“Rationality is thus an a priori assumption about the way the world should work rather than a description of the way the world has actually worked.”

“Manias are associated with general ‘irrationality’ or mob psychology.”

Manias, Panics, and Crashes: A History of Financial Crises
By Charles P. Kindleberger and Robert Aliber
Fifth Edition, Chapter 3, Speculative Manias

“The association between super skyscrapers and asset price bubbles is a strong one…The association between asset price bubbles and economic euphoria is also strong…There is a symmetry between increases in economic activity in response to increases in asset prices and the declines in economic activity when asset prices decline … Asset price bubbles – at least the large ones – are almost always associated with economic euphoria. In contrast, the bursting of the bubbles leads to a downturn in economic activity and is often associated with the failure of financial institutions, frequently on a large scale. The failure of these institutions disrupts the channels of credit that in turn can lead to a slowdown in economic activity.”

Manias, Panics, and Crashes: A History of Financial Crises
By Charles P. Kindelberger and Robert Aliber
Fifth Edition, Chapter 6, Euphoria and Economic Booms

“So off went the Emperor in procession under his splendid canopy. Everyone in the streets and the windows said, ‘Oh, how fine are the Emperor’s new clothes! Don’t they fit him to perfection? And see his long train!’ Nobody would confess that he couldn’t see anything, for that would prove him either unfit for his position or a fool. No costume the Emperor had worn before was ever such a complete success.

‘But he hasn’t got anything on,’ a little child said.

‘Did you ever hear such innocent prattle?’ said his father. And one person whispered to another what the child has said, “He hasn’t got anything on. A child says he hasn’t anything on.’

‘But he hasn’t got anything on!’ the whole town cried at last.”

The Emperor’s New Clothes
By Hans Christian Anderson, 1837

While the government Bond Market flirts with interest rates last seen during the Great Depression, Inflation appears headed upward. This is not because Inflation has been quiescent. But because the underlying rate of inflation has been masked by two factors over the past two years. First, oil and other commodities have seen a significant drop over this time frame. As these prices stop descending and level out, they will no longer be a negative input to the major inflation indices. And, as they move off the bottom towards long term sustainable levels, they will actually start to add to inflation. Second, the significant rise in the US Dollar has put pressure on manufactured goods prices throughout the economy. Whether a jet engine or a washing machine, goods prices have been falling at a 4% to 5% rate on a year-over-year basis. With the US Dollar leveling out this year, as the US Treasury threatened countries like Japan with retaliation in the currency markets, this drag on inflation should disappear as well. And this is prior to the potential for a pullback in 2017 under a new President, which would restore the US Dollar to fair value and enable US manufacturing to become, once again, globally competitive.

As these factors fade away, the real story will make itself clear. For those who do not find the government statistical releases scintillating reading, they have missed an exciting story. The government’s reported Service Inflation has accelerated significantly over the past two years. From a rate close to 2% annually, reported Service Inflation has now reached a rate of 3.2%. This is despite the actual raw data not making their way into the government’s computation of such statistics as the CPI (Consumer Price Index). For example, rental rate increases have been running near 4% and home prices have been rising in excess of 5%. However, the statistical whizzes in DC use statistical constructs in the reported indices, such as the CPI, providing them more flexibility. In this case, Owners Equivalent Rent, which relays the “cost of housing” for Americans according to the government, is rising at a rate of 3.3% while Rent of Primary Residence is rising at 3.8%, thus shaving a percent or so off the true underlying rate of inflation. With the drags on Inflation going away and the underlying rate accelerating, the government reported Inflation, whether through the Consumer Price Index, the Producer Price Index, or other measures, will continue to head upward. And, not only will these measures head upward, but they will head upward to levels that exceed current interest rates, potentially by a significant amount.

Now, for holders of bonds, this is not good news. Two things likely will occur. First, investors will see rates head upward creating losses for them on their bonds. This is just a function of discounting a future payment at a higher interest rate. Second, the interest they receive on their initial investment will likely provide a rate of return less than Inflation, producing a negative real return on their investment. And this is even before investors pay taxes on all that interest they will receive. As a result, the purchasing power of both the interest they receive and the principal they are owed on their bonds will erode over time.

These results for bondholders are before the intervention of Global Central Banks is factored into the equation. In places such as Europe and Japan, the Central Banks have engineered negative interest rates.
These interventions have led global investors to purchase US government bonds which appear to provide “relatively attractive” rates of return. Thus driving rates below what these bonds would have without these global flows. However, these same global investors, who seem to exhibit a herd mentality over time, have not considered the case of rising inflation in the US coupled with a potential fall in the US Dollar, as outlined above. Should this occur, the likely outcome would be a rush to the exits, as the herd moves onward. Thus, when rates do rise, they will likely rise at a faster rate and to levels significantly above those envisioned today.

One final factor needs to be taken into account when thinking about bonds. That is all the pieces of paper printed over the past few years that represent currency. While velocity, the measure of how quickly these pieces of paper circulate in the economy, is very low in a historical context, the history of velocity would indicate these good times will not last. If we look at just the US, the history of inflation is highly variable over time. While inflation can be low for a number of years, this quiescence tends to disappear suddenly. And with the link of US currency to gold broken in 1971, there is no longer a reference rate for the dollar, which restrained inflation in the 1950s and 1960s, after a nasty bout of post-war inflation in the late 1940s. And the history of governments using Central Banks to repurchase their debt and issue currency is replete with sudden rises in inflation and interest rates. Furthermore, with the US government likely to address the value of the US Dollar at some point in the near future, with the use of the Printing Press, inflation is likely to accelerate suddenly, as it has in past printing press episodes. (For example, see Not Worth A Continental in the 2012 Year End Letter, published in January 2013, which provides historical context for the value of the US Dollar.)

As the above analysis makes clear, while bonds and interest rates have moved in one direction, the fundamentals to support this move have moved in the opposite direction. Markets periodically disconnect from the underlying fundamentals. This can be seen in the recent episodes in the housing market in 2005 – 2007, in the valuation of public technology companies from 1999 – 2001, and in the Leveraged Buyout
(LBO) Market from 1988 – 1990. As these instances demonstrated, the disconnect between fundamentals and the markets was wiped out as storms with class five hurricane force winds demolished the structures and theories used to justify these disconnects. For the Bond Market, this storm lies ahead. However, in the meantime, investors should be mindful of Inflation, Central Banks, and the Inevitable Printing Press. (Data from Bureau of Labor Statistics, company reports, and public commodity prices coupled with Green Drake Advisors analysis.)