Sunday, December 16, 2012

An Overwhelming Fear of Reality

In part due to conflict of interest, the overwhelming majority of financial commentators still espouse a concern for inflation over deflation. Most financial commentators today who argue the imminent inflation hypothesis, either have already taken a position in inflation correlated assets (gold and silver), or gain advertisement revenue from these inflationary investment positions (gold/silver). Worse yet though, given that they feel a need to be fully invested in "something", most of these same people are far too afraid to gaze into the abyss and fully confront the idea of a global asset deflation (market crash), so they have magically just taken that scenario off of the table...

I just watched this interview with James Grant who writes the "Grant's Interest Rate Observer" newsletter. His overall thesis is that interest rates will rise at some point and therefore fixed income investments at the current low yields make no sense. As I said above, the most notable and ludicrous oversight is that he doesn't even leave the door open for an asset deflation. In other words, he expresses a lack of faith in Central Bank policy, and yet still implicitly assumes that the Central Bank drip feed market levitation trick will continue long enough to generate a general price inflation?! 

Interest Rates Rise For Two Reasons
Since Grant's central thesis is that a rise in interest rates is imminent, then let's examine that argument in light of the current situation. There are only two reasons why interest rates rise. The first reason that interest rates rise is due to increased probability of borrower default. This is exactly why yields on Spanish and Italian debt rose during the early part of this year - investors feared they would not get their money back. The key point in this default scenario, is that an interest rate rise due to default is a self-destructing scenario. When yields rise, it makes it harder for the borrower to roll-over their debt.  So interest rates rise to a certain high level, and then they go to infinity. They go to infinity, because the value of the underlying bonds goes to zero. At the point at which your investment goes to zero, suddenly the fear of rising interest rates is the last of your concerns.

The second reason interest rates rise is due to a general increase in prices across the economy caused by a monetary expansion. This is the "1970s" scenario Grant is assuming will occur. The only reason interest rates rose in the late 1970s is because incomes and prices across the entire spectrum rose as well. In other words, this general inflation scenario presumes that incomes are keeping up with rising interest rates thus allowing borrowers to continue servicing their debt. If incomes don't rise, and only interest rates rise, then we get back to scenario one above wherein the real interest rate is rising and therefore the loan is heading to zero because the borrower becomes bankrupt. What is even more amazing is that this scenario of rising real interest costs is already occurring. As I pointed out here, real median household income has been falling since 2007, therefore real interest costs are rising for the middle class. So it's already happening, yet these fucking out of touch commentators assume that since it's not happening to them, that it's not happening.

And since we know that incomes are falling, not rising, and have absolutely no underlying fundamental  mechanism that would allow them to rise (i.e. jobs and pay increases), then we are left to assume that any potential "rise" in interest rates would be self-destructive and bring about an asset crash. If one doesn't occur a lot sooner than that.

All of which means that all signs point down for asset prices, whether the comfort seekers of the day can face that reality or not. Therefore it's long overdue for these conflicted "advisors" to start thinking about return of capital and stop their obsession with return on capital. Whether they admit it or not, they have implicitly bought into the Central Bank Jedi Mind Trick that this current asset inflated regime will last indefinitely. 

The fact that these self-nominated "experts" at large are not discussing the potential for an asset crash at this juncture, has nothing to do with its probability of happening, and everything to do with their inability to face reality.