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Whither Bonds? Arnott Answers

June 23, 2015 1 comment

I really enjoy reading, and listening to, Rob Arnott of Research Affiliates. He is one of those few people – Cliff Asness is another – who is both really smart, in a cutting-edge-research sense, and really connected to the real world of investing. There are only a handful of these sorts of guys, and you want to align yourself with them when you can.

Rob has written and spoken a number of times over the last few years about the investing implications of the toppling of the demographic pyramid in developed markets. He has made the rather compelling point that much of the strong growth of the last half-century in the US can be attributed to the fact that the population as a whole was moving through its peak production years. Thus, if “natural” real growth was something like 2%, then with the demographic dividend we were able to sustain a faster pace, say 3% (I am making up the numbers here for illustration). The unfortunate side of the story is that as the center of gravity of the population, age-wise, gets closer to retirement, this tailwind becomes a headwind. So, for example, he figures that Japan’s sustainable growth rate over the next few decades is probably about zero. And ours is probably considerably less than 2%.

He wrote a piece that appeared this spring in the first quarter’s Conference Proceedings of the CFA Institute, called “Whither Bonds, After the Demographic Dividend?” It is the first time I have seen him tackle the question from the standpoint of a fixed-income investor, as opposed to an equity investor. I find it a compelling read, and strongly recommend it.

Don’t miss the “Question and Answer Session” after the article itself. You would think that someone who sees a demographic time bomb would be in the ‘deflation’ camp, but as I said Rob is a very thoughtful person and he reaches reasonable conclusions that are drawn not from knee-jerk hunches but from analytical insights. So, when asked about whether he sees an inflation problem, or continued disinflation, or deflation over the next five years, he says:

“I am not at all concerned about deflation. Any determined central banker can defeat deflation. All that is needed is a printing press. Japan has proven that. Japan is mired in what could only be described as a near depression, and it still has 1.5% inflation. So, if a central bank prints enough money, it can create inflation in an economy that is near a depression.”

This, more than anything else, explains why keeping interest rates low to avert deflation is a silly policy. If deflation happens, it is a problem that can be solved. Inflation is a much more difficult problem to solve because collapsing the money supply growth rate runs counter to political realities. I don’t think this Fed is worried about inflation at all, and they’re probably not worried too much about deflation either any longer. But they believe they can force growth higher with accommodative monetary policy, when all available evidence suggests they cannot. Moreover, Arnott’s analysis suggests that we are probably already growing at something near to, or even above, the probable maximum sustainable growth rate in this demographic reality.

Maybe we can get Arnott on the Federal Reserve Board? Probably not – no one who is truly qualified for that job would actually want it.

**Note – If you would like to be on the notification list for my new book, What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com and I will put you on the list!

Summary of My Post-CPI Tweets

Below is a summary of my post-CPI tweets. ou can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments.

  • Core CPI prints +0.145…just misses printing +0.2, which will make it seem weak. We will see the breakdown.
  • y/y core goes to 1.73% from 1.81%. A downtick there was very likely because we were dropping off +0.23%
  • This decreases odds of Sept Fed hike (I didn’t think likely anyway) but remember we have a couple more cpi prints so don’t exaggerate.
  • Core goods (-0.3% from -0.2%) and core services (2.4% from 2.5%) both declined. Again, some of that is base effects.
  • fwiw, next few months we drop off from core CPI: +0.137%, +0.098%, +0.052%, and +0.145%. So y/y core will be higher in a few months.
  • INteresting was housing declined to 1.9% from 2.2% y/y. But it was all Lodging away from home: 0.96% from 5.1% y/y!
  • Gotta tell you I am traveling now and that reminds you the difference between rate and level. Hotels are EXPENSIVE!
  • Owners’ Equiv Rent +2.79% from 2.77%. Primary Rents 3.47% unch. So the main housing action is still up. And should continue.
  • Remember the number we care about is actually Median CPI, a couple hours from now. That should stay 0.2 and around 2.2% y/y.
  • At root, this isn’t a very exciting CPI figure. It helps the doves, but that help will be short-lived. Internals didn’t move much tho.

