Trading, and to some extent investing, is all about knowing when markets are moving with the wisdom of the crowds and when they’re moving with the madness of the crowds. In recent years, there has seemed to be much more madness than wisdom (a statement which can probably be generalized beyond the financial markets themselves, come to think of it). Where do we stand now?
I think a recent letter by John Hussman of Hussman Strategic Advisors, entitled “An Open Letter to the FOMC: Recognizing the Valuation Bubble In Equities,” is worth reading. Hussman is far from the only person, nor even the most august or influential investor, questioning the valuation of equities at the moment. Our own valuation models have had the projected 10-year compounded real return of equities below 3% for several years, and below 2% since late April. For a time, that may have been sustainable because of the overall low level of real rates, but since the summertime rates selloff the expected equity premium has been below 1.5% per annum, compounded – and is now below 1% (see Chart, source Enduring Investments).
Hussman shows a number of other ways of looking at the data, all of which suggest that equity prices are unsustainable in the long run. But what really caught my eye was the section “Textbook speculative features”, where he cites none other than Didier Sornette. Sornette wrote a terrific book called Why Stock Markets Crash: Critical Events in Complex Financial Systems, in which he argues that markets at increased risk of failure demonstrate certain regular characteristics. There is now a considerable literature on non-linear dynamics in complex systems, including Ubiquity: Why Catastrophes Happen by Mark Buchanan and Paul Ormerod’s Why Most Things Fail: Evolution, Extinction and Economics . But Sornette’s book is one of the better balances between accessibility to the non-mathematician and utility to the financial practitioner. But Hussman is the first investor I’ve seen to publicly apply Sornette’s method to imply a point of singularity to markets in real time. While the time of ‘breakage’ of the markets cannot be assessed with any more, and probably less, confidence than one can predict a precise time that a certain material will break under load – and Hussman, it should be noted, “emphatically” does not lay out an explicit time path for prices – his assessment puts Sornette dates between mid-December and January.
Hussman, like me, is clearly of the belief that we are well beyond the wisdom of crowds, into the madness thereof.
One might reasonably ask “what could cause such a crash to happen?” My pat response is that I don’t know what will trigger such a crash, but the cause would be the extremely high valuations. The trigger and the cause are separate discussions. I can imagine a number of possibilities, including something as innocuous as a bad “catch-up” CPI print or two that produces a resurgence of taper talk or an ill-considered remark from Janet Yellen. But speculating on a specific trigger event is madness in itself. Again, the cause is valuations that imply poor equity returns over the long term; of the many paths that lead to poor long-term returns, some include really bad short-term returns and then moderate or even good returns thereafter.
I find this thought process of Hussman’s interesting because it seems consonant with another notion: that the effectiveness of QE might be approaching zero asymptotically as well. That is, if each increment of QE is producing smaller and smaller improvements in the variables of interest (depending who you are, that might mean equity prices, long-term interest rates, bank lending, unemployment, etc), then at some point the ability of QE to sustain highly speculative valuations goes away and we’re left with the coyote-running-over-the-cliff scenario. Some Fed officials have been expressing opinions about the declining efficacy of QE, and Janet Yellen comes to office on February 2nd. I suspect the market is likely to test her very early.
None of this means that stocks cannot go straight up from here for much longer. There’s absolutely nothing to keep stock prices from doubling or tripling from here, except the rationality of investors. And as Mackay said, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” Guessing at the date on which the crowd will toggle back from “madness” to “wisdom” is inherently difficult. What is interesting about the Sornette work, via Hussman, is that it circles a high-risk period on the calendar.
For two days in a row now, I’ve discussed other people’s views. On Wednesday or Thursday, I’ll share my own thoughts – about the possible effects of Obamacare on measured Medical Care inflation.
I guess we have to add to the list of uncomfortable comparisons to 1999’s equity mania the Twitter IPO. A widely-known company with no earnings…and no visible way to produce any revenues of note, much less earnings…went public and promptly doubled. Hedge funds which were able to get in on the IPO allocation cheered this nice kick to their performance numbers, and the backers of the now-$25bln-company are surely elated. But the rest of us have got to be thinking about Pets.com.
It was an article by Hussman Funds (ht rich t) that got me thinking more deeply about these comparisons. Although the article was referred to me partly because of the insightful comments about the Phillips Curve, which echo similar comments I have made in the past, I kept reading to the end as I usually do when trapped in a Hussman article! While there are a number of us (including Hussman, Grantham, Arnott, e.g.) who have been concerned for a while about equity market valuations since we use similar metrics, I really haven’t been terribly concerned about the possibility of an imminent and steep market decline for a while, though I think returns from these levels over the next decade will be close to flat in real terms as they were after the 1999 peak. However, Hussman had me thinking about this.
I do think that there is one key difference from 1999, and that is that not everyone is talking about stocks. That is, not yet…the Twitter IPO might get us there – on Fox Business News today a young talking head (who was no more than 10 years old in 1999) made sure that viewers were informed that anyone could buy Twitter, just by calling their broker. (Not just anyone, though, could get in at the IPO price…a point the cub reporter neglected to mention).
