Very low yield bonds and the Permanent Portfolio

[Zach]

Hello all, new member here! First, I just wanted to say thank you to all of you: it would not be an understatement to say that reading this board has really changed my life. I’m slowly but surely making the shift from being a total consumer to being more self-reliant thanks to what I’m learning here

I have a quick question about the Permanent Portfolio. I’ve been using it for about a year and a half now, and I’ve been very pleased with it so far. I feel quite comfortable using it for the foreseeable future, but in the interest of being vigilant, I’ve also been trying to think about and "war game" the types of circumstances that might warrant switching strategies.

Which brings me to bonds. Over the past few years, long-term bond yields in some countries have approached <1% or even negative yields. I’m a U.S.-based investor, so this hasn’t been much of a concern yet for long-term treasuries, but it’s not too difficult to imagine a scenario where the U.S. economy takes a turn for the worse, interests rates are cut, and yields get pushed down to very low or even negative amounts (I think I recall Yellen saying at one point that the Fed would be willing to experiment with negative rates if circumstances called for it).

The yields themselves aren’t what concerns me as much as the price ceiling for these bonds. In this scenario, would the bonds still provide enough protection in the event of a major deflationary episode when interest rates are already very low? I imagine the answer is somewhat subjective: how much protection is “enough” in this type of situation would probably vary by individual. If you’re a PP investor, what yield rate for 30-year treasuries would signal to you that it’s time to consider switching strategies?

Perhaps it could be argued that looking for safety in any form of financial asset is a dumb move in such a scenario. The only idea I’ve had for a hedge against a case like this would be to adapt the portfolio to an 80% orthodox PP (20 stocks/20 bonds/20 cash/20 gold) + 20% alpha strategy, but that would be a looooot of toilet paper

Any thoughts or ideas (or pointing out gaping holes in my reasoning) would be welcome!

[Tyler9000]

The thing about the Permanent Portfolio is that the long-term bonds do not really depend so much on bond interest as the income mechanism as much as the price movement on the bond itself. That runs counter to most traditional portfolio logic that uses bonds for fixed income, so the standard worry about low rates also falls a little short. Thanks to bond convexity, the lower the rate the more effect that small movements have on the bond price. So long bonds can still respond quite well when needed even at low rates.

Also, note that the PP did remarkably well in the 70's when bonds had nowhere to go but up (and did!). The firewalls are surprisingly effective.

[ThisDinosaur]

I have a similar concern about low yields. These are the lowest interest rates in 5,000 years of recorded history.
The explanation I see the most often is QE resulting in the bidding up of all investable assets. If that's the case, it seems like the Cash in the PP would be the long term winner, since it will allow you to buy the other three assets when they inevitably collapse in price. The problem with being in all cash, though, is that you can't expect to time the market correctly and you may miss out on gains in the mean time.

But I don't have a good mental model for how QE unwinds itself, so I'm probably missing something important.

[Dragline]

Yes, the purpose of long-term government bonds in PP is their historic negative correlation with equities. That's why they are specifically government bonds and not corporate bonds. The yield is ancillary to the real reason for holding them in this kind of portfolio.

@ThisDinosaur At what other points in history did societies experience declines in population and what was the outcome? Hint:
http://www.telegraph.co.uk/finance/econ ... Death.html

Declining populations put a heavy thumb on interest rates pushing them down. Even as the quantity of money may be expanding, the velocity of money contracts even more quickly with fewer people spending money or investing in shorter and shorter expected future lives. This favors LT bond prices. We'll know what ultimately will happen by watching Japan, since its on the leading edge of this trend.

[ThisDinosaur]

Govt bonds have been anticorrelated with equities during the last 30 year period of declining interest rates. Has that been +/- consistently true before that? Seems to me that a rise in interest rates now would be detrimental to both stock and bond holders. (Gold and cash would benefit, then.)

Wrt Japan, the narrative I'm most familiar with is the one that connects the aging population to deflation. The US markets may behave differently because of immigration. We still have a reputation as the Land of Opportunity where young people come to start businesses and families and buy homes.

Also, I've read interest rates are at their lowest when the sense of societal stability is at its highest. The perceived absence of risk=low yield from sovereign bonds in an Empire. Then come the barbarians. How does that jive with your narrative Dragline?

[Dragline]

It's the declining velocity of money since 1980 that has ultimately driven interest rates ever lower, even as the money supply itself has expanded. See https://fred.stlouisfed.org/series/MZMV

You will not see an increase in this without some kind of increased government spending (or a growing younger population), which would likely only provide a temporary boost (see that nice little bump for the Iraq war?). Without an increase in the velocity of money, interest rates cannot increase over the long term.