The last remark sums it up. While the movement in Lodging Away from Home made it briefly look like there was some weakness in housing, I probably would have dismissed that anyway. There’s simply too much momentum in housing prices for there to be anything other than accelerating inflation in that sector. We have a long way to go, I think, before we have any topping in housing inflation.

But overall, this was a fairly boring figure. While the year-on-year core CPI print declined, that was due as I mentioned to base effects: dropping off a curiously strong number from last year. (That said, this month’s core CPI definitely calms things a bit after last month’s upward surprise). However, the next few base effect changes will push y/y core CPI higher. While today’s data will be welcomed by the doves, by the time of the September meeting the momentum in core inflation will be evident and median inflation is likely to be heading higher as well.

Note that I don’t think the Fed tightens in September even with a core CPI at 2% or above, but the bond market will get very scared about that between now and then. Could be some rough sledding for fixed income later in the summer. But not for now!

Possibly a Tactical Chance for Bonds

This week, I am participating in a school-style debate at the Global Fixed Income Institute’s conferences in Madrid where the question before the house is whether or not inflation will resurface in major world economies in the next five years. As you might imagine, I feel that my part of the debate is the easy part, especially as inflation is pointing higher in the US and core inflation just surprised higher in Europe. However, I am sure the other side feels the same way.

The Institute is interested in this discussion partly to illuminate the question of whether the substantial rise in yields over the last three months or so in all developed bond markets (see chart, source Bloomberg, showing 10y yields in US, UK, Germany and Japan) is indicative of a return of fears of inflation.

all10s

The ironic part of this is that I do not believe that the rise in yields has much if anything to do with the expectation for higher inflation. Partly, it is due to a subtle sea change in the way investors are thinking about the prospects for central bank policy – to wit, the possibility (which I see as slim) that the Fed chooses to raise rates meaningfully above zero in the next year, starting in September. But to some degree, the market has been discounting higher forward rates for a very long time. It has been consistently wrong on that point, but the steeply sloped yield curve (the 2y/10y spread hasn’t been flatter than 120bps since early 2008 – see chart, source Bloomberg) implies higher forward rates.

2s10stoday

The rise in yields, in my view, is partly related to the prospect for changes in central bank policy, but also partly (and more sinisterly) related to the continuing intentional destruction by policymakers of the ability of large banks and dealers to make markets. We see worse liquidity in more and more markets almost by the day (as predicted five years ago in this space, for example here and here, as well as by many other observers). Less liquid markets tend to trade with more volatility, as it gets harder to move institutional size, and at lower prices since holders of assets need to factor in the difficulty of selling a position. Higher yields are going to happen in any event, and when institutional holders of bonds decide to diversify into commodities or into other real assets, interest rates could rise quickly depending how quickly that meme spreads. Of course, the same is true of equities, and commodities. Asset-allocation shifts will get messier.

I actually think this isn’t a bad time tactically to enter long positions in fixed-income. The Fed isn’t going to be as aggressive as people expect; also, bonds will get some support from investors fleeing fading momentum in stocks. The chart below (source: Bloomberg; Enduring Investments calculations) shows the 52-week price change in stocks. This is one measure of momentum, and a very important one as lots of investors look at their returns in annual chunks. Incredibly, since the latter part of 2012 investors have always been able to see double-digit returns from stocks when they looked in the rear-view mirror. Today, that number is 7.5%.

stockmo

That’s still a terrific real return of more than 5%, but (a) many investors have very screwy return expectations, (b) many investors are well aware that they’ve been living on borrowed time with a liquidity-inspired rally, and (c) certain quantitative investors place significant weight to momentum, over value, in their investment models.

It’s just another red flag for stocks, but it has become passé to point them out. From the standpoint of a bond investor, though, this is good news because all of those equity owners, when they decide to take their chips off the table, will become bond buyers.

And when that happens, the liquidity issues in fixed-income might cut the other way for a while.

