Dec 2017 Comments: Bitcoin & Interest Rates

Sam Ngooi Comments

Since Bitcoin has become a very popular topic of discussion in and out of the financial world, we thought it was time for Park Piedmont to add our viewpoint. As you might imagine from a firm that advocates long-term investing with asset allocations implemented using low cost index funds, even the mention of Bitcoin would be highly questionable. Nevertheless, we outline our perspective below.

We start by referencing Warren Buffet, who is among the best, if not the best, investors of our time. A December 2017 article from WealthAdvisor.com (http://bit.ly/wb1227), quotes Buffett as saying: “You can’t value bitcoin, because it is not a value-producing asset…” (In 2014, Buffett said, “the idea that it has some huge intrinsic value is just a joke….”)

The Wealth Advisor article notes that “Bitcoin is a complex idea. It is a virtual currency, created, owned and traded entirely online in anonymous and unregulated settings. In theory, there is a limited number of these physically non-existent digital coins, though that limit hasn’t yet been reached. A few years ago they were almost worthless; in December 2017, their value reached $19,000.”

The article states that “what drives the value of an essentially value-free asset is – FOMO – the fear of missing out,” and explains that the intrinsic value (of an investment) is a continuous flow of actual cash from the operation of a business (referencing Buffett for this principle), and that “the ultimate source of cash flow from digital coins created on the internet is the dollars flowing from the buyers who want to own those coins, for FOMO.”

Echoing this view is Professor Robert Shiller, the former manager of Yale’s endowment, who foresaw the housing bubble of 2007-08. In a recent New York Times article (http://bit.ly/shillerbc), Professor Shiller wrote, “True investing requires a rational appraisal of an asset’s value, simply not possible at present with Bitcoin. Real understanding of the economic issues underlying the cryptocurrency is almost nonexistent…. No one can attach objective probabilities to the various possible outcomes of the current Bitcoin enthusiasm.”

One problem in Bitcoin’s potential use as a currency is the extreme volatility of its price. This was illustrated on 12/22/17, when the price went from $17,500 to $12,000 in a single day, a decline of approximately 30%. (A similar decline on the Dow Jones, at 25,000, would be 7,500 points). In the same article describing this price decline (https://nyti.ms/2DsEc97), the reporters commented that “Bitcoins have mostly been treated as an investment because there is a cap of 21 million on the number of Bitcoins that will ever be released.” Aside from the obvious question of whether someone can actually ensure that the cap is maintained, an even more fundamental objection to the Times article is that a numerical cap on the supply of some object does not by itself create any value in the object.  Even if self-described as a currency, why would anyone treat it as a currency without some underlying economic unit to support its value?

Investment News, a weekly magazine mostly for investment professionals, wrote about Bitcoin (12/4/17) that “rarity can bid up prices, but even though Bitcoin limits its issuance to 21 million coins, there are some 100 other cryptocurrencies.” The article concludes that “it is hard to imagine a practical reason for owning bitcoin, aside from trading, or hiding criminal activity” (http://bit.ly/inbc124).

Two recent NY Times articles provide excellent examples of the validity of the Investment News observations. In a front-page article (https://nyti.ms/2E2KLim), the Times reported that “Russian and Venezuelan officials are hoping virtual currencies can help their countries make an end run around American sanctions. Both governments … are looking to take advantage of the promise that Bitcoin introduces to the world financial system: a new kind of money and financial infrastructure, outside the control of any central authority, particularly the United States…. But economists and virtual currency experts have given these currencies low probability of success … because Bitcoin and other virtual currencies are decentralized systems with no one in charge, while Russia and Venezuela would give leaders of both countries a measure of control over the new currencies.” And in another NY Times article (https://nyti.ms/2E8fFpk), it was reported that the virtual currency Ripple has increased more than 30,000 percent in the last year, making the “largest holder of ‘Ripple tokens’ worth more than $59 billion.” (Yes, that’s billions).

If this isn’t a “bubble” of manic proportion, we don’t know what is.

INTEREST RATES, UPDATED

One major interest rate story for the year 2017 deserves additional comment:  the fact that while there were three one-quarter point increases in the short term rates controlled by the Federal Reserve, the ten-year US Treasury rate, set by the marketplace of buyers and sellers, was almost unchanged for the year, starting at 2.45% and ending at 2.41%. The implications of this fact are discussed below.

Some context for this discussion: a key point in understanding bond price changes is that when market interest rates change, the longer the maturity, the more the price fluctuation. An example of this relationship follows: if market rates rise to 3%, a bond yielding 2% today and maturing in two years, will decline less than a bond yielding 2% today and maturing in six years, because investors get their money back sooner to reinvest at the higher rate with the shorter, two-year maturity.

Given this basic fact of bond investing, the question is how much more yield (interest income) do longer-term investors have to receive to be compensated for the extra price risk being taken?  In today’s bond market, the spread between a three-month US Treasury yielding 1.4% and a ten-year US Treasury yielding 2.4%, is quite clearly 1.0%.  So the question is: why would presumably rational investors take the risk of owning a bond for almost ten more years just to receive 1% more interest?

The explanation, to the extent there is one, is that the ten-year investors think that future yields will be going down, not up, in which case the longer-term bond becomes more valuable, and its price increases. These investors may be right, if economic growth slows and inflation remains low. (Our note: Inflation is the declining purchasing power of a currency over time, and interest is one way investors are compensated for receiving currency with less purchasing power in the future).

In the current environment of an expanding economy, high employment, a recently enacted tax bill that many observers believe is likely to increase the budget deficit and increase inflation, and a Federal Reserve seemingly poised to raise short-term rates again in 2018 (the consensus is for three more quarter point increases), the 1% spread between 3-month and 10-year bonds seems quite small.

Many investors looking for additional income from the longer maturity bonds are likely to absorb price declines in the bond portion of their portfolios if rates rise. Smaller price declines would come from shorter-term bonds, but that would reduce the income from the portfolio. These bond price declines, should they occur, are typically modest compared to possible stock price declines, and the bond price declines are offset in part by the higher interest received on bond portfolios.

At Park Piedmont, we suggest a mix of short and intermediate bonds, along with high yield investments and stocks, all in an allocation appropriate for each client and implemented mostly with low-cost index funds.