The counter-argument to “is this a 1999 set-up?” takes two forms. The less-sophisticated form is “nuh-uh”, although usually said in a slightly more elaborate way that implies the questioner is a mindless, not to mention soulless, Communist who isn’t getting enough loving at home. The more-sophisticated argument is worth considering, but isn’t particularly soothing to me. This hypothesis is that this isn’t 1999, it’s 1997, before the parabolic blow-off and with lots of room left to run. It wasn’t as if there was any lack of skepticism about the stock market’s levels (which, sweetly, we considered lofty at the time):
“Is it possible that there is something fundamentally new about this current period that would warrant such complacency? Yes, it is possible. Markets may have become more efficient, competition is more global, and information technology has doubtless enhanced the stability of business operations. But, regrettably, history is strewn with visions of such “new eras” that, in the end, have proven to be a mirage. In short, history counsels caution.” – Alan Greenspan, February 26th, 1997
The bubble, of course, did not pop in 1997. It popped in 1999, after Greenspan had abandoned his prior skepticism (in late 1998, as he came to believe that “I do not claim that all market behavior is a rational response to changes in the real world. But most of it must be. For, were it otherwise, the relatively stable economic environments that have been evident among the major industrial countries over the generations would not be possible”). Between 1997 and 1999, there was plenty of time for investors to make money, and as long as they realized they were taking money for the future and got out before 2000…alas, very few of them did.
But, speaking from experience, the 1997-1999 period was very lonely. While investors who gradually sold their long positions out in 1998 and 1999 did much better than the ones they were selling to, they were also very unpopular at cocktail parties. The bearish analysts were put on the street, begging for tuppence. Which, considering that most of them were in the United States, was also unsuccessful.
The 1999 bubble…and the later property bubble…also did not burst until the Fed was actually tightening policy. It is on this point that many bullish arguments depend, but it is a weak one I believe. To be sure, there is no chance that the Fed will be tightening policy any time soon. The taper is not going to happen until 2014Q2 at the earliest, and I think it will take until later in 2014, when inflation figures will become uncomfortable, before they will start pulling back on QE. Some observers believe it will be much later. A Wall Street Journal article on Wednesday detailed a recent research paper written by the head of the monetary affairs division at the Fed; it argued that it may make sense for the Fed to lower its Unemployment Rate threshold and said that “an ‘optimal’ policy might keep rates near zero as late as 2017.”
The activist Fed continues to be one of the biggest risks to the market and the economy. As a trader, I know that 90% of trading is just sitting there, waiting for the ‘fat pitch’ you can do something about. It boggles my mind that a central banker doesn’t sit around at least that much, considering that they know even less about the complexities of the global economy than I know about the complexities of the market. And, unlike the global economy, the market doesn’t fight back when I act on it.
I actually have a feeling that we won’t be worrying about those Unemployment thresholds, either the old ones or the ones proposed in that paper. As I wrote late last month, the expansion is getting a bit long in the tooth and I would not be surprised to see another recession looming in 2014. I don’t have any reason for that outlook other than the calendar, but sometimes these reasons become obvious only in hindsight.
In any event, though, I wouldn’t wait around for the Fed to be tightening. It isn’t overnight funding rates that I would worry about, but longer-term interest rates, and there has already been a warning shot fired that indicates the Fed is not wholly in control of those rates.
So, it may be too early to be out of equities. Maybe even a lot too early. But one thing I am sure of is that it isn’t too late. It is the latter condition, not the former, that is the most damaging to one’s financial position.
Everyone expected markets to provide a lot of late-day volatility today, and so they did. The Fed apparently doesn’t mind surprising the market with a non-consensus outcome when that surprise gooses stocks and bonds higher. Here are some (fairly unstructured) thoughts about today’s declaration from the Fed that there will be no “taper” in its QE program yet:
- This has nothing to do with the fact that there was a minor wiggle in the Employment data, some weakness in Retail Sales, and some other disappointments this month. If that is now the standard…that the Fed plans to expand its balance sheet without bound as long as growth is not smashing the cover off the ball, then we are truly lost for QE will never, ever end. This month’s numbers were all within the normal variation for economic data, which do in fact vary even when the underlying economy is not. The old standard was “ameliorate a deep recession.” Then Greenspan turned that to “resist even a mild recession.” And now, is the standard “robust growth no matter what the long-term cost?” I don’t think so, and so I reject the notion that the failure to begin the taper has anything to do with the growth numbers.
- Similarly, the inflation numbers cannot be the reason. Core inflation is now rising, and the Fed has previously recognized that some of the decline in inflation has been due to transient effects of the sequester. Median inflation has remained steady at 2.1%, which is basically the Fed’s long-term target. The cost of 10-year deflation floors in the market are at the lowest level since they began to trade in 2009 (see chart, source Bloomberg and BGC Partners – the price is in up-front basis points). So it isn’t a lingering fear of deflation that has the Fed concerned.
- The Fed speakers over the last month have had ample opportunity to shoot down the idea that taper would start at this meeting, which has been the consensus for a long time. None of them did so, implying that the Fed was comfortable with that consensus. But something changed in the last few days, and that is that the odds-on next Fed Chairman went from being Larry Summers to being Janet Yellen, who happened to be in the meeting today. Does this change the dynamic? Absolutely, since one reason Bernanke has started thinking and talking about tapering is so as to leave as clean a slate as possible so that the next Chairman wouldn’t have to start his term by tightening (sorry, I mean “reducing accommodation”) and scaring asset markets. Once Summers withdrew his name, Yellen’s vote got automatically much more important and the urgency to start the taper much less (since Yellen doesn’t believe there are any important costs to QE). Indeed, in his post-meeting presser Bernanke noted that the “first step” on a taper is “possible this year.” That is far to the dovish side of what the Street was expecting, but consistent with the notion that Yellen’s opinion will carry a heavy weight unless someone else is appointed to the post.
