It’s yet to be seen whether the recent market correction has run its course. But one thing is certain: the Federal Reserve didn’t expect the panicked reaction that its recent comments on potential policy changes triggered. The market hadn’t even lost 5 percent before Ben Bernanke sent his minions out into the media to dispel any fears that the Federal Reserve would abandon the markets. Such backpedaling is highly dysfunctional. But, it appears that we live in a world that can’t tolerate even a modest market correction, which bodes poorly for the time when the Federal Reserve finally does what it has to do and starts normalizing monetary policy.
Even after selling off to yield about 2.5 percent, where they were trading at the beginning of July, benchmark 10-year Treasuries are at very low yields. Other credit instruments that saw large losses in June are also still yielding far below historical norms. High yield bonds saw their average yields increase by about 200 basis points, from an absurdly low 4.8 percent in early May to about 6.8 percent today. This greater than 40 percent move in yields is the biggest percentage moves in history. Municipal bonds and investment grade bond also suffered huge losses but are hardly offering generous returns for investors. The real problem for all of these markets is that further interest rate increases are likely over the next 12 to 18 months, which will place further pressure on bond prices. Investors need to proceed very cautiously by keeping the durations of their portfolios (which measures their sensitivity to rising rates) as short as possible and investing in floating rate debt as much as possible.
Finally, the price of gold has dropped sharply by 27 percent this year (23 percent in the second quarter). I would attribute the plunge in gold to several factors. First, a lot of gold was held by leveraged speculators who were forced out of the market as prices dropped. Second, investors who view gold as an inflation hedge are abandoning the trade based on the low level of consumer price inflation in the United States. Third, investors who view gold as an inflation against central bank money printing are coming to believe – wrongly in my view – that central banks are going to slow their activities in that area. For all of these reasons, gold is back to levels last seen in 2010. Gold remains an insurance policy against the inevitable decline of the fiat paper standard. There’s far too much debt in the world that can never be repaid in constant dollars. This debt can only be repaid in one of three ways: (1) partially, which means through defaults and restructurings (for example, as happened in Greece and Cyprus); (2) through inflation; and (3) through currency devaluation. The global economy is simply incapable of generating sufficient income to service and then repay the trillions of dollars of debt on the balance sheets of the central banks ($14 trillion), not to mention all of the other public and private sector debt, not to mention the hundreds of trillions of dollars of future entitlement obligations of its governments. In the end, paper money will continue to be devalued and gold will be the beneficiary of that phenomenon. I would be perfectly comfortable adding to gold positions at this level as a long-term trade and would strongly advise investors who do so to purchase physical gold.