Most of them are hard-headed because they have never known anything else. A few are a bit smarter — they know that their business model is cooked if the underlying assumptions change and they’re being intentionally dishonest in trying to grab the last few nickels in front of the steamroller, and to hell with you (their customer.)
Then there are those who have it figured out and are attempting to find a way to adapt to what is going to happen.
More than 30 years ago I fell into the trap of believing the press on alleged “100mpg carburetors” that were supposedly “suppressed” by oil companies. This was in the time of the Arab Oil shocks and it was all the rage to blame evil oil companies for the fact that American cars typically got 15 mpg. There were several who claimed that such 100mph carbs existed but had been bought out and suppressed or that their inventors had been murdered.
I fell for it.
The reason that these claims were a scam became clear to me later on — I hadn’t had a physics class yet and thus didn’t understand thermodynamics. Specifically, I did not understand that the best efficiency a heat engine can obtain is the difference between the combustion and exhaust temperature in Kelvin, and that this was a theoretical maximum that is never achieved (since some of the energy goes out the exhaust pipe as heat, some more is blown into the air through the radiator, and still more is lost directly to the air via the engine block and other components, never mind losses in the gearbox, differential and similar.)
If I had understood this I would have also understood that 100mpg for a typical car when one accounts for rolling and aerodynamic resistance wasimpossible. There simply weren’t enough BTUs of energy in the gasoline when one accounted for the maximum theoretical efficiency, to get there.
The arithmetic said this couldn’t happen, in short.
Now I want you to pay particular attention to this chart for a few minutes.
Note the long-term trendline — downward. But also note the pink boxes. The first was 1987, and we all know what happened in October. The second was the dislocation that led me to be able to pick up Class “A” office space in Chicago for 1/5th the going rate, along with taking advantage of a number of other opportunities — in short, being able to take advantage of it was what made MCSNet, my former Internet company, so successful. The third was the causative feature that led to both LTCM and the Tech Implosion. And the last was what set off AIG and Lehman, along with the rest of the crisis, as banksters and their minions, along with Americans, refused to deal with the short-term counter-trend move higher in rates.
But make no mistake, all four of those were counter-trend moves in a secular bull market for bond prices — and a bear market for rates that stretched over30 years.
What you need to understand about this dynamic is that in a secular bull market for bond prices the value of the “asset” in those instruments goes up over time as the coupon goes down. Bonds are typically highly leveraged both in terms of trading activity and the underlying things they fund. The truth of this is self-evident to anyone who bothers to look — when was the last time you saw a municipality, state or national government actually pay one off, and how often do corporations pay them off instead of simply rolling them over?
What led to the blow-up in home ownership was a shift in trend of average Americans from taking out a mortgage and paying it off to mimicking the behavior of governments and corporations, rolling and refinancing the debt into ever-lower rates. When there was a short-term cyclical change in this trend those people got murdered.
In a declining interest rate environment turning the crank of leverage higher both makes you money (because every refinance lowers your debt service on a given amount of debt) and the additional credit issued into the economy makes everyone else’s assets go up in price as well. But even if you don’t personally turn the crank you still win due to everyone else’s actions.
In a rising rate environment turning the crank of leverage higher loses money instead because now the interest payments go up for each refinance instead of down!
But if you take down leverage not only do you crystallize your own loss you also contract total systemic credit and thus cause other people to lose value too.
The winning position for an individual or corporation in a rising rate environment is to have no leverage. Those firms are the ones that have the opportunity to pick up assets or needed business resources at pennies on the dollar from others who are forced to sell.
This will be the winning strategy for the next couple of decades.
This is not to say that there won’t be cyclical decreasing rates in a generally-bearish market for bond prices. There will be. But it is to say that the trend is shifting and that in fact it must shift, simply on the math — there is nowhere else to go.
The Japanese were able to prevent this and instead flatten their bond market for two decades but they did it by consuming essentially the entirety of their population’s saved capital! We have virtually no saved capital to consume and as such that option is not available to us.
Municipalities, state and national governments would be well-advised to do the same thing but they can’t because they’re too far into the hole. They also can’t raise taxes in sufficient amount to get out of the hole because the earnings power of their citizens is insufficient to allow them to do so. As Detroit discovered any attempt to continue to feed the pigs at the trough via ever-high taxation drives out the people who produce and instead of raising more revenue it collapses the funding base instead. The same applies to nations; witness Greece.
The problem with the game-playing that has been put into the market since 2008 to “buy time” (to quote the BIS) is not that it delays recognition and adjustment. It is that every shift of this sort is exponentially worse in terms of the impact on the economy when it reverses, and arithmetically itmust eventually reverse.
This is not a cyclical, short-term change folks. It’s a secular shift and right now absolutely nobody is talking about what it means.
Realize this — we are now back to where we were in the depths of the collapse in 2008 and 2009 in terms of rates, but asset prices are much higher. They’re too high by half or more on that basis and what was predicated on a short-term cyclical move.
This does not mean that we will instantly see rates shoot higher and the entire economy collapse. But there is extremely strong support for any instrument at zero, and we’re very close to there right here and now. At best The Fed and Government games can buy themselves a short amount of additional time — but not much more.
The secular shift is upon us and you either recognize this and adjust your personal and corporate world to comport with what is certain from an arithmetic perspective or you will suffer the consequences for not doing so.