- Yellen said last June that the Fed’s objective is a quick return to full employment, and that Fed action might be justified “to insure against adverse shocks [emphasis mine],” or even if the Fed concludes that the recovery “is unlikely to proceed at a satisfactory pace.” So, perhaps I need to reconsider my point #1 above. Maybe that is the standard now.
- If in fact QE has no cost, then there is no reason to ever stop it. In fact, it should be accelerated. Most Fed officials seem recently to be coming to the realization that there is highly unlikely to be a costless economic remedy, even if they are not sure what the costs are or think they can be contained. Those people clearly have no voice any more, even though it appeared that those views in the last few months were gaining currency (no pun intended, since the dollar dropped to the lowest level since February after the announcement today – a Fed that was edging however slowly to being more-hawkish than average was good for the dollar; a weak, more-dovish than average central bank will be worse for the dollar all else equal). This is pedal-to-the-metal time.
- TIPS got a lot more expensive today, with the 10-year rallying 20bps to 0.475% and breakevens up 4.5bps one day before the Treasury auctions another slug of them. The auction ought still to go well, because caution has been thrown to the wind by our beloved central bankers. This is also good for commodities, and they rose today led by precious and industrial metals. Is it good for equities? Well…
- Equity analysts are like puppies. They completely forget what happened 5 minutes ago and every experience is brand new. There is never any context. So stocks shot higher today, with the S&P gaining 1.2%, because of the dovish Fed and lower interest rates. But over the last few months, as the taper grew closer and interest rates shot higher, all equities did was move to new highs. So, higher interest rates and a (relatively) hawkish Fed doesn’t hurt stock prices, but lower interest rates and a dovish Fed helps them? This may be why the Fed thinks that buying bonds keeps interest rates low and selling bonds doesn’t raise them. It’s a strange market-based notion of a perpetual motion machine. For goodness’ sake, let’s crank interest rates down 200bps, back up 200bps, down 200bps, and keep doing that and the stock market will be at 1,000,000 before you know it. Prosperity! But in fact it is probably more like a bicycle pump. Pushing down inflates the tire, pulling up doesn’t deflate it. It seems costless. However, if you keep doing that, eventually the tire will pop.
- Speaking of the perpetual motion machine, I enjoyed this little gem from the FOMC statement:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative…
Really? It hasn’t worked recently. Lest they forget: the taper hadn’t started yet, but until today it was busy being discounted in the bond market. I don’t expect that merely continuing to buy bonds into the SOMA will push rates much lower again. We all know that this game ends, and we know how it ends. With 10-year notes at 2.70% I wouldn’t be selling them, but I also wouldn’t expect a massive rally to unfold. I would hold long positions in September and October, because those are the right months in which to hold bonds (especially with debt ceiling fight #2, Syria, Italy’s government disintegrating, and Germany’s election), but if the market gave me 2.45% to sell, I would sell.
 Note, though, that no person who has ever held the office of Fed Vice-Chairman has later been appointed to be Chairman…although Donald Kohn, since he was Vice-Chairman from 2006-2010, would also represent a departure from this same tradition. However, he was not in the room.
When I remark, from time to time, that I think the Fed has made a mistake in increasing transparency of its deliberations and actions, people occasionally look at me as if I had come out opposed to motherhood or apple pie. But my point is that transparency is good if it permanently decreases risk…but it doesn’t.
What matters is how market actors respond to increased transparency. It is much like the old debate about whether football players ought to wear helmets. It is clear that helmets decrease the likelihood of brain damage in any given collision, compared to the un-helmeted rider in an identical collision. But it is also clear that as helmets have gotten better and better, football players have played faster and faster, with more abandon, and lead with their heads a lot more than they did when all they had was a leather cap. The net effect is indeterminate.
In markets, increased transparency from a central bank or regulator leads to increased leverage in a very direct way. The central bank’s dial is for transparency, but the investor’s dial is for risk appetite and when the central bank turns its dial it does not change the investor’s risk preferences. The result is that increasing transparency, which decreases the risk at any given leverage and at any particular moment, leads to higher levels of leverage, which lowers the tolerance for error. And, as we have seen, central banks and regulators are quite prone to error.
In an interesting way, this is tied into the volume question. The chart below (source: Bloomberg) shows rolling 250-trading-day volume for the NYSE in billions of shares. As has been well-documented, market volumes have been steadily declining for years.
As we have mentioned here before, there are lots of excuses for lower market volumes on the major exchanges, and probably many of those excuses are part of the answer. But we can no longer simply attribute this to the movement of volumes to “dark pools.” There is simply less going on in the markets, whether in rates or in equities. Ask the dealers. Dodd-Frank and the Volcker Rule are simply decimating volumes. And this is not just bad for dealers, it is bad for everyone.
When a trade happens, there is information revealed. Indeed, in some markets a meaningful proportion of the volume transacted is between dealers who are testing the market to get more information. More trades means that there are more quanta of information. More quanta of information produces more confidence in prices. More confidence in prices means more support for the current prices, and more de facto liquidity.
Think of it this way. If a bond has never traded, and two counterparties come together to trade some at a price of 103, what is your estimate of the true market for another trade? Is it one tick around 103? If so, then you are displaying almost outrageous overconfidence – one data point between two counterparties, about whose motivations you know precisely nothing, tells you almost zero about what the true market (by which I mean, the prices at which you could buy, for an offer, or sell, for a bid, a typical-sized transaction) is, and even less about what the support market (by which I mean the prices at which you could transact in substantially larger sizes) is. And so bid/offer spreads, whether quoted on-screen or over-the-counter from a dealer in the security, must be wider since the market-maker just doesn’t know as much as he would if volumes were higher – and, more to the point, the market must be wider because the client who initiates the trade is likely to know more than the market-maker does about the right price. This is because the market-maker must make a market whether or not he knows the fair price, but the buyer or seller doesn’t have to trade unless he/she believes the fair price is outside of the quoted range. Of course, that’s where the information comes from: if the offer is lifted, it means someone is saying “I think the fair price is higher than your offer,” and that is information.
