Washington, DC -- (ReleaseWire) -- 03/31/2015 --DAWN BENNETT: Mike Pento is the founder and president of Pento Portfolio Strategies. He is also the author of the book The Coming Bond Market Collapse, in which he examines how policies followed by both the Federal Reserve and private industry have contributed to the impending interest rate disaster.
BENNETT: Mike, just to educate our listeners, I want to say that high-yielding bonds are long term IOUs used by companies with shaky credit rates. In recent years, interest rates in these junk bonds have gone down to ridiculously low levels which is a real concern, because we saw this happen previously just before the stock market crash in 2008. Will junk bonds lead to a stock market crash in 2015?
PENTO: Well, no one knows the exact timing, Dawn, but I will tell you this. When you have 75 months of zero percent interest rate, the economy becomes addicted to the level of free money that's existed for that time. When the economy becomes addicted to these machinations there is a hundred trillion dollars' worth of interest rate derivatives that could blowup. These are people who have basically sold insurance against interest rates ever rising. So one of those things that I think could blow up are the high-yield markets, you are exactly correct.
BENNETT: The energy sector accounts for approximately 15 to 20 percent of the entire junk bond market. And now that oil is trading at about 44 dollars a barrel, those energy bonds are really taking a tremendous beating.
PENTO: Well, this is in part because of what the Fed has done. They've created an imbalance of capital. You create all this money for free for so long, you create a bubble in oil prices—as you said, West Texas was up above a hundred dollars a barrel. That engendered the entire U.S. fracking industry. It is basically insolvency and an unviable industry when oil is properly priced where it is right now at around 50 dollars a barrel.
Because the Fed has created this massive surge for yield, people go out along the risk curve and say, 'OK. This is higher than zero. Let me buy it. I don't care what the covenants are. I don't care what's backing it.' So they search for yield. They get 5-6 percent on these bonds. And then when these wells become absolutely unprofitable, they can't service the debt and then that debt explodes. That's just one miniature example of what's going to occur once interest rates normalize. I wouldn't even focus on that. That's the least of our problems. But you can see that the whole capital structure of Europe, Japan, the United States is completely out of balance.
BENNETT: You published your book The Coming Bond Market Collapse: How to Survive the Demise of the U.S. Debt Market two years ago. Have your views evolved?
PENTO: Well, yes, they've evolved dramatically. I never could possibly have imagined how far interest rates on the sovereign debt market could be distorted. Let's just take a look at Japan, for example. In my book I talk about Japan and back then when I wrote the book it was nowhere near where it is today. You have a quadrillion yen in debt. You have the Bank of Japan printing 80 trillion yen per annum ad infinitum, with no possible way of escaping. So you have an insolvent nation—250 percent debt in GDP—and you have a Central bank hell-bent on creating 2 percent inflation. The 10-year note is now yielding 0.3 percent.
Think about that. Think about what's going to happen when the day comes that the Bank of Japan has to make the announcement that they've achieved their two percent target. You're getting 0.3 percent on your 10-year. Inflation is now running at two percent. You are an insolvent nation and now not only are you going to stop buying every single bond that the Government of Japan issues, but you actually have to start selling these bonds into a market that doesn't exist. You're going to have a massive interest rate spike and you're getting into one 100 percent plus of all of your revenue just to pay interest on the debt. That's Japan. That's the case in Europe and in America too. I am sorry to say it, the entire developed world has entered the twilight zone.
BENNETT: Apparently Europe thinks they were left out of how quantitative easing somehow 'saved the U.S. and Japan,' so they've started a money printing campaign of their own. They have had a sluggish economy for almost four decades now, did they just order a dose of inflation?
PENTO: Only the Keynesians and those who don't believe in capitalism and free markets believe that QE saved the economy. In 2010, the U.S. GDP was 2.5 percent -- the annual growth of GDP. In 2014, it was 2.4 percent. So we have not at all saved the economy by all this massive money printing and complete distortion of markets. What we've done is we've re-inflated asset bubbles, we've re-inflated the stock market bubble. If you look at all the market capitalization of stocks, we're trading right now at 127 percent of GDP. It has never been higher outside of early 2000 and we know what happened then. And it is much higher than it was in 2007. So we've created a massive bubble in stocks, a huge bubble again in real estate, another massive bubble in bonds from which there is absolutely no escape. All of this has done one thing: we have, in aggregate, increased the amount of global debt by $60 trillion since the great recession began in December of 2007. So we've taken interest rates to zero, made money free, re-inflated asset bubbles, massively re-leveraged economies all over the planet and the only thing keeping this whole thing together is the fact that we can have a zero percent interest rate that is unsustainable, and when that ends, that's when the calamity will occur.
BENNETT: The U.S., Europe, Japan are all buying in to the idea of just printing money. What about other currencies? Are there any currencies that are actually a smart place to keep your money?
