Michael is a well-known money manager and a fantastic market commentator, and over the past few years has been a wonderful guest and one of our favorite interviews here on the Money Metals Podcast and we always enjoy getting his Austrian economist viewpoint.
Michael, welcome back and thanks for joining us again.
Michael Pento: What a great introduction. Thanks for having me back on, Mike.
Mike Gleason: Well, we often talk about bond yields with you, Michael, and I think that’s a good place to start today. You recently published an article where you made the case that 4% would be the floor when it comes to the 10-year note – not the ceiling, the floor, and you made some observations that now seem striking. The yield on that note averaged 4.6% in 2007, just the year before the 2008 financial crisis.
Today practically nobody remembers yields ever being that high… 10 years is a long time we suppose. Heck, it seems like investors have already forgotten the early February selloff in the equities market, so I guess we can’t be surprised that they can’t remember the situation a decade ago.
In any event, markets are not prepared, or priced for 4% yields on the 10-year. Talk a bit about why 4% is likely to be a minimum and why yields should probably be much higher than that.
Michael Pento: Let’s start with the fact that normally speaking throughout history, the 10-year note seems to run with nominal GDP growth, which is basically your real growth plus inflation. So, if we’re running around 2% inflation and we have growth at 2.5% around that, you would assume that the 10-year note should be historically speaking around 4.5% right now. But I can make a very cogent argument, Mike, that rates should be much, much higher because if you look back … as you mentioned the 2007 when that average interest rate was, again, 4.6% and nominal GDP was sort of around that same ballpark, the annual deficit was 1.1% of GDP.
But going into fiscal 2019… sounds far away, not maybe that far away, but it sounds further away than really what it is. It begins in October of this year. Our annual amount of red ink will be $1.2 trillion. That is the Treasury’s annual deficit, but you have to add to that to the fact that the central bank of the United States will be selling… and I say selling, because what they don’t buy the Treasury must issue to the public, $600 billion less of Treasury Bonds. So, that’s $1.8 trillion deficit. That has never before happened in the history of mankind, a $1.8 trillion deficit, which happens to be 8.6% of our phony GDP if we don’t go into a recession.
If we go into a recession anytime in the near future, and I don’t think the business cycle has been outlawed, then we’re talking about $3 trillion annual deficits. Let’s just take the 1.8 which is 8.6% of GDP. Why would the 10-year note not go to at least 4.5% where nominal GDP is? It would probably go much higher, especially even the fact that back in 2007 we had $5.1 trillion dollars of publicly traded debt, but not we have $15 trillion dollars of publicly traded debt. So over above the fact that the Fed’s balance sheet went from $700 billion to $4.5 trillion; it’s $4.4 trillion right now.
But you still have $4.5 trillion that they hold, but guess what? There’s an extra … what’s that, $11 trillion of publicly traded debt that has to be absorbed by private bond holders? So deficits are exploding. The amount of publicly traded debt has exploded. And there isn’t any reason, and there isn’t any rationale. Central banks are getting out of the bond buying business so there isn’t any cohesion, rationale, for rates not to not only normalize but be much higher than they were normally.
Let’s just say they normalize… 4.6%, 4.5%, maybe higher than that. By the way, let me just add this quickly Mike, the average interest rate going on a 10-year note going back since 1969 is over 7%. So, the interest rate on the 10-year right now is 2.88%. It is going to not only go up much higher, but it’s going to rise dramatically, probably towards the end of this year as the ECB, European Central Bank gets out of their QE. They’ll be ending QE by the end of this year.
So then you’ll have only the Bank of Japan in the bond buying business. So, yields are going up … and I’ll let you in after this one more comment … if the yield on a 10-year note goes from 2.8 … and don’t forget … it was 1.4. Now it’s 2.88 or 2.9, it’s going to go to 4.5 very quickly in my opinion. Probably by the end of this year, unless we have a recession and a stock market collapse.
