Saturday, August 9, 2014

Recap of Various Thoughts on Interest Rates

  • Remember first and second level thinking. First level thinking is that loose monetary policy leads to inflation so buy metals and stocks and short bonds. The second level thought is that loose monetary policy leads to some goods increasing in price, mostly the hoard-able primary inputs like energy and base metals. Much of the causation is psychological. The input price increase squeezes producers who can't raise their prices as much to compensate for rising input costs. Maybe they even go out of business or layoff workers. Overall, society is poorer thanks to the misallocation of resources. Also, fear of loose monetary policy causes investors to sell bonds and interest rates rise. Both the rising input costs and rising interest rates choke off the economy; the inflationary policy is self-limiting because of the damage it does.
  • In general, bond bears who are long stocks don't realize that they would be hurt by interest rate increases too. Stocks compete with bonds; interest rate increases would make low dividend yields even less attractive in comparison. Also, many companies' business models are interest rate sensitive - think what would happen to car sales if bond bears got their rising interest rates. We already saw in 2013-2014 what an interest rate rise did to housing sales.
  • Being long credit and short duration is absolutely consensus, as in this Morgan Stanley research: "As rates rise, we expect a reversal of the YTD outperformance of longer-duration credit. We like credit over rates, and prefer High Yield over Investment Grade credit, as we believe the biggest risk to investors today is rate driven, rather than credit driven." They take it as a given that rates will rise! They also believe that rates are the biggest risk even though credit spreads are at all time lows!
  • Cliff Asness has a smarter thought on bonds: "[T]ake US government bonds. They are without a doubt priced to offer a lower prospective real return now than at most times in the past (as, in my view, are equities). But could it work out? With an unchanged yield curve, which is certainly possible, you would make a very comfortable 4%+ nominal (call it 1%–2% real) a year now on a 10-year US bond, and to find a case where bonds worked out from similar levels, one only has to utter the word 'Japan.' Does this make bonds a particularly good investment right now? No. Does it show that they do not satisfy the criteria for the word bubble, thereby demonstrating how the word is overused? Yes." But also, note that tepid dislike of bonds passes for bullishness in the current environment.
  • The increase in average monthly mortgage payment (which was caused by home price increase but also by interest rate increase - the 10 year bond yield almost doubled in four months) stopped the housing rally in its tracks. I think there is a low probability that the 10 year yield could rise to the 4% level that bond bears were predicting, because of the effects that even a 3% yield had on the housing market. What would another 100bps on top of that do to housing, or car purchases, or business capex decisions? If my self-limiting hypothesis is correct, then 10 year bonds have more upside than downside, and they are not asymmetrically unfavorable as bond bears believe but rather asymmetrically favorable.


whydibuy said...

What low dividend yields on stocks are you talking about?
Many quality stocks are paying 2% or more. Yes, stocks compete with bonds and with bonds so low, stocks are even more attractive. Add to that that many stocks increase their dividend year after year while bonds are stagnant.
Your zest for bonds has clouded your thinking.
You assert that stocks are "low" paying while ignoring reality that stocks pay MORE that bonds.
I guess a man sees what he wants to see and disregards the rest.

Nathan said...

I think what people miss when comparing dividend yields to long-term interest rates is that low rates remove barriers to entry. You can't compare a 5% AT&T dividend to a 2.5% 10-year treasury bond because the difference in yield, if it is perceived to be durable, is precisely what will inspire new competition for AT&T. For example, Google could create a viable competitor to AT&T or Comcast for a small fraction of their current market caps. Even natural monopolies can be threatened by new technology (e.g. solar).

People also don't realize that stocks yielding significantly more than bonds is actually the historical norm. Prior to 1960 that's exactly how things worked.

Nathan said...

As a concrete example, consider the proposed canal across Nicaragua.

It takes a special kind of stupid to apply the Fed model to these "high-yielding" businesses and not realize that any purported increase to their NPV invites more competition. Consider that we even have industries with excess capacity (e.g. retail, automobiles) where investors are willing to fund new entrants for the vague promise of future earnings.

Whose profits are safe while there are buyers for AMZN, FB, NFLX and TSLA?

Anonymous said...

The S&P dividend yield is 1.93%, less than the yield on the 10 year treasury.

Unknown said...

You assert that stocks are "low" paying while ignoring reality that stocks pay MORE that bonds

The comparison is meaningless because stocks and Treasurys have completely different durations. The ten-year note has a ten-year duration. Stocks have a decades-long effective duration.

Also what Nathan said.

CP said...

Exactly, stocks are actually much more sensitive to interest rate increases than treasuries.