PENTO: Yes. Real currency, real money is gold. Let me just talk about the dollar for a second. The U.S. dollar is not really strengthening, Dawn. We've had, as I said, 75 months of zero percent interest rate. We have $3.7 trillion in quantitative easing, which is actually expansion of the monetary base that's known as high powered money. So, the dollar is only strong when compared to insolvent nations like the EU-18 and Japan that are still engaged in QE. But the intrinsic value of the dollar is not getting stronger. We have negative real interest rates for now and a weakening dollar against real money, gold. If you look at the dollar and its relationship with gold, dollar is really basically unchanged over the course of the 25 percent surge in the dollar on the DXY. So, when Yellen has to ascend to the fact that she cannot raise interest rates unilaterally, she will be unable to send the dollar higher, primarily because it will destroy earnings. I mean, I also love a strong currency, but she is worried about two things: deflation and earnings growth in the S&P 500. Both those things are going to be greatly exacerbated by a stronger dollar and by raising interests rates. So she is not going to be able to do it unilaterally. She's got to have to stay at zero, most likely until Japan and Europe end their quantitative easing.
BENNETT: Based on everything you said, it's almost like 'magic' seemed to have sustained this universal faith in currencies until about the middle of 2014 when a lot of monies went south. Except the dollar, which of course has continued to magically levitate. What is it levitating on?
PENTO: Why is the dollar strong against the euro and the Japanese yen?
PENTO: Because we stopped our quantitative easing. The Fed has been threatening to stop QE and raise interest rates since 2010. And every time we get to the precipice of actually having some normalization in the sovereign debt market of the United States, every time they even threaten to do that, the dollar will surge, the stock market falls apart and some bubble head will come out and tell you that, 'Oh, we really didn't mean what we said.' Now, Janet Yellen said that she was going to raise interest rates when the unemployment rate drops to 7 percent. Then it was 6.5, then it was 6.00, then it was 5.5. Now after last week's FOMC meeting, it was now 5.1 percent. That's a magical rate that the unemployment rate can drop to where inflation will start to surge. Now, inflation has absolutely nothing to do with how many people are employed. Zero. But, look, we are dealing with Keynesians who are infatuated with the Phillips curve, and they're so worried about people. Ask them, why would you worry about people working and producing things and being productive? To me it is completely asinine, but that's what she's focused on. But every time we get close to the point where we have to raise interest rates, she has to remove the word 'patience', then she puts the phrase that we won't be 'inpatient' back into her statement. Like I said, she is trapped. She boxed herself into a corner. She won't be able to raise rates until the Bank of Japan and ECB stop printing.
BENNETT: The U.S. seems to be waging this currency war against other nations that can only blow back by incurring the animosity of every trading partner we have. Do you expect China and Russia to begin undermining the dollar's reserve status, with gold as a weapon?
PENTO: Well, this is not a prediction on- my part. China and the Middle East, they are all moving away from having the U.S. dollar as the primary reserve currency and the primary currency in which trade is conducted. That's a fact.
BENNETT: You never hear them talk about it here in the United States.
PENTO: Well, that's because if the U.S. dollar was no longer the reserve currency then we'd have a big buying strike in our bond market. So your listeners understand: the ten year note—if you go back 45 years, the average interest rate is 7.3 percent on the 10-year note. Today, we are about 1.9 percent on the 10-year. If interest rates were just to normalize—and I can make a very solid argument about why they can go much, much higher given the amount of debt that we have piled up as a nation. Now we are 18.3 trillion with over a 100 trillion in unfunded liabilities. We have had, as I said, zero percent interest states for so long. We had a massive increase in the monetary base. So rates can go much higher. But if they are normalized, we will be spending a trillion dollars per annum just on interest payments on our debt. So deficits rights now, the administration is saying "we are down to half a trillion dollars a year, five hundred billion dollars a year," as it is some kind of grand achievement. They are going to quickly go back to a trillion just based on demographics, but then if interest rate normalize, we are going to pay a trillion in interest, and guess what? The denominator in the debt, the GDP ratio goes away. We saw that what happened in 2008 that our phony economy, not just the United States, also in Europe and Japan, and in China too, which derives its growth in massive capital imbalances. When that phony economy goes away—we saw what happened when the housing market crashed, when the stock market crashed. We immediately go into a violent recession and that completely eviscerates GDP, so that those ratios go all out of whack as soon as that happens.
BENNETT: Some are arguing that a strong dollar is not actually in America's best interests as it means exports are going to become unaffordable and foreign nations are going to have harder time servicing their debt. Where do you come down on this issue?