Where do you think junk bonds will be? The average yield on junk bonds is 5%… a little bit over 5%. So, junk bond yields are going to spike. That means that prices are going to plummet. And my god, you’re talking about a complete blow-up of the income market across the spectrum, especially in the riskiest part of it. Just like subprime mortgages. So buckle your seat belts, the low-volatility regime is dead and gone.
Mike Gleason: The housing market is a very big part of the economy and that’s tied to the 10-year and it’s likely to get crushed. And honestly that’s just the most direct example, but honestly there is so much in our financial world, as you just alluded to, that’s dictated by that treasury note. So, if people are ever wondering why you talk so much about these bond rates it’s because it’s so vitally important, isn’t it Michael?
Michael Pento: Absolutely. You have not only junk bonds, you’ve got collateralized bonds, you’ve got collateralized loan obligations, leverage loans, private equity deals … you have the risk-free rate of return, sovereign debt, taken to 1.4% and that was in the summer of 2016. So, let’s just say, that if I’m correct, it goes to 4.4%. So, the 10-year note goes from 1.4 to 4.4 just at 300 basis point increase in yields leads to a 24% plunge in your principle.
So, if you lose a quarter of your net worth that you have in bonds in the risk-free treasury, imagine what your loss will be in leverage loans, COOs, junk bonds, muni bonds, equities, real estate, REITS, I mean you could go on and on. Everything is based off of that risk-free rate of return, which by the way, if hedge fund’s rate was 0% for almost 9 years, and a German bund into 0.7%, it was negative for many years, people in corporations in Europe were floating debt with a negative yield, so you had the biggest bond bubble in history that’s slamming into the hugest gargantuan increase in debt in history. And when those things meet, it’s an awful deadly cocktail.
So, like I said, buckle your seat belts because this is going to be one hell of a year coming up. It already has been and it’s only going to intensify.
Mike Gleason: Now with that said, there are some that argue that the Fed will not let yields move that high, they simply cannot. Officials there know well what will happen to growth and to the federal budget if rates should rise so do you think the Fed will intervene and can they continue to keep rates capped indefinitely?
Michael Pento: Well if you listen to the new Fed chair Jerome Powell, testifying yesterday saying he’s so ebullient and upbeat about the stock market and the economy. I don’t know what he’s looking at, I mean we had two quarters in a row at 3%, now the 4th quarter came in at 2.5%.
If you listen to the Atlanta Fed, they started Q1 at 4.5% now it’s down to 2.6%. So I don’t know where the excitement is about GDP. I don’t know where it’s coming from. You mentioned housing, if you look at pending home sales it’s 4.7% down. It was announced this morning. All the other data on all prices is heading south, including existing home sales and new home sales. And that’s only when we had a slight uptick in interest rates.
People talk about how beneficial the tax cuts are, but they forgot about the other side of the equation which is rising rates. Rising debt service costs are erasing any and all benefits that’s coming from the tax plan. So, what we’re seeing now in the economy is a sugar high, an adrenalin shot. But going towards the end of this year I fully expect the economy to fall out of bed.
And Jerome Powell who is still upbeat on the stock market and the economy, he’s going to have to change his tune. But what happens when you change your tune, is the Fed is going to have to admit, Mike, that they had the mistake. In other words, their 9 year experiment in Quantitative Easings, and huge increase in the size of the balance sheet, failed to rescue the economy. And instead of being able to ever normalize interest rates … this is why this watershed epiphany is going to be so hard for the Fed to admit … they’re going to have to admit that all of their manipulations failed to provide viable and sustainable economic growth.
And then they’re going to have to change course, because as you said, if interest rates rise and rise they must, and we’re paying all this extra interest on this debt. And they’ll say well, we have to cap interest rates from rising, this is a watershed epiphany that they’re very much loathe to admit. Because if you change your tune at 5.25% on a Fed funds rate as they did in 2008, that’s one thing. But if you change your tune when interest rates on the Fed funds rate … the effect on Fed funds rate is 1.4% as it is today … that’s a totally different story. You’re not only going to have to take back your 150 basis points of rate hikes, but then you have to go right back into QE, you have to admit that you can never drain your balance sheet, you have to admit that interest rates can never normalize.
