What is the safest place you can think of to store precious valuables? Many would suggest a safety deposit box at the bank. There is usually a double-key entry system and a foot-thick steel door, not to mention the reputation of the bank itself. The “safety” aspect seems ironclad.
And yet, imagine this scenario: You have $10 million worth of valuables in a safety deposit box, in the form of gold bullion or diamonds or precious heirlooms. One day, you check on the contexts of the box — and the valuables are gone. You ask the bank to make it right. They refuse. You spend tens of thousands of dollars in a lawsuit against the bank. The judge sides with the bank. Your millions are simply gone.
This is not a hypothetical scenario. It has happened multiple times. American citizens have seen huge losses in their safety deposit box holdings — sometimes hundreds of thousands, sometimes multiple millions. Tens of thousands of safety deposit boxes see their contents “lost” every year. And the bank has limited liability — as spelled out in the fine print of the lease contract — with payout caps as low as $500.
By some estimates, more than 33,000 safety deposit boxes each year see their contents go missing. Millions in valuables gone? The core of your retirement nest egg vanished into thin air? Too bad. The bank doesn’t care. The real slogan for renting a safety deposit box should be “caveat emptor.”
Safety deposit boxes aren’t the only thing that appears “safe,” but is actually booby-trapped. This problem looms on a much larger scale, in a way that could impact the retirement of tens of millions of Americans. This time, it has to do with U.S. treasury bonds.
U.S. treasury bonds, like bank safety deposit boxes, appear “safe” but really aren’t. In today’s environment, bonds can be a dangerous asset to own in size. The danger is high precisely because the illusion of safety is so prominent. Many investors have a feeling of comfort putting 60% of their retirement account in treasury bonds — or even higher percentages, sometimes 70% or 80%. That safety is an illusion.
We’ll get to treasury bonds shortly. But first, let’s dig into the wild story around safety deposit boxes.
Last month, the New York Times ran an eye-opening (and horrifying) story titled “Safe Deposit Boxes Aren’t Safe.” You can read it here. The story explains how individuals can lose their precious valuables, sometimes millions of dollars’ worth, without any recourse from the bank.
The problem is that banks hate the safety deposit box business. There are an estimated 25 million safety deposit boxes in the United States, but no protective regulation. And banks are trying to get away from safety deposit boxes entirely — when a new branch opens, there are typically none on the premises.
This is how the valuables get lost. It’s not that a bank robber gets in. Most of the time, the bank moves the contents of a box from one location to another when a branch closes down, and the contents of the box are then lost. At other times, the bank can empty a box for lack of payment, but someone makes an error and empties the wrong box by mistake. When this happens, the valuables can disappear.
If the banks can’t find your valuables after losing them in this manner, they don’t make you whole. They point to the fine print, which limits their liability.
As the NYT explains, Philip Poniz lost millions of dollars’ worth of rare watches because of a bank error (they emptied the wrong box, then lost the contents). His retirement hopes were dashed by this.
Lianna Saribekyan and Agassi Halajyan, a married couple, lost millions of dollars’ worth of jewelry, cash, gemstones, and heirlooms in a similar way when a Bank of America branch closed down. They sued the bank and won more than $4 million in compensation and damages — until a judge reversed the verdict and cut the payment to almost nothing relative to what was lost, a little over $152,000.
The system is designed to protect the banks, not you. If you don’t read the fine print, you can lose everything due to a bank mistake. There is a similar dynamic with treasury bonds, which are widely believed to be the ultimate shelter in a storm.
It doesn’t help matters that U.S. treasury bonds are richly priced right now. In fact, U.S. treasury bonds are more expensive than they have ever been, ever.
The yield on the 30-year U.S. treasury bond fell below 2% this week, the lowest in all recorded history. When bond yields go down, bond prices go up. This is not a correlation but a one-to-one mechanical relationship. We can see how expensive bonds are by looking at a weekly chart for TLT, the 20+ year treasury bond ETF, dating back more than 15 years.
With yields plummeting, bond prices have never been this high. The logical fear is that, if interest rates ever rise sharply again, bond prices could crash. If overseas holders of U.S. treasury bonds (like China) decide to dump their bonds en masse, treasury bond prices could also crash.
But the threat of a “crash” in bond prices is actually a red herring. That isn’t where the real danger lies. The danger in holding bonds in large quantities over the next few years does not reside in the possibility of a crash. Instead, it’s the threat of hidden losses created by inflation.
