Yields on United States 10-year bonds rose above 3% at the beginning of January. The yield on the 10-year had reached its lowest point in history in July 2012 at 1.43% as a result of the Fed’s policy of Quantitative Easing. Since then yields have doubled as markets have incorporated the impact of the Fed tapering their purchase of U.S. Government securities. This raises the question, how high could interest rates go from here? Could interest rates move up to 3% per quarter? U.S. interest rates were that high back in 1981 when the yield on US 10-year Treasuries hit 15.84% and 30-year mortgage rates hit 18.63%. What about 3% per month? That works out to 42% per annum compounded. Although interest rates have never been that high in the United States, they have been that high in other countries. The yields on 3-year bonds in Mexico were over 50% back in the 1990s. Other countries, mainly in the developing world where inflation was more common in the 1970s to the 1990s also experienced double or triple digit interest rates.The government, however, had a different point of view. What is the point of having a hyperinflation if you don’t at least wipe out your government debt? By October 1923, the German government was issuing 100 Billion Mark (100,000,000,000) banknotes (equal to 100 Trillion Marks by US measurement), and when the government finally did convert the currency from old Marks into Rentenmark, it took 1 trillion old marks to get a new Rentenmark. What about government bonds? What happened to them? Did the speculators reap a windfall from the revaluation of the currency? Of course not.This proves two things. First, markets are efficient. The net price in Berlin after the inflation and in London after the devaluation ended up the same. Second, don’t try to outsmart the government who deals the deck of cards. You will lose.
The Impact of HyperinflationInterest rates at that level can only occur because of inflation. The problem is that as inflation rates rise, they become more unstable and unpredictable. Consequently, the maturity of debt instruments shrinks as the uncertainty increases. Annual interest rates become meaningless, and the maturity shrinks to months or days. What about 3% per week? At this level, the compounding of interest rates takes over. An interest rate of 3% per week works out to 365% per annum. Interest rates rose significantly beyond even this level during the German hyperinflation of 1923. The interest rate charged at the Berlin Stock Exchange in October 1923 hit a high of 7950%, the equivalent of 9% per week. Although this interest rate is high enough to even make a Payday Loan store blanch, it didn’t even come close to compensating for the inflation that occurred in October 1923. The monthly inflation rate in Germany during October 1923 was 24,380%, which far exceeded the 45% monthly interest rate implied by the 7950% interest rate the Berlin Stock Exchange charged. During that month, the US Dollar exchange rate went from 242 million Marks to the USD on October 1, 1923 to 100 billion Marks by November 1, 1923.
Investors and Speculators Get Wiped OutAt these levels of hyperinflation, interest rates become meaningless. When prices are rising at the rate of 30% per day, as occurred during Germany in October 1923, fixed-income assets are completely wiped out by the inflation, and no one will deposit or lend cash that will become worthless in a few days. During hyperinflations, the future ceases to exist and cash becomes the only medium of exchange as the value of assets with a maturity over a few days is completely wiped out. Interestingly enough, government bonds rose in price along with inflation during 1923 in Germany. The German 3% bond paying 3 marks in interest actually traded for 37 million Marks in September 1923, right before the inflation came to an end. This provided a yield on the bond of less than one-ten millionth of a percent (i.e. 0.0000001%). The price on the bond had risen from 475,000 Marks just one month before, and a chart of the stock is illustrated below.
Why, you might ask, would someone pay 37 million Marks for a bond that pays 3 marks in interest? The answer is easy, speculators were hoping that once the inflation was over, the government would redeem the bonds at their inflation adjusted value. The people buying the 3% Perpetuities of Germany thought the government would revalue the bonds providing them with both a hedge against hyperinflation as well as a huge profit.
The German government decided that all outstanding bonds would be redenominated at one-tenth Pfennig on the Mark. In other words, a government bond that had originally been issued at 100 Marks was now worth 10 Pfennig. In effect, investors lost 99.9% of their investment. The price of the bond traded up from there to reflect higher interest rates after the inflation was over with, but the difference was small. The German bonds also traded in London where the price reflected the devaluation of the currency. The value of the bonds on the London Stock Exchange fell from 100 Pounds to 5 shillings (25 pence), a loss of almost 99.9%.