Do you know what that would do to the currency? Do you know what that would do to the price of precious metals? Do you know what that would do to the fate of the stock market and the state of the treasury? So, all these things are going to be loath to admit but they will have to come back into QE as the stock market and the economy plunges. And then it’s game over. I think the faith in fiat currencies goes away and it’s going to end very quickly, and it’s probably going to start by the end of this year.
Mike Gleason: Yeah it’s certainly a hyper-inflationary type of scenario could play out there if all that comes to pass for sure. I was recently watching an interview you did with legendary investor Jim Rodgers, which was really great and very fascinating by the way, and you guys were talking about ETFs and the dangers that those funds may pose the next time equity investors rush for the exits.
You made some really great points. Now back in 2008 the markets were crushed by derivatives – securities so complex that lots of people who were on them didn’t understand what was in them or how they might perform. These days the markets may be at risk from exchange traded funds which are designed to make investing simple.
Please explain why you were so concerned about ETFs and their increasing dominance in the markets, and how a sell-off could be made much worse by the fact that so many people are invested in these things.
Michael Pento: Well you look at what happened with inverse volatility trade. I’m sure you guys are aware of what happened there. So, people were lulled to sleep in the stock market, believing that the only direction that stocks can go is up. Because there was no other alternative. You take yields to 0%, leave them there for 9 years, and of course people are going to go out, way out, along the risk curve.
So, people were actually saying to themselves after a while, hey, why don’t I just short volatility? Well the problem is, when everybody shorts volatility, is that when volatility spikes by 100%, inverse vol goes to zero. And that wiped out billions of dollars of net worth, pretty much in hours. And it’s not exactly the same thing, but that same concept is now in play with the ETF’s spectrum. So, 9 years, 0% interest rates, everybody went into passive ETF funds, by the way Mike, a lot of these funds own very much the same securities. So, Amazon, Facebook, Netflix, Google, Apple, these are all contained in various weightings in all of these passive ETFs. Or much of them.
So what happens is you have passive ETFs ownership, which has gone off the charts, as well as a huge surge, a gargantuan increase, in passive ETFs that are leveraged to the bond market. So you have ETFs that own bonds, that are long bonds, ETFs that are long, high-yield junk, ETFs that are long the same securities. And when everybody hits the exit door at once, as they did with these inverse volatility trades, they will blow up.
So you try to redeem the ETFs. The ETFs in turn have to redeem the underlying securities, which in turn causes the ETF’s value to fall, so it’s a vicious cycle, a downward spiral. And that’s what I’m afraid is going to happen. Because you have globe investors to sleep by 9 years of inculcation that yields can only go down and prices on bonds and equities can only go up. And when that changes, and it could change violently as yields start to rise, then you’re going to have this implosion in pretty much everything … you had bubble in everything, you’re going to have an implosion in everything.
That’s the real danger. I’m not a Cassandra. I was way out in front of the spectrum of all these perma-bulls in 2007 and in the year 2000, I warned about the housing market in 2005 and 2006. So, I have a history of identifying these problems. I have said for the last few years that you cannot construct a healthy, viable economy by taking interest rates to 0 and leaving them there for years.
And also increasing a massive amount of debt… $230 trillion dollars, 330% of GDP. That is the total amount of debt in the globe today. Up $70 trillion dollars since the great recession. While you’ve taken interest rates and deformed the whole risk spectrum, while you’ve increased debt, you’ve also blown up the biggest asset bubble in equities ever. So, we’re now at 150%, 1.5 times. The market cap of equities are now 1.5 times the underlying economy.
