A case for diversification
Bonds are a tough sell these days, with good reason. Buying US Treasuries – the benchmark for all dollar-denominated bonds – is effectively lending to the entity which holds the dubious distinction of being the most indebted of any in human history. And the debt is growing fast, such that the borrower is borrowing just to pay the interest. Worse yet, those in charge can’t even bring themselves to tap on the brakes.
It will pay the promised dollars. But it has the ability to create dollars from nothing, meaning the dollars it repays will be worth less than the dollars borrowed. That’s the usual mode of sovereign default.
Yet people own treasuries anyway.
With good reason. The Fed dreams of a world where it can manage a nice, steady pace of inflation, where the currency it issues loses value at a predictable and controllable rate. But that’s an economist’s fantasy that could only occur in a world without humans.
Why? When people are certain that the value of something will fall, they short it. This means they borrow it and owe it back to the lender. As the short positions pile up, so does the amount owed. This debt represents demand for the shorted security. Eventually a “short squeeze” develops in which the security shorted soars in value due to people who are short desperately demanding it in order to cover their short obligations.
The phenomenon is fundamentally the same regardless of what the shorted security is. Even if it’s a currency. The only difference is that shorting a currency isn’t reserved for financial types. Everybody does it. They short currency when they buy homes, cars, start businesses, hedge funds … it’s all the same.
Lest you be tempted to imagine this is a merely theoretical argument, consider Exhibit A: 2008.
In the middle of that year, break-neck inflation suddenly turned into white-knuckle deflation. People had shorted dollars against just about everything, conspicuously including housing. Dollars surged in value as demand for them to cover debt soared. As they did, it took fewer dollars to buy things with, including houses and stocks. Another way of saying this is prices plunged. It took months for the Fed to produce enough inflation to arrest the process. But in the mean time, many people lost their homes and even their retirements.
Of course 2008s don’t happen very often. Except they do, just on smaller scales. I routinely identify such events in these pages. Big events like 2008 are rare, but little 2008s happen all the time. We saw an example just a few weeks ago when out of a panic over dollar debasement, dollars suddenly surged, sending prices of stocks and commodities, even gold and silver, suddenly downward.
Whenever you see prices falling across the board, for stocks, commodities, even gold – things that don’t have anything in common except being priced in dollars – it’s the dollars rising. Occam’s Razor compels it.
This creates a buying opportunity. But if you had nothing but stocks and commodities to begin with, whatcha gonna buy them with?
Cash is good. But it’s really just a limiting case of treasuries … treasuries of zero maturity. Longer maturities can be even better, because the falling interest rates that result from falling prices mean falling bond yields and rising bond prices.
It may seem counterintuitive, but if you’ve followed my logic, the higher the rate of inflation, the greater the risk of deflation. So it’s virtually always a good idea to have some bonds, even – especially – when they seem like a bad idea.
There’s also the global market portfolio rationale. It’s in a very real sense the least risky portfolio you can own, because by owning the entire market of assets the world’s investors own, you can never underperform them. This isn’t to say it’s the ideal portfolio for any one investor, but it is the ideal benchmark, the comparator for informing you of exactly what risks you’re taking. And it not only reduces risk, but can increase returns, due to the effect of including multiple uncorrelated assets we discussed in Invest With A Demon, and that hedge fund legend Ray Dalio credits with his success.
Another reason … if you own stocks or real estate, you probably have a hidden short position in bonds. Most companies have debt on their balance sheets, effectively short bonds, and it’s necessary for a portfolio to include some bonds just to be neutral. The $38T US Treasury market is a big part of that global market portfolio. It might be wise to underweight it, but to exclude it completely involves both risks and foregone opportunities many investors may not be aware of.
What about other bonds? As mentioned, Treasuries are the benchmark for all dollar-denominated bonds, so the rest have all the risks of treasuries, plus their own default risks. Treasuries are the only dollar-denominated bonds most investors need consider.
In sum, viewed in isolation, bonds have relatively poor real return prospects due to inflation. But inflation doesn’t proceed in a straight line, and in the context of a multi-asset portfolio, including some bonds not only reduces risk but can enhance returns by serving as dry powder to take advantage of deflationary interruptions … of all sizes.
2025’s Implications for the Future: “Some Like it Hot”?
Gold was back on the job today, rallying when stocks were … not.
This is a welcome sign of good health after that little queasy spell.
Speaking of bonds, even Treasuries were pitching in.
Mega’s Dispatch from England:- THe Fall of the House?
Ah My friends please forgive the lack of MDFE, its not because of a lack of things to discuss……but what to discuss?
The Royal house is in full disarray, everyday now more & more is coming out. Yesterday the former British Ambassador to the US was arrested in connection with the Epstein files.
Its likely to stagger on now but with less heat.
The PM is enjoying the “Rest” from being the most hated person in the UK. With new staff he making some small progress but nothing like a recovery. We have a local BY election coming up in what was a VERY safe Labour seat.
The Question is not if Labour will loss the seat, but by how much…….some polls have them 3rd or 4th!
The Economy is at zero growth, any “Growth figs” are produced by “Creative” accounts rather than anything else. House price growth has stalled & even now falling in some areas of the nation. This loss of “Wealth effect” together with increasingly unserviceable debt & MEGA TAXES on EVERYTHING means a crash is coming.