Two Quick Items

Two relatively quick items that I want to address today; they have been in my ‘to do’ box for a while.

Negative Rates

One of the most interesting features of the fixed-income landscape today, and one that will likely serve in the future as an exam question on finance quizzes, is the increasingly widespread proliferation of negative nominal interest rates among government bond markets…and occasionally even for high-quality corporate paper.

In finance theory, this can’t happen. Because currency earns a 0% nominal interest rate, theory says that no rational person would ever accept a negative nominal interest rate. If I have $50 today, and put it in the bank, I will have $49 tomorrow. So why not just keep the $50 in my wallet? (Obviously this leads to high cash balances, which means low monetary velocity, by the way). And this is true in the absence of “other costs.”

So why are so many interest rates negative? Are individuals irrational? No: at least not so irrational that they prefer less money to more money. However, what is true at an individual level does not necessarily scale to the institutional level. An institution, such as a money fund or corporation, does not have the freedom to hold its assets in physical currency. Microsoft has $90 billion in cash and equivalents. If this were in $100 bills, it would weigh about one thousand tons. That’s a pretty big vault. And vaults cost money. Guards cost money. And, if Microsoft had this money in the vault, it would be harder to spend. It is much easier to wire $5 million than it is to send an armored car.

In the presence of those costs, Microsoft and other institutions will accept a negative interest rate. It will invest its money at a negative rate rather than build a vault.

Now, an important (if obvious) point is that cash balances are so high, and interest rates so low, because global central banks are making sure we have plenty of cash. Too much cash chasing too few investment opportunities causes rates to be low.

Walmart and Minimum Wage Increases

It has been a few weeks now, but when Walmart in February announced it was going to increase the minimum wages it plans to pay its employees (preceded by Starbucks, Aetna, and the Gap and followed by TJX and Target), I received a number of queries about what the hike was going to do to inflation. Is this the beginning of the much-feared “cost-push inflation”?

The answer is no. Wages, as I have said many times, follow inflation rather than lead it. Think about it: wouldn’t it be really weird for companies to raise wages and then raise prices, to the extent that they have control – at least with respect to timing – over both? No, whatever price increase is going to be caused by the increase in the wages Walmart expects to pay is already in the price. Walmart is not surprised by their own move to raise wages. Nor is anyone surprised by the general increase in the minimum wage, which happened in 2009.

So, while I continue to believe that inflation is rising, and will continue to rise…I don’t believe that the increase in prices is going to be any faster due to these wage increases. It does, however, increase my confidence that inflation is rising, since obviously these retailers are confident enough in the pricing environment to be able to increase wages (which are sticky – it is harder to lower them than to raise them).

Lots to Worry About but Nothing to Fear?

As we tick towards the end of the quarter, the news feeds are starting to look like they occasionally do when we are having a big spike in volatility.

We have the Greece deadline coming up. I don’t think anyone knows exactly when Greece’s finances will hit the wall, but it is going to be soon. And, compared with prior incarnations of this exact same crisis, there doesn’t seem to be nearly as much optimism about the probability of a “positive” resolution to this crisis. By “positive,” I mean in the sense that the status quo remains more or less preserved: Greece gets money, and pledges reforms, but nothing actually happens except that Greece’s depression continues. I don’t at all mean positive from the standpoint of the Greeks (I continue to think they will be better off in the medium-term to exit the Eurozone and default on Euro-denominated debt), or even from the standpoint of the Euro (assuming the single currency survives, the departure of Greece will be an important test case for the ramifications of re-shaping the currency bloc to a sturdier subset of countries that intend to move towards fiscal union). Interestingly, and in contrast to prior iterations of the exact same crisis, both sides appear to understand that Grexit does not mean disaster, and to perceive the possibility that it might make sense to let this happen – since, in any event, it is inevitable. There seems to be little urgency to craft a real deal, and the panicky increase in market volatility is missing this time.

