Sunday, May 1, 2016

Not Bullish On Bonds

Last summer I noticed that the possible bond bear market was three years old. Now we might be four years into it!

Not saying that it's going to happen, but it's going to upset a lot of people's plans if SPX starts falling and bond yields start rising.

People are used to an overall falling interest rate trend (since Sept 1981!), which has been a tailwind for asset values, but they are also used to a shorter term inverse correlation where people flee equities for the safety of bonds.

That's the principle that 60/40 asset allocation is based on - if you own stocks and bonds, at least one will always be "working".

But remember Charles Dow Looks at the Long Wave: that pattern that asset allocation is based on has existed because we've been in the long period in between the peak in interest rates and the peak in stock prices, as Charles Kirkpatrick explained:

"The period after interest rates peak is when stock prices rise as an alternative investment. During that period declining interest rates force yield-conscious investors into alternative investments of lesser quality in order to maintain yield. Since stocks are the most risky and least quality investments, they become the final alternative, especially when their price continues to appreciate as a result of increasing cash flow into the stock market. [positive feedback loop] The recent conversion of government-guaranteed CD deposits into stock mutual funds is typical during this period. Unfortunately, it eventually leads to the declining long wave in stock prices."
There could be a period when stocks and bonds go down together. For example, instead of stock declines -> people wanting the security of bonds, people might decide that stock declines lead to bailouts which are really stealth currency devaluations, and decide they want no part of the long end of the yield curve.

Remember, all of the federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls. They think it will be no big deal thanks to low interest rates. In the most recent Fortune, Trump essentially says that he would grow the national debt - he's a developer and he loves low interest rates!

I've said that the federal public debt was only $6 trillion when Bush left office, and there's easy ballpark math that says that within a decade, the public sector will need to borrow that much every year.

The other scary thing for bonds is the effect that interest rate increases have on this system, because it contains so many feedback loops. The pension assets become worth a lot less, the interest expenditures rise (and they are borrowing to pay the interest since there is no debt service), so the credit quality (such as it is) deteriorates.

Also, corporate pensions have the same problem and an interesting feedback loop of their own. To the extent that their pension funds lose money, earnings will take a hit. As we know from Grantham, when earnings fall multiples fall too.

It is very, very nonlinear, because once bonds lose momentum, who will want to own them? Professional asset management and retail investor sentiment are both all about momentum. And every credit - government or corporate - looks much worse with rising interest expense. I think we will come to realize that a lot of stuff in the economy (junk bonds, private equity) was part of a virtuous interest rate cycle.

For the counterargument that the Fed will just buy bonds to "keep rates low", you have to face the fact that QE invariably caused rates to rise, and you could (and we did) make money buying bonds every time the Fed stopped buying them. As I kept trying to explain, the QE bond purchases may have been respectably large in relation to the flow of debt issuance, but they were puny in relation to the stock of $60T of dollar denominated debt. It freaked creditors out about inflation more than it helped.

The legitimate purpose of public debt is to borrow money to build infrastructure improvements that have a positive net present value. However, a vast portion of federal expenditure now leaves nothing tangible, leaves no collateral. A treasury bond is a certificate that money has successfully been expended on section 8 housing, or on make-work military "jobs".

The lack of collateral makes these treasuries creatures of social mood. They are no more valuable than tulip bulbs or south sea shares. That makes them vulnerable to going down with stocks when social mood becomes more pessimistic.

If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest extraordinary popular delusion.

Krugman has spent years poking at the "invisible" bond bear. The problem is that years of success at borrowing for consumption (not investment) without any noticeable effect on interest rates made the Keynesians in government complacent and cocky.

P.S. For Buffett fans: he didn't become a billionaire until 1986, five years after rates peaked. 99% of his net worth was made during the declining interest rate trend.


Taylor Conant said...

If bonds weaken because people are scared of inflation, cash would seem to have a limited shelf life in terms of its optionality outweighing it's depreciating value. I wonder how long we'd have in that environment to buy something of value?

And what of gold?

CP said...

We can see with Trump's tax plan (implausible tax cuts and no specific expenditure cuts) that the personalities no longer really matter to the ultimate outcome: sovereign debt crisis, inability to debt finance expenditure, followed by loss of legitimacy of government.

Nathan said...

Thanks for continuing to write on this topic CP.

What do you make of Japan's inability to create self-sustaining inflation? With persistent deficits of 5-10% GDP and the BoJ's QQE they seem to have adopted more aggressive fiscal *and* monetary policy than I think is possible in the US.

My only theory is that Japan has reached the maximum wealth (credit + asset values) that can be sustained and therefore these various policies are zero sum. So, the benefit to exporters that comes by depressing the Yen is completely offset by households who immediately cut back on spending. More uniform fiscal stimulus (aka helicopter money) might overcome some of those problems, but I still think it's approximately zero sum.

Personally, I think semi-serious talk about helicopter money is more likely to result in tax reform than fiscal stimulus. Rich people don't want to pay taxes, but I'd wager they'd more readily accept higher taxes than giving the hoi polloi the ability to declare a debt jubilee.

Stagflationary Mark said...

Real Deposits per Capita

A growing deposit glut is not the path to higher yields, in my opinion.

Of course, it could stop growing. Need to think up a reason why though. I'm all ears.

Bullish on bonds, especially the ones I bought with intent to hold to maturity (all of them) because parking money in a bank earning nothing over the long-term seemed like a really bad plan, and still does.

Always looking for reasons I could be wrong though.

CP said...

the assumed one-to-one relationship between valuations and 10-year Treasury yields (the so-called “Fed Model”) is wholly an artifact of the disinflationary period from 1980-1997.

CP said...

I'm not saying that short term yields would go up, necessarily.

The trouble I see is with the long end of the curve.

Stagflationary Mark said...

The 30-year TIPS currently yields 0.88% plus inflation. Is it ideal? No. Could it get even worse? Absolutely.

It's not just yields that have fallen since the early 1980s, but real yields too.

It's been a long-standing theory of mine that it is getting harder and harder to make money off of money. Since I believe that, I embraced long-term TIPS, and still do. Perhaps I'll regret it someday, but I sure haven't so far.

I bought with intent to hold to maturity. Unless we default on our debt (possible), I don't really care what the market values my bonds at. To me, they're good enough over the long-term. They have ample value to me, compared to the alternatives. Since I do not plan to resell these bonds, I do not require a greater fool to buy them from me. That brings me some comfort.

If real yields go up I'll lose some opportunity to have done better. No big deal. I actually root for this outcome so that I can reinvest at higher real yields as my bonds mature.

If real yields continue to fall though, I'll be very thankful that I locked rates in. Short-term savers have and may continue to be slaughtered.

I think the key point many are missing is that money printing doesn't itself cause yields to rise. Yields actually rise if there is less money to buy the bonds, not more. The interest rate paid on savings accounts goes down when more and more money is deposited, not up.

The world has a lot of money that can buy US treasury bonds. We've flooded the wotld with our money due to our massive trade deficit, and we continue to do so. We buy the world's goods. We send them our money.

So what do they do with the money? They either buy our assets or they stuff the money under their matresses. There aren't any other choices. Treasury bonds are just one of our assets. I've wanted to buy before "they" did, and once again, I have yet to regret it.

Unknown said...

With regards to Buffett, he had extraordinary return throughout his career and most of his huge positions tend to be the type that don't need huge capital expenditures that the low interest rate environment would carry. If your point was that simply that his numbers are inflated along with everyone else's, hey it's true, your right.