Having killed its manufacturing economy in the 1979-2000 time frame & having a fast contracting service industry fueled by debt driven demand……its not looking good. We not much in terms natural resources to use either.
Its not looking good.
So………………wot did everyone think about Trumps little chat last night?
I only saw a few minutes before tiring of econostats and superlatives. The only thing I really cared about was policy direction and figured if there was any it would be a needle in the haystack search.
I think all the braggadocio is a waste of breath. People care about their own economy and know how well they’re doing. Being told how great everybody else is doing doesn’t make them feel any better.
What I’d like to have heard from Trump was how he was going to use his considerable leadership energies to spearhead simplification of the tax code, Medicare and Social Security and put them on a sustainable fiscal path. Based on what I’ve heard the closest he came was more personal finance complexification through yet another new kind of account.
Iran?
Will he attack?……………already tried & failed
Not especially high on most Trump voters’ priority lists. They voted for the guy who was going to put “America First”.
The one thing that most could’ve helped his ‘support me’ case would have been to say he was going to push for renewal of the broader ACA tax credits. Republicans effed up big on that one and are gonna pay in November. Tax hikes for ordinary people amid tax cuts for trillion dollar corporations is practically writing Democrats’ talking points.
If they “Drop the hammer” again this time its a VERY long fight, so what can he do?
Shitty dirty war more likely………..
Oh Hum
Mike
Anything that’s not over within a few weeks, better yet days, would not help Mr Trump and his party.
They fail to connect the dots. There’s a direct connection between federal expenditures and affordability … especially if the spending is going overseas. The same problem that bedeviled Mr Biden.
Team Trump is pushing HARD on the “IRAN WMD” thing tonight…………..they got to know its going to backfire on them in all sorts of ways
OK, Heads up
It seems WSJ is reporting Iran gave Trump the finger………..so wots it to be?
War or more Epstein files?
Mike
Markets seem mildly impressed with Nvidia’s latest financial report. Trading up from about $196 to $200. Hardly lives up to all the breathless hype though.
The context is more significant. We’re seeing a correction in the AI-is-gonna-eat-everybody-else’s-lunch trade. Big manias die hard, especially with the Wall-Street-Silicon-Valley media promotion machine carpet-bombing the public with non-stop marketing. Even bitcoin bounced today. The trend got a little ahead of itself and needed a temporary reversal.
Here’s a quotable quote from the State of the Union:
“We have an old grid, it could never handle the kind of numbers — the amount of electricity — that’s needed,” Trump said. “So I’m telling [companies] they can build their own plant; they’re going to produce their own electricity.”
Is Trump reading Finster?
Has The AI Bubble Sprung A Leak?
“And you might have to build your own nuclear power plant to run it all.”
This might help explain the downfall of bitcoin. I’ve mentioned Tether Gold before, but there are apparently a number of digital tokens with a better claim to “digital gold” than bitcoin.
Tokenised gold outshines crypto prices amidst political chaos
China tells its people to leave Israel ASAP
The U.S. Embassy in Jerusalem calls upon its citizens to leave Israel immediately
If possible today, while commercial flights are still available
It wasn’t my intent to make a market call with this post, but it’s worth noting that Treasury prices have risen markedly since. This represents an at least temporary return of their stock hedging value.
Whether and when they provide this value depends on the source of weakness in stock prices. In the last bear market in stocks in 2022, the source of stock price weakness was bonds themselves as yields rose in response to consumer price inflation. This led to widespread declarations that bonds were no longer useful as stock hedges.
As I’ve noted before, however, such overgeneralizations were ill founded. Recent trading bears this out as weakness in stock prices has arisen from factors other than rising bond yields. Regardless of their fundamental investment merit or lack thereof, bonds are still an independent asset class with diversification value.
Usually when I refer to “bonds”, I have in mind treasuries. Partly because it takes less time to type, but also because treasuries are such a huge part of the bond market. They’re also the purest form of bonds, without the credit complications that give corporates and high yields a bit of an equity-like character.
Private credit is related, and has become the object of attention lately due to some signs of distress, Blue Owl being just the most recent high profile example. Jamie Dimon of JP Morgan has expressed concern about some lending behavior recalling the runup to 2008. It should go without saying that when even such respected mainstream figures are getting “anxiety” over it, it’s something that should be on every investor’s radar screen.
Jamie Dimon Says His ‘Anxiety is High’ Over What Could Cause the Next Financial Crisis
Gold prices push back above $5,200; sees solid rebound in February to end month with another record
“She added that she is concerned that because of gold’s elevated price levels, investors might be looking at other safe-haven assets, specifically bonds.
…
“Rising bond prices could be a signal that investors are worried about a recession, and I don’t know if gold will do as well in a recession,” she said. “Bonds could be new competition for gold that holds back the market.””
You can make a case that treasuries are getting elevated too, but of late both have been providing good ballast for stock weakness. No need to choose one of the other when you can choose both.
Gold could easily do well in a recession though … recessions typically prompt inflationary monetary and fiscal policy responses. Bonds could too initially, as markets factor in rate cuts.