That has never before happened in history. It was only reached about that same level in March of 2000. This is a dangerous bubble and it’s going to burst, and you and your investors need to be aware of how dangerous it is. And you should also understand if you’re going to invest, you should have somebody that understands this dynamic now and can at least try to profit from the 3rd, 50%+ plunge in prices since the year 2000.
Mike Gleason: Yeah a very troubling set up for sure. Well as we begin to close here Michael, I wanted to talk to you about gold and silver. They’re often viewed as safe havens, and in the aforementioned scenario you got to think metals would get a boost. But if we go back to the last financial crisis, they did get taken down, gold and silver, they did get taken down with equities although they bounced back much sooner.
However, leading up to the fall of ‘08, we had a pretty hot commodities market that drove metals up in the preceding few years, but this time metals have been languishing a bit and seem cheap compared to everything else. So, what do you see happening in the metals markets this time around during a big stock market crash, if and when we do get one?
Michael Pento: So, you know Mike that I love gold, I think it’s going to be supplanting fiat currencies after the debacle ensues. But I’m underweight gold in the portfolio now. You once talked about 2008, what happened in 2008 don’t forget. If you remember back then we had the BRICs trade going. So people were short dollars and long Brazil, Russia, India, China currencies. So, when people became aware that the stock market globally … and economies globally and real estate market globally … was going to tank, they had to close out that carry trade, which involved buying dollars.
That trade is not prevalent today, so I don’t think gold is going to get hurt the next time this happens. But I’m underweight gold now, precisely, because while the dollar does stand to weaken because of these massive trade deficits … we have huge trade deficits, in fact the last one came out at minus $74 billion dollars for one month of goods and services in the deficit … we also have, and I mentioned it, the massive debt. That’s very negative for the dollar and positive for gold. What we have on the negative side for gold is rising nominal and real interest rates. So that is never good for gold. So, there’s a battle on right now, it’s like this $1,300 to $1,350 kind of battle. You see gold tries to get higher and then you realize well, rising rates are not very good for gold, and then it starts to fall and you realize that hey, a falling dollar is really good for gold, so it’s kind of caught in this trading range of ignominy.
But that all ends when that epiphany, that watershed moment comes from the Federal Reserve that yes, we have to stop draining our balance sheet, and we must reduce the federal funds rate. And then I think, as I said, fiat currencies get flushed down the toilet and there’s going to be a mad rush into gold like you’ve never seen before. Because what’s going to happen is you’re going to have bond prices and equities tanking simultaneously. And people will be fleeing to gold, flocking to gold, in the realization that normalization in the interest rate spectrum, normalization in the economy, is not going to be able to be achieved any time in the near future.
Mike Gleason: It’ll certainly be interesting to see if you could get your hands on it in that sort of a mad rush of retail investors trying to get gold. Right now, we’ve got a lot of access to inventory and it’s on sale still so people should heed that warning.
Well we appreciate it as always Michael, it’s great having you on once again and we always love getting your insights. Now before we let you go, as we always do, please tell people about how they can both read and hear more of your wonderful market commentaries and also learn about your firm and how they could potentially become a client if they want to do that.
Michael Pento: Well thank you. It’s Pento Portfolio Strategies, PentoPort.com. My email address is firstname.lastname@example.org. The office number here is 732-772-9500 give us a call, we won’t bite. And please subscribe to my podcast, its only $49.99 a year and it gives you my ideas on a weekly basis, kind of analysis of economics and markets that you won’t find anywhere else.
Mike Gleason: Yeah it’s truly great stuff. Michael is somebody that I’ve been following for a long time, we always love having his comments here on the podcast, and we certainly appreciate it and look forward to catching up with you again before long. Thanks very much for all you do Michael.
Michael Pento: Thank you, Mike.
Mike Gleason: Well that will wrap it up for this week, thanks again to Michael Pento of Pento Portfolio Strategies. For more information visit PentoPort.com. You can sign up for his email list, listen to his mid-week podcast and get his fantastic marking commentaries on a regular basis. Again, just go to PentoPort.com.