. To him, the specter of inflation made bond investing a rather speculative affair.
As Rothchild noted, investors in Uncle Sam’s debts were “victims of a triple swindle” since they got a fixed return as the “inflation aroused by government printing ate away at the value of their principal.” Also, in the top income tax brackets, investors paid 94 percent of their return back to Uncle Sam.
Yet, as Rothchild notes, “ad campaigns insisted it was patriotic to buy bonds and the sheepish patriots dutifully bought all the inventory the government dare print.” It is one of financial history’s supreme ironies that those who thought they had put their money in the safest of investments—in the bonds of the United States government—had in fact invested in a very risky proposition. Patriotism has seldom led to sound investments.
These sheepish patriots would be fleeced of their savings over the ensuing thirty-five years. Rothchild writes that “the same government bond that sold for $101 in 1946 was worth only $17 in 1981! After three decades, loyal bondholders who had held their bonds lost 83 cents on every dollar they’d invested.” Are today’s bond investors committing a similar blunder with Treasury yields around 5 percent, despite an environment of an escalating money supply? It is impossible to know for sure, but given the history of paper money, the longer-term trend of continuing inflation seems a better bet.
Paper Money and Inflation
The gold standard (or some form of money based on an underlying commodity), was the money of choice for hundreds of years. Today, the world’s currencies are all so much paper. Persistent inflation, a phenomenon not known to earlier generations of Americans, has become a commonplace and accepted reality.
It is truly staggering to consider the depreciation of the world’s currencies in the twentieth century. Even the almighty dollar has lost tremendous amounts of value. As Lord Rees-Mogg wrote in his column for Strategic Investment, “In the last 88 years, since the start of the First World War, the strongest currency has been the US dollar. Even the dollar has not been a good store of value. The purchasing power of the dollar has depreciated over 90 percent since the beginning of the last century, and, at current low forecasts of inflation, it will depreciate by another 90 percent by the end of this century.”
And keep in mind that we are talking about the dollar here, which has been the best of the paper currencies. This persistent inflation forced some tectonic shifts in the debt markets during the twentieth century that forever changed it from what went before.
The threat of inflation led to the extinction of long-term corporate bonds, which were popular in the early twentieth century. Bonds with 100-year terms were not uncommon. Making such commitments is surely difficult to fathom for American investors today, who have grown accustomed to inflation and, indeed, have grown to accept it.
But the investors of the early twentieth century had no such experiences. They were just as accustomed to deflation, which often followed the inflationary booms of the nineteenth century. As an extreme example, the years 2361 and 2862 represent maturity dates for two railroad bonds issued in 1900. However, even as late as 1960, it was still common for corporate bonds to carry maturity dates of twenty to forty years into the future.
Another shift was the change in peoples’ perceptions of government debt. Looking back, Homer notes that “the nineteenth-century American concept that the national debt is temporary and must all be redeemable and redeemed at an early date has changed.” Indeed, government debt has become a permanent part of American politics and markets. Not only government debt itself, but also the quasi-government debts of the government sponsored enterprises (GSEs) such as Fannie Mae continue to grow.
Learning from History
The lesson of this eclectic view into the past is to be wary of inflation, even when it does not seem immediately threatening, and points to the inadequacy of trying to get a handle on inflation by trying to read the bond markets.
Currently, there is an ongoing debate as to what the world will likely experience going forward—inflation or deflation. There are good arguments in both camps, but the inflationary forces are ingrained in the monetary system. They are politically more palatable, and they continue the powerful historical trend of all paper currencies losing value over time.
Christopher Mayer is a commercial lending agent in Baltimore, Maryland (cwmayer@aol.com).