The possibility of a bond crash is overrated. Hedge fund managers who have tried shorting government bonds over the years have mostly lost money, and sometimes had their heads handed to them. Why? Because central banks are happy to “prop up” the bond market with direct purchases.
If the bond market starts to look wobbly, central banks can just buy bonds with newly created currency and take the bonds onto their multi-trillion balance sheets. This isn’t hypothetical. Japan has been doing it for decades. There are predictions of a looming collapse in the Japanese government bond market that are more than 20 years old. It hasn’t happened yet because the Bank of Japan (BOJ) prevents it.
Bonds are still deeply risky though. The real risk is having most of your portfolio earning in the neighborhood of 1% or 2% — the current yield window for 10-year notes and 30-year bonds — as creeping inflation eats up the value of your assets.
Many investors don’t realize that inflation is a hidden form of tax. Technically speaking, the government doesn’t have to collect direct tax revenue to fund itself. It can just print the currency it needs to buy what it wants. When a government (or rather a central bank) goes overboard with currency printing, the result is inflation — which indirectly confiscates value from savers and investors.
To determine the value of a payment stream, you want to know the “real” yield on an asset. The real yield is just the nominal yield (what it says on the label) minus the hidden cost of inflation. For example:
- If the nominal yield on 30-year bonds is 2%;
- But hidden inflation is running at 12%;
- The “real” yield is negative 10% (2 minus 12).
If central banks start printing up fresh currency like crazy for new stimulus and other emergency measures, the cost of creeping inflation could create “real” yields that are negative. This is easy to do because nominal yields are so low. If the cost of inflation is higher than the bond yield, your return is negative. You aren’t making money in that situation — in reality you are losing it.
This is how the government could actively destroy the retirement accounts of tens of millions of retirees, by way of the illusion of “safe” government bonds. The real value of the account can get eaten up by inflation, like termites eating the foundation of a house.
If you have a real yield that is -10% after inflation, that is like someone taking 10% out of your banking account every year — except you don’t even see it. The dollars, or treasury bonds, that sit in your account at nominal values are still there. But they are worth less with each passing year because of the hidden inflation tax.
So how do you beat a hidden inflation tax? Not with bonds and their miniscule yields. The only way to really do it is by owning assets that rise in value faster than the pace of inflation.
Remember, to get the “real” yield on something, you take the nominal (surface level) yield, or annual amount of price appreciation, and then subtract the cost of inflation. So let’s say gold is rising 20% a year in an environment with 10% inflation:
- Nominal price appreciation in gold: 20%
- Hidden inflation cost: 10%
- The “real” yield is plus 10% (20 minus 10)
This leads to the $64 trillion question: What assets can rise faster than the pace of inflation in a stimulus-driven, debt-laden, central bank money-printing environment?
There is more than one answer. It depends on which scenario we get.
For example, in a “risk-off” scenario where investors grow fearful, some of the best assets to own could be gold, gold stocks, and Bitcoin. These assets could serve as shelters in a monetary policy crisis, a geopolitical crisis, a prolonged trade war, or all of the above.
In a different scenario, however, the most inflation-proof assets could be the top-tier FANG stocks — big winners like Amazon and Google. Why? Because, from a certain perspective, Amazon and Google, and other big tech winners of that nature, can be seen as inflation-proof via their ability to conquer new markets and create new profits. They have the ability, at least in theory, to sustain earnings increases through innovation and technological expansion, even when everything else is going haywire.
This is why, if investors are still committed to equities as inflation ramps up, the FANG stocks could see their heady multiples actually expand dramatically. If investors remain bullish on stocks — a real possibility — then the Amazons and Googles of the world could see their shares in ultra-high demand as innovation-driven growth vehicles in a world of low growth.
Given that possibility, it’s notable that Warren Buffett is bullish on Amazon. In its latest regulatory filing, Berkshire Hathaway revealed an 11% boost in the size of its Amazon stake, to more than $1 billion!
The world is a dangerous place right now. With regard to investment assets, we can’t say what is “safe” and what is not. That which appears to be ultra-safe — e.g. safety deposit boxes and U.S. treasury bonds — has actually shown itself to be risky. And some volatile assets, which appear risky on the surface, could be safer than most realize.
No matter what happens, now is not the time for complacency. We need to be vigilant and aware as different scenarios compete for dominance heading into the next decade. That is why, at TradeSmith, we are actively monitoring the situation, and using our tools to track developments as the story plays out.
Richard Smith, Ph.D.
CEO & Founder, TradeSmith