You may see bonds and equities move in the same direction for periods of time, but when the shit really hits the fan for equities and short-term liquidity dries up, everybody buys treasuries in a highly disproportionate way giving you those infamous inverted yield curves that have always been associated with stock market declines.

As for immigration, people don't even want to vacation in the US anymore and we're actively discouraging them from coming here long-term. See: https://techcrunch.com/2017/05/24/fours ... s-is-down/

[ThisDinosaur]

If I follow your logic, Dragline, the aging population is saving more in stocks and bonds (bidding up their price) and spending less on consumer products (reducing real return in the economy) and that will result in currency being relatively more valuable than goods (deflation) when they all retire. Did I get it right?

As for immigration, I'm cautious not to extrapolate recent trends too far into the future. I think a flood of able-bodied immigrants is more likely in the US than in Japan. What's the Fourth Turning predict about that?

[disparatum]

It's the declining velocity of money since 1980 that has ultimately driven interest rates ever lower, even as the money supply itself has expanded. See https://fred.stlouisfed.org/series/MZMV

I wasn't familiar with this relationship, so I looked it up. It seems like the direction of causation is usually described going the other way, ie interest rates decrease therefore the velocity of money decreases.

I was looking at:
http://www.themoneyillusion.com/?p=18812
http://www.philipji.com/item/2014-04-02 ... rest-rates

Money velocity seems to have more to do with inflation (See: https://www.stlouisfed.org/On-The-Econo ... -in-the-US). Nominal interest rates and inflation are related, but even the equilibrium real interest rate appears to be incredibly low. I mean, the conclusions you are stating seem right but the logic seems backwards to me. Maybe I'm misunderstanding something you are saying?

@ThisDinosaur
I thought this article was good: https://www.brookings.edu/blog/ben-bern ... es-so-low/
Another hypothesis for why interest rates are so low: http://larrysummers.com/2016/02/17/the- ... tagnation/

The secular stagnation theory essentially comes down to demography (plus some other factors. Also see http://time.com/4269733/secular-stagnat ... y-summers/) like you mentioned although I'm not sure I understand the second half of your first sentence about currency being relatively more valuable than goods.

[Dragline]

I agree that monetary velocity is related to inflation, but it is fundamentally caused by individuals engaging in transactions -- that is what velocity is measuring, whereas inflation is a measure of those transactions and other factors (e.g., central bank policies) on prices . If there are no transactions or fewer individuals engaged in transactions, both velocity and inflation will be retarded. Central banks have a lot of control on short-term interest rates, but much less on long-term, which are dictated by long-term expectations in comparison with other investment options.

The demographic problem (fewer individual and fewer transactions) is why the central bank of Japan has been unable to induce much inflation, higher long-term interest rates or velocity. Any model must explain the data coming from Japan, and most simply do not, but instead claim it is some kind of cultural outlier that can be disregarded. I don't think that is true.

[Zach]

Thanks everyone for the responses---very enlightening!

@Tyler, your link and explanation were both incredibly helpful, thank you. So, if I understand correctly, because of the higher convexity of bonds with very low coupon rates, they would still have plenty of “juice” to increase in price in response to a deflationary event? That’s fascinating.

Do you think this would hold even in the case of negative yields? If the PP investor’s concern isn’t with income per se, as you said, but rather to protect the overall portfolio from the effects of deflation, then the investor should continue purchasing long-term government bonds even if they come with a guaranteed loss, correct? The yields can theoretically dip even deeper into negative territory, and therefore the price of the “less” negative bond that the investor initially purchased could increase in response to deflation.

[ThisDinosaur]

If it pleases the court, I'm gonna summarize some of these links for myself and anyone reading along.
Feel free to correct my errors.

Here's what I extrapolate from the money illusion link;
lower rates=>reduced bond investment=>more consumer transactions=>more demand=>higher prices/inflation
simultaneously; lower rates=>more business borrowing=>more production and products=>oversupply/deflation

The philipji link also implies a negative feedback loop, where the fed induces one effect and the result is the other effect being more prevalent.
Then it says lower rates correlate with lower velocity. This is said to be a surprise to economists, but I don't grasp his "simple" explanation for it.

St.Louisfed link shows the formula for money velocity:

MV = PQ

In this equation:
•M stands for money.
•V stands for the velocity of money (or the rate at which people spend money).
•P stands for the general price level.
•Q stands for the quantity of goods and services produced.

While the fed can only control money supply, it can't control what people do with it. Behaviorally, individuals and businesses can just horde cash and thwart the fed's efforts to produce inflation.

