On Friday, December 11, 2015, stocks took a tumble. The Dow was down over 300 points on the day. The S&P 500 was down nearly 2%. Gold ticked up slightly.
The most interesting thing of note is what happened to bonds. The yield on the 10-year Treasury fell to 2.12%. It had been at almost 2.3% at the beginning of the week and even as high as 2.24% in the previous 24 hours.
We can never count on one day as a microcosm of what will happen, but this trend has been fairly consistent. When stocks drop big, government bonds tend to do well.
The Fed is widely expected to raise interest rates this week, although it has found excuses up until now. But when we say “interest rates”, the Fed would really just be raising its federal funds rate. The only way to do this is to increase the interest paid on bank reserves.
Here is the problem though. If the Fed raises its key rate, it will curtail further lending by banks, at least on the margin. This could be slightly deflationary, even though the Fed’s balance sheet is staying the same. Less bank lending will mean a slight reversal in the fractional reserve lending process.
The Fed has already been in tight money mode for a year. The end of QE3 was announced at the end of October of 2014. If we believe the Austrian Business Cycle Theory – and we should – then we are likely to see something of a bust if there are no other drastic changes from here.
The longer we move away from QE3 without any additional monetary inflation, the closer we move to a recession. If the Fed hikes its key rate, which results in even less bank lending, this should just speed up the process.
Many analysts are worried about a higher federal funds rate because it will lead to higher market rates. This would mean a higher cost of borrowing, including higher mortgage rates.
But the real threat is that the previous artificial boom gets exposed and it leads to a bust. The lack of monetary inflation will inevitably expose the misallocated resources. Even continued monetary inflation would eventually result in a bust, but it can be dragged out longer.
If we hit a recession though, then yields – at least on U.S. government debt – are likely to go down. In other words, a hike by the Fed may actually result in lower market interest rates.
Most libertarians are not big fans of buying U.S. government debt, often for more than one reason. When you buy U.S. government debt, it is not a good hedge against inflation. It is quite the opposite.
In addition, some libertarians don’t like to buy U.S. bonds just because they don’t like investing in anything having to do with the U.S. government. This is understandable, but I don’t think we should let it cloud our logic.
It is ultimately a personal decision, but I don’t think it is immoral to buy U.S. government debt. Congress is going to spend its money regardless of what you do. They already force you to pay taxes that you cannot avoid without the threat of going to jail.
In terms of investing, many libertarians understandably do not trust the U.S. government and therefore do not view government bonds as a trustworthy investment. But even though we don’t see it as a safe investment, it really only matters what others think. If every other investor is running to bonds for safety, then the early buyers will make money.
So while owning U.S. government debt makes me nervous, not owning some makes me even more nervous. The permanent portfolio recommends 25% in government bonds. If there is anything to tweak, that would be it for me. But given the current conditions and the higher probability of a recession hitting in 2016, long-term government bonds are an important piece to your investment portfolio.
There will come a day when interest rates finally go up significantly, but we are still not there yet. There will be a time when shorting bonds will be highly profitable. Now is not that time.