Woe...woe...woe... - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 13 August 2013
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Poitou, France

Still no action in the stock market. Investors waiting...wondering...

Gold, meanwhile, went up $22. Has the bottom in the gold market correction come and gone? Maybe...

Our guess is that we've seen major turning points in stocks, bonds and gold. Stocks and bonds are now on the way down. Gold is on the way up.

And if we're wrong? It won't be the first time!

Most likely, we won't see any action - confirming or denying these trends -- until after the first of September. But August is passing away quickly. In just a couple of days we'll close the shutters, turn off the water, and say goodbye to Poitou for the year.

Last night, we had dinner with neighbors.

"Bad luck is sometimes good luck," said one. "My grandfather invested his fortune in bonds - Russian bonds. This was before the Russian Revolution. At the time, he was told that he couldn't lose money. Because the bonds were pegged to gold. So there was no currency risk. And these were bonds of Russian railways, which was the most solid business in the world, and they were guaranteed by the Tsarist government. No currency risk. No default risk. No business risk. They were as close to risk-free as you can get.

"Then, when the Bolsheviks took over they seized the railways...and stopped paying the bonds. The Tsar was killed. It didn't make any difference if the bonds were pegged to gold or not; they were worthless.

"It just reminds you of how things can go very bad in a way you don't expect. Who would have imagined a communist revolution in Russia? Marxist revolutions were supposed to happen in developed countries. They were supposed to be led by the urban proletariat - by factory workers. Russia was the last place you would have expected such a thing.

"But this experience did have one positive benefit. Our family has been inoculated against bonds ever since. We haven't bought any for 100 years."

"Well, you lost money for the last 32 years," we replied cheerfully.

"But I don't think we'll lose for the next 32," said our friend.

"It's hard to make predictions, especially about the future," as Yogi Berra put it. Maybe there's another version of the Russian Revolution coming - a big event that is totally unexpected. And maybe it will wipe us all out. Who knows? So we will confine our predictions to the past, where we're on more solid ground.

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What we notice about the past is that bond yields are cyclical. And crises in the bond market are episodic.

And now, we can tell you why. We just figured it out, thanks to a visit from our friend Dylan Grice. Dylan explained that vampire bats share blood (their food) with one another. This helps the colony survive periods of food shortage.

But as the colony flourishes, individual bats have less incentive to share; the colony is in no danger. The individual bat gains nothing from sharing his food with others if 1) other bats will give up their food (assuring the survival of the colony)...and 2) they will give it to him when he needs it. In other words, the more the bats cooperate with one another, the less a single bat gains from cooperating.

Quick witted dear readers will see parallels in the bond market. When you lend money (buying a bond, for example), you have to trust the person you lend to. As your level of trust goes up, you accept lower interest rates, because your risk of loss goes down. This is equivalent to the cooperation in a bat colony.

As interest rates decline, borrowers go deeper into debt...but, as the quantity of debt increases the quality decreases. Or, to put it another way, as cooperation and trust go up (with falling bond yields), the foundation under bond values (the ability of the borrower to repay his debt) actually goes down.

Eventually, you necessarily reach a point where the trend must reverse - where trust declines and bond yields go up.

Are you still with us? Hope so, because this is important. It's why bond yields are never stable.

As far as we can tell, we are the only candidate for the top Fed job who seems to understand the cyclical nature of the bond market. The others appear to think they can jimmy up bond prices forever. But as we have seen, it ain't possible. The higher bond prices go (or the lower bond yields go) the more the trustworthiness of the participants is undermined.

Markets go up and down, correcting mistakes in both directions. Bonds trade in a market. Ergo, bond yields will go up and down. As long as bond yields are going down, borrowers can afford to borrow more. But when they go up...woe to the debtor. He won't be able to repay his debt. Then, woe to the lender; he won't get his money back. And woe to the central banker who tries to stand in the way of the market. And woe to the investor who buys bonds and fails to see all this woe coming his way.

And woe to the holders of US bonds. At this point in history, Russian railway bond certificates - as collectors' items - would probably be a better place to put your money.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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1 Responses to "Woe...woe...woe..."

LOVEPAREEK

Aug 13, 2013

AS ALWAYS, AN EXCELLENT ARTICLE....BUT WENT OVER MY HEAD. UNFORTUNATELY, I M NOT SO EQUIPPED AS U MENTALLY TO GRASP SUCH INTRICACIES, BUT FORTUNATELY, I CAN RECOGNISE A PIECE OF ART. THANKS AGAIN FOR THE INSIGHT. AND NO FINANCIAL ANALYST IN THE WORLD CAN WRITE A LINE LIKE "And if we're wrong? It won't be the first time". GREAT CANDOUR.

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