I mention this today for several reasons. First, because it has been a while since I showed the NYSE volumes chart in a while. Second, because there was an article on Bloomberg today entitled “Professor Who Helped Pop Junk Bubble Says Trace Slows Trade” which ties transparency to diminished volumes. To the extent that Trace produces true transparency and reduces the need for “testing” trades, it is a good thing…but then we should see tighter spreads for size, and while the study is suggestive it isn’t conclusive on this point. More interestingly, the professor in question also made the point that “less trading may hurt investors if, instead of reducing ‘noise’ from the market, the reduction slows how quickly new information alters prices.” And this point is also key:
”…if the decrease in trading activity is the result of dealers’ unwillingness to hold inventory, transparency will have caused a reduction in the range of investing opportunities. That is, even if a decline in price dispersion reflects a decrease in transaction costs, the concomitant decrease in trading activity could reflect an increased cost of transacting due to the inability to complete trades.”
So transparency, it seems, is not an unalloyed positive like apple pie. But lower trading volumes, which are partly the result of transparency (and partly the result of poorly-conceived rules like Dodd-Frank, the Volcker Rule, and Basel III), are very probably bad for everyone. This doesn’t just affect hedge funds. Markets which are deep and liquid are much less prone to sudden price breaks. With the US equity market still floating near the highs despite rapid increases in nominal and real interest rates and worst-ever outflows from ETFs last month, this is a point that may be more than academic at the moment.
 However, no one disputes that the faster game is a lot more fun to watch. What I suspect has happened is that the introduction of hard-sided helmets probably increased injuries until players essentially reached maximum speed/recklessness, after which point the further improvements in helmet design probably started to make the game safer again. But it is really hard to prove that.
I am disinclined to take victory laps when most people are losing money, but the recovery in commodities prices over the last week at the same time that bond and equity prices are both declining is a taste of success for my view that has been rare enough lately. That is, of course, the burden that a contrarian investor bears: to be wrong when everyone else is having fun, and to be right when no one wants to go out and celebrate. In fact, if you find yourself sharing your successes too often with other people who are having the same successes, I would submit you should be wary.
It is worth noting that the commodities rally has not been led by energy, despite the terrible violence in Egypt which threatens, again, to ignite a spark in the region. Today, the rise in commodities was led by gold and grains; yesterday by cows and copper (well, livestock and industrials).
I don’t think that this is because of a sudden epiphany about inflation. In fact, although breakevens have been recovering from the oversold condition in June (more on that in a moment), the inflation data today did nothing to persuade inflation investors that more protection is needed. I gave some thoughts about the CPI report earlier today in this post, but suffice it to say that it was not an upside surprise. (And yet, there are starting to appear more-frequent smart articles on inflation risks. I commend this article by Allan Meltzer to you as being unusually clear-eyed.)
And commodities are not moving higher because of renewed enthusiasm about growth, I don’t think. Today economic bell cow Wal-Mart cut its profit forecast because higher taxes are causing shoppers to be more conservative (perhaps in more ways that one). And, while today’s Initial Claims figure was good news (320k versus expectations for 335k), weakness was seen in Industrial Production (flat, with downward revisions, versus expectations for +0.3%) and both Empire Manufacturing and Philly Fed came in slightly weaker than expectations. None of this is apocalyptic, but neither is it cause for elation about domestic or global growth prospects.
While the nascent commodity rally makes me personally feel warm and fuzzy, the more-momentous move is in what is happening to interest rates. And here I need to recognize that until very recently, I thought that bonds would follow the typical pattern of a convexity-exacerbated selloff: after a rapid decline, the market would consolidate for a few weeks and then recover once the overhang had cleared. I’ve seen it aplenty in the past, and that was the model I was operating on.
But I believe rates are heading higher. Although the overhang from the prior convexity selloff has probably been distributed, there is a new problem as illustrated by the news today about Bridgewater’s “All Weather” fund. The All-Weather Fund is an example of a “risk parity” strategy in which, in simplified form, “low-volatility” strategies are levered up to have the same natural volatility as “high volatility” strategies. The problem is that levering up an asset class with a poor risk-adjusted return, as fixed-income is now, doesn’t improve returns or risks of the portfolio at large. The -8% return of the AWF in Q2 illustrates that point, and makes clear to anyone who bought the great marketing of “risk parity” strategies that they probably have much more rate risk than they want (although according to the Bloomberg article linked to above, Bridgewater “hadn’t fully grasped the interest-rate sensitivity” of being long 70% of net assets in inflation-linked bonds and another 48% in nominal bonds. I do hope that’s a mis-quote).
The unwinding of some of that rate risk (Bloomberg called the panicky dumping of a relatively cheap asset class, TIPS, into the teeth of a retail and convexity-led selloff “patching” the risk) helped TIPS bellyflop in May and June, and to the extent that institutional investors wake up and reduce their levered long bets on fixed income we might see lower prices much sooner than I expected across the entire spectrum of fixed-income. Indeed, without the Fed or highly levered buyers, it’s not entirely clear what the fair clearing price might be for the Treasury’s debt. I was at one time optimistic that we would get a bounce to lower yields after a period of consolidation, but this news is potentially a game-changer. Although the seasonal patterns favor buying bonds in August and early September, the potential downside is much worse than the potential upside.
