A contrarian view on interest rates

How many times a week do you read that interest rates have no where to go but up? That bonds are terrible investments and will be crushed by rising rates? And when was the first time you started to hear these stories? If you read pretty much any source of investment news then you’ve been hearing these stories for almost 4 years now and, at least to me, they seem to be constant. Yesterday the latest one I heard was ‘the bond bubble will pop tomorrow’. Oh dear. Well, today I wanted to provide a counterpoint to all the rising rate hysteria and posit that there is something more fundamental going on that has a high potential to keep rates low for a lot longer than most people think.

The contrarian view on rates is that what happened in 2008 is no where near a standard recession, it was a much bigger event, the ending of a long cycle of financial speculation and debt increase by the private sector. The ending of this cycle leads to the next cycle of debt deleveraging and deflationary forces. And add onto to that a large demographic transition as the baby boom generation ages. The last time we saw anything like this in the western world was the great depression. But it turns out the world has seen this a lot more recently. The elephant in the room is Japan. Why more people don’t look at the Japanese experience is beyond me. The Japanese housing and stock markets, their own debt bubble, first burst in about 1990. What has been the Japanese experience on interest rates since that time? The chart below shows the yield on the Japanese 10 yr bond since that time. A great source of Japanese data is here.

Pretty shocking. Its been 22 years since the start of Japan’s financial crisis and rates still show no signs of going higher. If you date the US crisis to a similar time frame, starting 2008, you’re looking at potentially a very long time of continued low rates, we’re talking the year 2030! And how about Japan’s fiscal situation during this period? Japan’s net debt to GDP has increased by 3X during this time, its credit rating has been downgraded at least 4 times and it has skirted with deflation, not inflation, the entire time . This has defied the conventional wisdom for so long at most people just throw their hands in the air and say things like ‘Japan is a bug searching for a windshield’. Gee, that’s helpful. There is something else going in here that merits consideration. I personally think its the deleveraging, deflation, demographic story that the US has more in common than most people think. If you want to learn more about the Japanese situation I highly recommend Richard Koo’s book, The Holy Grail of Macroeconomics. Now, I’m not saying the US is going to follow Japan, there are some fundamental differences. But I do think the conventional wisdom is very wrong and we have a longer period of lower rates in front of us than is expected. And that creates investment opportunity.

The conventional investment stance on rising rates has lost an investor a lot of money or opportunity in the last 4 years, whether it is the aggressive position of shorting treasuries or the conservative position of staying in short maturity bonds. The chart below shows the performance of the long bond ETF (TLT), the short term bond fund (SHY), and of the ETF that shorts the long bond (TBT).

As is often the case, it has paid to be a contrarian. Great, but what does that mean going forward? Of course, that’s the hard part. Personally, while I don’t think rates are going up anytime soon, the fed has made it explicitly clear that rates won’t go up until at least the end of 2014, that doesn’t mean I want to be in government bonds. I think they are expensive even relative to the low growth low inflation environment we’re in. I think the opportunities are better out the credit curve. Investors are getting paid pretty well to take on credit risk especially further out on the maturity curve (i.e. longer term bonds). Long term munis, high yield corp bonds, mortgage bonds, and even investment grade corporates are pricing in higher default risk than is warranted. And even better yet, in this environment, many dividend paying stocks are a good value.

In summary, the conventional view on interest rates is missing something very fundamental. Interest rates a likely to remain low for a lot longer than people think based on the example of the Japanese history of their financial crisis. For investors who understand this it creates great opportunity to at the minimum protect capital and potentially make some good conservative returns.