Brookings link: When high inflation is present or anticipated, investors demand high interest in their bonds. So rates go up.
Additionally, low expectations of economic growth mean limited appeal of investments. This means low competition amongst investments and thus lower interest rates. Because of finite material wealth, government borrowing reduces private capital investment(if you pay money in taxes or lose it to inflation, you don't have it to spend or invest.)

Larry Summers' link repeats the idea that a society of savers/horders don't spend money, so interest rates drop both because bonds are overbought and because easy borrowing is expected to encourage business growth. Alternatively, deleveraging of private and sovereign debt means we're putting more of our money into paying off debt than we are putting into future investment and present consumption.

Time link I read as Secular Stagnation="This time, its different." (For those who aren't familiar, that phrase is always uttered by someone who expects current trends to continue indefinitely before the economy abruptly/inevitably changes direction.)

tl;dr:
I'm getting from all this that there are many, conflicting causes of bond yield changes. At any given time, one or more of those influences is more important than the others. This is a good argument in favor of holding something like an agnostic permanent portfolio.

But the question in this thread is whether to buy long term bonds. The PP performed well in the past when the rising tide raised all ships. But in a setting of secular stagnation, is it better to switch to active investment in anticipation that we are now in a zero sum game? Do the various factors that effect interest rates line up for or against buying bonds now? Which brings me back to my assertion that historically low interest rates imply they should eventually move the other way. And your LTT allocation should sit in cash or somewhere else for the time being until rates go up.

[Tyler9000]

So, if I understand correctly, because of the higher convexity of bonds with very low coupon rates, they would still have plenty of “juice” to increase in price in response to a deflationary event? That’s fascinating.

Do you think this would hold even in the case of negative yields?

Theoretically, yes. Practically, I can't say for sure. But the thing I like about the PP is that it hedges your bets so that one asset not performing as expected doesn't kill you.

[disparatum]

@Dragline:
I agree with what you said in the last post. My original claim was that interest rates caused the velocity of money to decline rather than vice versa (which was what I got from your earlier post). To be honest, this might be a minor point (I'm not an expert), but if the velocity of money causes the decline in interest rates, I'm not sure what causes the decline in the velocity of money. If it's the other way around, there are a number of theories to explain why interest rates are lower (described in the Summers and Bernanke articles linked above)

@Zach/Tyler:
I am a big fan of the PP, although I have drifted from it to some extent. I am overweight cash (about 35%) and I choose individual stocks. If I'm honest, I think some of it is a reaction to noise rather than a fundamental shift in philosophy (which is bad!). I did sell a good chunk of long term treasuries as they fell to about 2.4% and then to 2.1% and then re-bought when they got to 2.9 and 3%. But negative interest rates do make me nervous. It's unclear how negative they can really get before you have to consider pretty drastic policy changes like eliminating cash, etc.

@ThisDinosaur
I liked the executive summary. It crystallized one thing for me, but I think it's the opposite conclusion you came to. If secular stagnation is a good explanation for what's happening, it implies to me that instead of interest rates moving decisively higher, that they'll bounce around at low levels for the forseeable future (a decade or two?) and that they'll still serve their purpose in the PP as a way to smooth the volatility of equities.

[Dragline]

To be honest, this might be a minor point (I'm not an expert), but if the velocity of money causes the decline in interest rates, I'm not sure what causes the decline in the velocity of money.

Basically, its some combination of fewer economic actors buying fewer products and services relative to a prior time period. That's why demographics matter. Inequality may also play a factor.

As a thought experiment, if you ever get to a point where you only have one economic actor, the velocity would drop to zero. It would be close to that if you have one economic actor that controls all the money.

[Zach]

Thanks again for weighing in, everyone. Looks like it'll just have to be a judgment call if long-term treasuries end up moving into negative territory. Perhaps the data coming out of Japan or countries in Europe experimenting with negative rates will shed some light on this later down the line. They might prove to be the canary in the coal mine for what could happen if the U.S. experiences something similar. In the meantime, I'll sleep better at night in the current low interest rate environment

But negative interest rates do make me nervous. It's unclear how negative they can really get before you have to consider pretty drastic policy changes like eliminating cash, etc.

Me too. I've often thought about what I would do if the time came to re-balance and the only options for cash and long-term bonds were negative I vaguely recall Harry Browne mentioning in one of his radio shows that people kept buying T-bills during the Great Depression even when they effectively had a negative yield because it was seen as preferable to keeping money in the banking system. Essentially, they were paying a fee to have the government store their money.

Perhaps it's important to distinguish too between a nominal loss in purchasing power vs. a real one. In a severe deflationary environment, the value of the money we DO hold would increase significantly, right? So even negative-yield cash and bonds could theoretically still provide some degree of protection?