So far in 2014, emerging markets have significantly underperformed Developed Markets. Turkey has been forced to raise their interest rates dramatically to defend the Lira while Argentina saw a collapse in its own currency. The Fed is expected to continue to taper in 2014, reducing the flow of funds to Emerging Markets and causing them to further weaken relative to Developed Markets. The MSCI Emerging Markets Index has failed to break above its 2011 highs and could soon break critical support right below 900. How long can this continue? The chart below shows the long-term relative performance of Emerging markets relative to Developed Markets. Global Financial Data has extended the MSCI Developed and MSCI Emerging Markets back to the 1920s so their long-term interaction can be analyzed.How far can Emerging Markets fall relative to Developed Markets? If the trend follows the pattern of the past, quite a lot. Whether it continues down to the levels of 1985 or of 2000, or even 1968, remains to be seen, but this chart does not bode well for Emerging Markets over the rest of the decade. This technical analysis is backed up by the fundamentals. The end of tapering, and eventually the end of Zero Interest Rate Policy will attract more money to Developed Markets. Assuming the worst of the Eurocrisis is over, growth may soon return to Europe. Many Emerging Markets will have to see their exchange rates decline in order to make their labor markets more competitive. In the coastal areas of China, wage rates have risen substantially over the past decade, reducing the future gains from trade. Countries like India struggle with providing the infrastructure necessary for economic growth. Commodities made a huge move over the past decade, and they are unlikely to continue their relative appreciation, reversing the improvement in the terms of trade that some Emerging Markets had enjoyed. In short, the chart and the fundamentals say that you should not see the current weakness in Emerging Markets as a buying opportunity. Instead, it probably foreshadows continued weakness for several years to come. Don’t try to catch a falling knife because you are likely to get hurt.
As can be seen by the chart, the Emerging-Developed Equity Cycle lasts around seven to ten years. Developed markets outperformed Emerging Markets from 1945-1968, 1979-1986, 1994 to 2001 and since the beginning of 2010. Emerging Markets outperformed Developed Markets between 1968-1979, 1986-1994, and from 2001 to 2010. We are now four years into the current market cycle. Based upon the past, you would expect the current underperformance of Emerging Markets to continue until 2017 or 2020 at the latest when the trend would reverse itself.
Global Financial Data is proud to announce the addition of almost 40,000 files that our subscribers can now access. The source of the data is the World Bank, which has made their data archives available to all users. These files cover every country in the world, and a wealth of topics from the environment to the economy. All the data files are annual with some providing data back to 1960. Global Financial Data has gone through these series and chosen the ones that would be most useful to our subscribers. The focus has been on choosing series that provide long-term data and supplement the 20,000 series in the original GFDatabase and the 45,000 series we provide from Eurostat. Between these three databases, subscribers now have access to over 100,000 data series that cover the world. Included in the series GFD has chosen are new series providing data on Gross Domestic Product, Exports and Imports, Debt, Education, Technology, the Environment, Health Care, Trade Barriers, Infrastructure, Defense and Income Distribution. In addition to these areas, we have expanded coverage of topics traditionally covered by the GFDatabase including Interest Rates, Price Indices, the Stock Market, Monetary Aggregates, Population, and Exchange Rates. To highlight the World Bank Data, we provide a separate tab in our Search Engine so you can find topics that will help you to do your research. If you would like, we would be happy to send you an Excel file with information on the series that have been added. Global Financial Data plans to provide a new release of data each month to its subscribers to the GFDatabase, US Stock Database and UK Stock Database. We will provide updates on these releases both through our blog and through e-mails. If you have any questions about these releases, please feel free to contact your sales representative.
Yields on United States 10-year bonds passed the 3% in January. The yield on the 10-year had reached its lowest point in history in 2012 at 1.43% as a result of the Fed’s policy of Quantitative Easing. Since then yields have doubled as the markets incorporated the impact of tapering their purchase of U.S. Government securities. This raises the question, how high could interest rates go from here? Could interest rates move up to 3% per quarter? U.S. interest rates were that high back in 1981 when the yield on US 10-year Treasuries 15.84% while 30-year mortgage rates hit 18.63%. What about 3% per month, per week, or even per day?
HYPERINFLATION AS THE NEW NORMALBrazil was one of the worst of the Latin American hyperinflators of the 1960s to 1990s. New currencies were introduced in 1967, 1986, 1989, 1990, 1993 and 1994. The Real, introduced on July 1, 1994, put an end to Brazil’s addiction to inflation, but by the time the Real was introduced, the new currency, was equal to 2.75 Quintillion (2,750,000,000,000,000,000) Reis, the original currency Brazil had used as a Portuguese colony. The impact of these inflations on the currency is illustrated below in the log chart of exchange rates between the Brazilian currency and the US Dollar from 1950 to 2014.
The Banco do Brazil uses the SELIC (Sistema Especial de Liquidação e Custodia – Special Clearance and Escrow System) to set interest rates for the economy, just as the Federal Reserve uses the Discount rate in the United States. The SELIC became the basis for all interest rates throughout the Brazilian economy as hyperinflation took over. At first the SELIC was adjusted every few years, then every few months, then daily. Along with the exchange rate for the SELIC became the primary indicator of inflation on the Brazilian economy.