Ah, it is so nice to be in this illiquid period right before quarter-end, when interested parties can easily ramp up prices to where they need them to be in order to get good end-of-period marks. One would think this game would diminish somewhat, given the crusades against the LIBOR and possibly FX price-setting conspiracies, but there’s no conspiracy here. There’s no need for investors and dealers to discuss putting the stock market up; everyone knows it happens and everyone knows why. The hedgies who flush microcaps higher because they can ought to be stopped, but there’s no way to stop the general tendency, especially when you have very clear indications of when that trade is supposed to begin…such as when Fed officials show up and start chanting “stocks shouldn’t go down!” in unison.
For the last couple of days, Fed officials have been out in force saying that the “market overreacted.” (Mostly, they mean the bond market, but for many people “the market” equals “stocks” because they think CNBC is about “markets” rather than “stocks”.) Today, New York Fed President Dudley, Fed Governor Powell, and Atlanta Fed President Lockhart pursued the overreaction theory in separate speeches, echoing Minneapolis Fed President Kocherlakota’s sentiment from yesterday. Yes, yes, we all know that everyone else will treat that as a signal to get long again (both stocks and bonds) into quarter-end, but what it really shows is that utter cluelessness of the people in charge at the Fed. Powell said that “Market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy.” Well, duh. As I pointed out a while ago – before the real selloff – such a virulent selloff was entirely to be expected at some point due to convexity demands. The most-virulent part of the selloff may have coincided with Bernanke’s statements last week, and that might have triggered some of the convexity selling, but the degree of selloff had nothing to do with the Fed.
Someone should tell these guys that not everything is controlled by the Fed. Sometimes, rates move for other reasons.
To be sure, the Fed is correct about the fact that their communication is helping to cause the volatility. But it isn’t because they haven’t been clear enough, or that what they said was misinterpreted. The problem is too much communication, and making the path of policy (and any inflections in that policy path) crystal clear. When policymakers are opaque about monetary policy, then investors change their opinions stochastically, at random intervals; when policymakers set off a flare for every minor change in the trajectory, all investors change positions simultaneously. Transparency not only doesn’t reduce volatility, it is a prescription for creating volatility.
Clarity on the fiscal and regulatory front, incidentally, is quite different. Volatility in business ventures is high enough already to ensure that entrepreneurs don’t have an incentive to get too far out over their skis no matter how clear the regulatory environment, and decisions made in a business context don’t have the hair-trigger half-life of decisions in financial markets. Uncertainty, when long-term decisions have to be made, impairs that decision-making. But uncertainty is good when decisions are easily reversible and the cause of volatility is that consecutive orders to sell aren’t spread out enough. For stable markets, you want buys and sells to come all jumbled up, rather than all the buys together or all the sells together. For maximum economic growth, you want risk-takers to have the ability to make long-term decisions with confidence.
So while equity markets have rallied as we approach quarter-end, I don’t think this rally will far outlast quarter-end, because there are just too many negatives at the moment for equities – high multiples, rising interest rates, softening global growth, a less-benign regulatory environment etc. The selloff in stocks was never very bad (compared to bonds), because there’s not the same kind of convexity problem in stocks, but it also has a lot further to go than bonds do.
Fixed-income markets have rallied along with stocks, with TIPS leading the way up as they led the way down. The interpretation here is different, because in the case of the bond market we are looking at the well-known phenomenon of convexity selling. My advice for fixed-income investors, from long and painful experience, is this: don’t jump in with both feet yet. These bounces are normal in this kind of flush. It does probably mean we are closer to the end of the flush than to the beginning, but usually you need a period of a couple of weeks of sideways action before you can start to retrace the “convexity selling” damage and get back to something like fair value.
The healing period is necessary because every prospective bond buyer knows (or should know) that there are large trapped sellers out there who are waiting to pitch bonds overboard (at the new, improved levels!) if there is any sign of further market weakness. The rally over the last few days is fast money, doing what they think the news is telling them to do, and they will be back out as quickly as they got in.
We’ll see what happens next week. On the one hand, dealers will have more ability to hold positions (although they’re not supposed to, under the Volcker Rule); on the other hand, quarter end will be past and any inclination to hold off to avoid making a bad situation worse will be past as well. It will still be fairly illiquid, with a half-day on Wednesday, the Independence Day holiday on Thursday, and then Payrolls on Friday. I suspect we will see a resumption of prior trends in fixed-income and equities – although I hasten to add as a reminder that there will eventually be a rally off these rates. I just don’t think we’ve exhausted all of the sellers yet.
The beatings are continuing, and apparently morale really does improve with such treatment. Consumer Confidence for June vaulted to the highest level since early 2008, at 81.4 handily beating the 75.1 consensus. Both “present situation” and “expectations” advanced markedly, although the “Jobs Hard to Get” subindex barely budged. It is unclear what caused the sharp increase, since gasoline prices (one of the key drivers, along with employment) also didn’t move much and equity prices had been steadily gaining for some time. It may be that the rise in home prices is finally lifting the spirits of consumers, or it may be that credit is finally trickling down to the average consumer.