PENTO: I am very much in favor of a strong dollar. A strong dollar is very beneficial to U.S. consumers, equates to a rising standard of living; it is great for foreign direct investment. If you want to build a factory here, you're more comfortable doing that if you are a foreign nation. I mean, I am all in favor of a strong dollar. However, the dollar is rising in this case, as I said, primarily due to the fear trade and a sign of global deflation and the deflation of those massive asset bubbles that we built up, primarily since 1997. And those collapsing asset bubbles are not good news for anyone in the short term, but they are great news if they allowed to consummate, if they are allowed to play out. But I have no confidence at all that these central bankers—if you look at Haruhiko Kuroda over there in Japan who's absolutely in love with quantitate easing; if you look at Mario Draghi who thinks he can save the world. I mean, does anybody really believe that the stagnation and malaise in Europe is a cause of money being too expensive? You can go out seven years on the German Bund and you have to actually owe that money at the end of that contract. What we have is negative interest rates in nominal terms. So you could take interest rates to zero as they are doing in Europe and that is not going to engender growth. You need some massive structural reforms in Europe. You need tax cuts. You need supply side economics. You need austerity. But none of these things are happening.
BENNETT: After Yellen spoke Wednesday, sounding more dovish than ever, or actually sounding more dovish then the Fed watchers anticipated, the dollar actually crashed in overnight trading but then it recovered Thursday morning. Some are actually calling this a 'flash crash.' Do you know what happened?
PENTO: OK. So here is my assumption as to what occurred. The Street was on one side of the trade. They believed that Janet Yellen was going to remove the word 'patience' from her statement and then also maintain a very optimistic view over the economy. But what she did, she took out the word 'patience' like everybody predicted. However, she lowered her estimation. They call it a "dot plot." They lowered their estimation as to how high GDP growth would be, how high inflation would be, and what level the federal funds rate would be. So if you lower all those estimations, it becomes an extremely dovish meeting. So everybody was on one side of the trade. They were long dollar, short euro and they had to unwind that very quickly and you see how violently that move occurred. And then I'm sure you had some unwinding of that unwinding. But here is the point, tough, Dawn. This is part and parcel of what's occurred through the Central bank machinations. They have eviscerated and vanquished any semblance of the free market.
PENTO: We don't know what level the dollar should be. We don't know what level interest rates would be. We don't know where home prices should be. We don't know where the bond yields should be. We know one thing for sure: they don't belong anywhere near where these prices are because the free market, as I said, has been completely eviscerated. So this just a small example of what's going to happen as the Fed and other central banks try to return to normal. It is not going to be a very smooth process. I liken it to landing a jet airliner on a driveway. It's not going to be very pretty. It never has been pretty and because they have been so dominant and because they've replaced markets for so long, this time around it is going to be much worse than what happened in 2000 and in 2008.
BENNETT: Are there are any short term strategies you're suggesting based on where the dollar is right now? Are you shorting it, or are you long?
PENTO: I had been. I had been in my fund. I have an inflation/deflation fund and that's where I think we are headed right now. This is where the rubber meets the road as far as your investors are concerned. We're going through more and more violent swings between inflation and deflation. If you look at what happened in the year 2000, we had a mild, or a semi-mild recession because they took interest rates to 1 percent and left them there for one year. I'm sorry if this is review, but it is important to understand.
Of course, that engendered the housing bubble, just having interest rates at one percent for one year. When the housing bubble burst in 2007 and in 2008, we took interest rates to zero percent, printed $3.7 trillion in the monetary base, and when that housing bubble burst, the GDP was wiped out. We lost about 50 percent of the equity value in the stock market. Our home prices fell 35 percent. And now what do you think is going to happen this time around? So you have to position your portfolio for both cycles of inflation and deflation. Every time central banks try to escape from their domination of markets, you are going to see a massive retrenchment in asset prices and you'll see deflation. And when they print trillions and trillions of dollars you are going to re-inflate these asset prices.
So that's where I think we are at. And right now, my fund has been short the Euro, long the dollar. We did that through a very simple ETF EUO. We also very recently went into dividend paying stocks because Janet Yellen appeared extremely dovish after her statement, and I think that can be very beneficial to people who are seeking yield. But here is the point I want to make to you and your listeners. You cannot do a buy-and-hold strategy anymore in your investments. You can't do the Jack Vogel modern portfolio theory of investigating any longer.
BENNETT: That's right.
PENTO: There's going to be a time very soon when both bond prices and equity prices fall in tandem. And when that occurs, you're going to have a much more dynamic strategy in place. And that's what I do hear in terms of portfolio strategies.
BENNETT: Mike, I want to thank you for being on Financial Myth Busting. Mike Pento's book The Coming Bond Market Collapse is available on Amazon.com.
All data sourced through Bloomberg
Securities offered through Western International Securities, Inc., Member FINRA & SIPC. Bennett Group Financial & Western International Securities, Inc. are separate and unaffiliated companies.
About Dawn Bennett
Dawn Bennett is CEO and Founder of Bennett Group Financial Services. She hosts a national radio program called Financial Myth Busting http://www.financialmythbusting.com
She discusses educational topics and events in the financial news, along with her thoughts on the economy, financial markets, investments, and more with her live guests, who have included rock legend Ted Nugent, as well as Steve Forbes and Grover Norquist. Listeners can call 855-884-DAWN a as well as take podcasts on the road and forums for interaction.
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