Whatever the cause, it is not likely to prevent the rise in money velocity that is likely under way, driven by the rise in interest rates. Between the rise in home prices – the Case-Shiller home price index rose a bubble-like 12.05% over the year ended April, and Existing Home Sales median prices have advanced a remarkable 14.1% faster than core inflation (a near record, as the chart below shows) over the year ended in May. (Lagged 18 months, such a performance suggests about a 3.9% rise in Owners’ Equivalent Rent for 2014).
The nonsense about deflation is incredible to me. Euro M2 growth hasn’t been this high (4.73% for year ended April) since August of 2009. Japanese M2 growth hasn’t been this rapid (3.4% for year ended May) since May 2002. US money supply is “only” growing at 6.5% or so, down from its highs but still far too fast for a sluggishly-growing economy to avoid inflation unless velocity continues to decline. But you don’t have to be a monetarist to be concerned about these things. You only need to be able to see home prices.
Core inflation in the US is being held down by core goods, as I have recently noted. In particular, CPI for Medical Care just recorded its lowest year-on-year rise since 1972, and Prescription Drugs (1.32% of CPI and an important part of core goods) declined on a y/y basis for the first time since 1973. The chart below (source: Bloomberg) illustrates that as recently as last August, that category was rising at a 4.0% pace.
Now, I suspect that this has something to do with Obamacare, but no one seems to know the full impact of the law. Keep in mind that Medical Care in CPI excludes government spending on medical care. So, one possible narrative is that the really sick people are leaving for Obamacare while the healthy people are continuing to consume non-governmental health care services. This would be a composition effect and would imply that we should start looking at CPI ex-medical for a cleaner view of general price trends. I have no idea if this is what is happening, but I am skeptical that prescription meds are about to decline in price for an extended period of time!
But that’s the bet: either core inflation is going to go up, driven by things like housing, or it’s going to go down, driven by things like prescription medication. Place your bets.
Equity prices recovered today, but bond prices continued to slide into the long, dark night. For a really incredible picture, look at the chart below (source: Bloomberg), which shows the multi-decade decline in 10-year yields on a log scale, culminating in the celebrated breakout below that channel. Incredibly, the recent selloff has yields back to the midpoint of the channel and not outrageously far from a breakout on the other side!
Incidentally, students of bond market history may be interested to know that the selloff has now reached the status of the worst ever bond market selloff (of 90 days or less) in percentage terms. Since May 2nd, 10-year yields have risen from 1.626% to 2.609%, a 98.3bp selloff which means that yields have risen 60.5% in less than two months.
And we are probably not done yet. I wrote about a month ago about the “convexity trade,” and I made the seemingly absurd remark that “This means the bond market is very vulnerable to a convexity trade to higher yields, especially once the ball gets rolling. The recent move to new high yields for the last 12 months could trigger such a phenomenon. If it does, then we will see 10-year note rates above 3% in fairly short order.”[emphasis in original] Incredibly, here we are with 10-year yields at 2.61%, up 60bps over the last month, and that statement doesn’t seem quite so crazy. As I said: I have seen it before! And indeed, the convexity trade is partly to blame for what we are seeing. I asked one old colleague today about convexity selling, and here was his response:
“massive – the REITs are forced deleveraging and there are other forced hands as well. The real money guys are too large and haven’t even sold yet – no liquidity for them. The muni market has basically crashed and at 5% yields in muni there is huge extension risk on a large amount of bonds: something like $750bln in bonds go from 10-year to 30-year maturities as you cross 5%.” (name withheld)
Now, I am not a muni expert so I have no idea what index it is I am waiting to see cross 5%. But the convexity trade is indeed happening.
Lots of bad things have happened to the market, but they really aren’t big bad things. In fact, I move that we stop using the term “perfect storm” to mean “modestly bad luck, but I had a lot of leverage.” The Fed was never going to be aggressively easy forever, and as various speakers have pointed out recently they didn’t exactly promise to be aggressively tightening any time soon. There is bad news on the inflation front, but the market is clearly not reacting to that. Some ETFs have had some liquidity issues, and emerging markets have tumbled, and there was a liquidity squeeze in China. But these are hardly end-of-the-world developments. What makes this a really bad month is the excess leverage, combined with the diminished risk appetite among primary dealers who have been warned against taking too much “proprietary risk.”
And markets are mispriced. Three-year inflation swaps imply that core inflation will be only 1.9% compounded for the next three years (the 1-year swap implied 1.6%; the 2y implies 1.75%). That is more than a little bit silly. While I have not been amazed that the convexity trade drove yields very high, and probably will drive them higher, it has surprised me that inflation swaps and inflation breakevens have continued to decline. Still, investors who paid heed to our admonition to be long breakevens rather than TIPS have done quite a bit better, as the chart below (source Bloomberg), normalized to February 25th (the date of one of our quarterly outlook pieces) illustrates.
As the bond selloff extends, I don’t think TIPS will continue to underperform nominal bonds. I believe breakevens, already at low levels (the 10-year breakeven, at 1.97%, is lower than any actual 10-year inflation experience since 1958-1968), will be hard to push much lower, especially in a rising-yield environment.
I have been quasi-vacationing this week on the Continent, and trying to follow the news and the markets. This will be a brief comment but I wanted to make a couple of quick notes:
1. I did not, and I still do not, understand why there was such a violent (and negative) reaction to the Fed’s statement and Bernanke’s suggestion that the “taper” may start later this year and end in mid-2014. There are all kinds of reasons not to freak out about that. First, it was approximately what was expected (although two weeks ago there were many who thought absurdly that the Fed would begin a taper at this meeting). Second, the taper is contingent on growth continuing to strengthen, and there are scant signs of that. Third, as Bullard showed today there is far from a consensus on whether Bernanke’s time frame is going to work out – and, while ordinarily the Fed Chairman’s vote is the only one that matters, in this case he is not going to be present for the end of the taper so what really matters is who is selected to replace him. Fourth, QE isn’t doing anything right now, except artificially depressing long Treasury yields. It is probably pressuring money supply growth, but not very much. The only thing that further QE will do is make the exit that much more difficult.
That said, the violent reactions to the Fed statement are prima facie evidence of what critics of the QE policy (me, for one) have always said: we have no idea how rates and markets will react when the Fed finishes and unwinds this policy, regardless of Bernanke’s assurances. The harsh reaction (quite a bit more than I expected, especially with such a tepid adjustment to the expected trajectory) is great evidence of how over-dependent the market is on the view that the Fed’s support makes losses extremely difficult. And, I will say again, this would be so much easier if the Fed wasn’t telegraphing everything, because then investors would have invested with much more caution. The reaction this week was partly due to the shock of actually hearing the Fed mention a date for the first time.
2. Speaking of investing with much more caution, the amazing stress in certain ETFs that has accompanied significant but not exactly dramatic moves in (for example) emerging markets should blare two huge lessons to investors. The first is that you can’t increase liquidity of a pool of assets by putting them in an ETF wrapper. A pile of illiquid securities, or securities that can become illiquid in a crisis, are not more liquid because you can get a quotation every second. An ETF consisting of emerging markets bonds is never going to be more liquid than the underlying emerging markets bonds (although it may be more granular, and there are other ETF advantages…but not liquidity). An ETF consisting of commodity futures, by contrast, will be tremendously liquid because the underlying commodity markets are tremendously liquid. The second lesson is more subtle, and that is that an ETF of less-liquid securities is, in a crisis, only as liquid as the least liquid element. If you present an ETF to me for redemption and there is 1% of it that I can’t get any bid on, then the best you’re going to get is a quote at 99% of the “fair” market price. And that is especially true these days, since dealers and market-makers are capital-constrained and can’t merely take those illiquid positions on the books.
3. There is a lot of dry tinder around in the world today, and never for a minute suppose that they are not related. Stress begets stress. Two million people protesting in Brazil are doing so partly because of economic stress. Tight money market rates in China (persistent since if the central bank adds too much liquidity it will cause the CNY to depreciate) is a partial consequence of economic stress. A return of Greece from the frying pan to the fire: economic stress. And so on. This is not a safer world for all of the QE.
4. Finally, remember that growth and inflation are not related in any meaningful way. Median home prices rose more than 15% over the last year according to a report this week, and not because of great economic results. Money velocity is rising with interest rates although we may not see the results for some months. Inflation, which got a boost in the US this week with a strong CPI report (see my brief comments here), surprised on the high side in the EU and UK. TIPS yields are at +0.56% in the 10-year sector and 10-year breakevens are at 1.92%. There is absolutely no reason to own Treasuries rather than TIPS at this point. The 10-year expected real return of stocks is now less than 1.5% per annum above 10-year TIPS, and there is absolutely no reason to own equities rather than TIPS. Are TIPS cheap on an absolute basis? No. But they are screamingly cheap on a relative basis in an environment of rising inflation (and nothing the central banks can do about it – at least those who aren’t actively trying to boost it). Long-time readers will know I have been tepid at best about TIPS for some time. But, while 0.56% isn’t ridiculously cheap (and they could still get there!), our models are already maxed out on breakeven exposure and are starting to add to outright long exposure in TIPS.
It has been a long time since we have had to worry about and think about the phenomenon of mortgage convexity and the effect that it can have on the bond market. But with 10-year interest rates up 50bps in less than 1 month, and some of the selloff recently being attributed to “convexity-related selling,” it is worth reminiscing.
We need to start with the concept of “negative convexity.” This is a fancy way of saying that a market position gets shorter (or less long) when the market is going up, and longer (or less short) when the market is going down. That’s obviously a bad thing: you would prefer to be longer when the market is going up and less long when the market is going down (and, not surprisingly, we call that positive convexity).
Now, a portfolio of current-coupon residential mortgages in the US exhibits the property of negative convexity because the homeowner has the right to pre-pay the mortgage at any time, and for any reason – for example, because the home is being sold, or because the homeowner wants to refinance at a lower rate. Indeed, holders of mortgage-backed securities expect that in any collection of mortgages, a certain number of them will pre-pay for non-economic reasons (such as the house being sold) and the rest will be pre-paid when economic circumstances permit. Suppose that in a pool of mortgages, the average mortgage is expected to be paid off in (just to make up a number, not intended to be an accurate or current figure) ten years. This means that the security backed by those mortgages (MBS for short) would have a duration of about ten years, so that a 1% decline in interest rates would, in the absence of convexity, cause prices to rise about 10%.
Now, that’s really just a guess based on where interest rates are currently. As interest rates change, so does the duration of the bond. If mortgage interest rates fall significantly, then most of the mortgages in that MBS would pre-pay and the duration of the security would fall sharply. Suppose that after a sufficient decline in interest rates, the same pool of mortgages in that MBS is expected to be pre-paid on average in only 3 years. Now a further 1% decline in interest rates will only cause the price of the MBS to rise about 3%. This is negative convexity, and what is significant here is how holders of MBS respond. In order to maintain a similar market exposure, the owner of the MBS needs to buy more bonds, swaps, or MBS to maintain his duration. That is, into a rally, the MBS owner needs to buy more. This is “buying high,” and it’s the manifestation of one side of that negative convexity.
Suppose that instead interest rates rise sharply. Now, instead of expecting those mortgages to economically pre-pay over the next 10 years, we realize that the opportunities for these homeowners to refinance just went away (at least for a while); consequently, we now expect the mortgages to pay off in 15 years on average, rather than 10. A further rise of 1% in interest rates will cause prices to fall 15% rather than 10%. Again, the MBS holders need to respond, and they do so by selling bonds, swaps, or MBS to maintain duration. That is, into a selloff, the MBS owner needs to sell more. This is “selling low,” and it’s the manifestation of the other side of that negative convexity.
Put together, a manager of a large MBS portfolio is earning a higher-than-average coupon, but is also systematically buying high and selling low on his hedges and losing a little money each time. More importantly for our case here is that if the market moves enough to trigger the hedging activity then we say that “the convexity trade” has caused a significant amount of selling into a selloff, or a significant amount of buying into a rally, and this essentially means fuel is being added to the fire and the move is worsened. The mortgage market is massive, and especially with dealers having less capacity for market-making risk-taking a big convexity trade could cause a huge move. In the 2000s, I recall two massive selloffs of at least 125bps over a period of just a few weeks, in which every 5bps seemed to bring out another huge seller and push the market another 5bps.
Figuring out exactly what the trigger level is at which the convexity trade kicks in is the domain of mortgage analysts, and there is a lot of brainpower and computing power put to this analysis. These folks can tell you that “a 10-year note rate of 2.25% will cause the market to get longer by 150bln 10-year note equivalents [just to be clear, this is a made up example],” which in turn implies that there will be substantially more selling when interest rates approach that level.
Now, I don’t know what the current trigger levels are, but I can tell you a few more things from years of experience.
First is that the market’s negative convexity is greatest when the market has rallied to a new level and stayed there for a long time, allowing most borrowers to refinance their mortgages to the current coupon. The chart of 10-year yields below (Source: Bloomberg) illustrates this point. In 2008, 10-year note yields fell below 2.5%, but did so very quickly and few people had a chance to refinance (plus, mortgage spreads were quite wide and credit was hard to get), so the mortgage market maintained something like its prior equilibrium.
However, over 2010 and especially after mid-2011, rates got substantially lower and stayed lower; mortgage credit also got somewhat easier than in early 2009 (although obviously underwater homeowners cannot refinance, and this limited the amount of refinancing activity so that MBS prepay speeds weren’t as rapid as the pre-2008 models had expected). We have now been at these levels for some time, so that I suspect the market’s average coupon is substantially lower today than it was two years ago. This means the bond market is very vulnerable to a convexity trade to higher yields, especially once the ball gets rolling. The recent move to new high yields for the last 12 months could trigger such a phenomenon. If it does, then we will see 10-year note rates above 3% in fairly short order.
The second point is somewhat more subtle. The nature of the negative convexity in the higher rate direction is different from the nature of the negative convexity in the lower rate direction. When rates fall, we are looking at borrowers refinancing, which means that we can stair-step lower: rates fall, borrowers refinance, rates fall further, borrowers refinance again, etcetera. But when rates rise, the duration increase is caused by a lack of activity. Borrowers eschew refinancing. And this, fundamentally, can only happen once no matter how far rates move. If it is not economical to refinance with rates 2% higher, then few borrowers will refinance. But at 5% higher rates, there is no additional effect: once your model expects essentially zero refinancing, the convexity trade is over until you get substantial new origination of mortgages, and this takes longer. Therefore, in a selloff the convexity trade is somewhat self-limiting. It sure doesn’t feel like it at the time, but it is.
This is a long article but it is worth reflecting on because of the conclusion, and that is this: if rates rise because the Fed begins to raise rates (or finds it doesn’t have enough will to keep them low, once the bond market expects much higher inflation), then there is no “cap” on how high they can go. But if rates rise in a sloppy fashion because of a convexity trade, there really is a cap. It would be ugly to see interest rates rise another 100bps (and really, really bad for stocks I think), but if they did so because of the convexity trade then we would probably get a bunch of that move reversed thereafter.
I don’t have a strong opinion about whether we are at that point yet, and I no longer have access to great mortgage analysts. But Fed speakers should tread very lightly, as I doubt the first trigger point is terribly far away and you surely don’t want to hit it.
There is one reason I don’t think that the bond market selloff we have seen to date is heavily driven by convexity-related flows, and that is that TIPS yields have risen faster than nominal bond yields. Over the period during which nominal 10-year yields have risen 50bps, 10-year TIPS yields have actually risen 58bps. If the trade was a convexity-driven trade, it would be primarily affecting nominal yields, which means that while TIPS would be suffering, they would be suffering less than nominal bonds, rather than more. (The flip side is that if you are bearish here because you think the convexity trade might kick in, you should also expect breakevens to widen substantially when that trade does kick in). Indeed, TIPS at -0.13% is the best bargain we have seen in quite some time (see chart, source Bloomberg).
Indeed, our multi-asset strategy has kicked the TIPS component all the way up to 11%, which is the highest it has been in a long while. TIPS are not cheap, but they are cheaper, and they are extremely cheap relative to nominal bonds. And they are not yet as cheap as i-Series savings bonds, although the yield advantage of those bonds has dropped from the 159bps it was when I wrote about it here to “only” 93bps. But that’s still a great arb, and so I continue to advocate i-bonds.
 I am abstracting from the niceties of Macaulay versus modified versus option-adjusted duration here for the purposes of exposition.