The Middle East is increasingly in flames. What I call the “black I’s” of Iran, Iraq, and ISIS are as unstable as ever, but now Yemen is in civil war with the existing government fighting Iranian-backed rebels and today Saudi Arabia plunged into the fight as a counterweight to Iran’s influence.  The comments that this should be only a short-term influence on crude oil prices because “the market remains oversupplied” make two assumptions that are possibly questionable here.

One is the technical point that the oil market is oversupplied (true), but that this means current prices should not react to disruptions to future supply. Of course, that is wrong: if it was suddenly discovered that all oil in the world was scheduled to evaporate on January 1st, 2020, you can bet your bottom petrodollar that prices today would (and should) react, even though that date is far in the future. Efficient markets reflect not only spot supply and demand, but also discount expectations for future changes in supply and demand (at least, for commodities that are storable at a reasonable cost).

The second assumption that may be questionable is whether the battle over Yemen is just a skirmish over a country with a small oil production footprint. Indeed, that may be the case. However, the appearance of Saudi Arabia into the fray does make one wonder whether the Saudi Kingdom does see a bigger conflict at play here. To the extent that Yemen is an opportunity for Sunnis (most of the Arab world) and Shia (Iran, most of Iraq) to engage indirectly, it signals rising structural tensions in the region and the possibility for much wider conflict. An analogy might be the Cold War phenomenon of the US and the USSR engaging in conflict by proxy; that conflict never emerged into a hot war but that didn’t make those of us hiding under our desks any more confident in the stability of the situation.

I don’t have a strong opinion on whether either assumption is warranted, but it strikes me that markets for implied volatility ought to be somewhat more bid on either possibility, not to mention what is happening in Greece. And yet, they’re not. The two charts below (source: Bloomberg) show the VIX and the MOVE (for bonds). Neither seems to be displaying much alarm at this point. It feels like we should be having a spike in volatility, but we are not. To me, this makes the buying of protective puts an attractive alternative to consider.

vix

move

Categories: Bond Market Tags: , ,

That’s Not How Any of This Works

March 18, 2015 1 comment

I wonder how many times the Fed needs to be more dovish than expected before investors realize that this is a dovish Fed?

It may indeed be the most dovish Fed ever, judging from Dr. Yellen’s prior statements and history. And yet, investors seemed to have convinced themselves that with core inflation measured in the Fed’s preferred way far below its target (to be sure, it’s not the right way to measure it, but they’re not looking for excuses to hike), with structural unemployment still high (see chart of “Not in Labor Force, Want a Job Now,” source Bloomberg, below), with other central banks aggressively easing so that our dollar is aggressively strengthening, and with recent economic indicators surprising on the low side at the most-rapid pace since 2011, the Fed was going to put itself on a track to start hiking rates by early summer.

wanna

In the event, the Fed told us that they are no longer going to be automatically “patient” – which was the word that 90% of economists expected them to remove from the statement – but the Committee’s median projections for the year-end Fed funds rate dropped 50bps since the last meeting, to just above 0.5%.

Why won’t investors listen? It isn’t as if the last Fed Chairman was a renowned hawk. It’s been a generation since we had a real hawk in the Chairman’s seat. So I have no idea why it is a shock to people that the Fed acts dovishly, even as Chairman Yellen says the Fed will need to “monitor inflation developments carefully.”

If they were monitoring inflation developments carefully, they would know that median inflation is already at levels that represent achievement of the Fed’s target. If they were monitoring inflation developments carefully, then they would know that the dollar (which Yellen says will keep inflation lower for longer) has very little impact on domestic pricing, outside of goods that are largely produced overseas (apparel) or certain raw commodities (like energies).

Or, perhaps, just perhaps…they actually do know these things, but prefer to rely on obfuscation to keep rates as low as they can for as long as they can, until the market absolutely demands that they raise them. With market interest rates low, and the dollar strong, there is absolutely no market pressure for the FOMC to raise rates. Therefore, they will not.

At this writing, 10-year breakevens are +11bps on the day. Over the last week or two, after a mild bounce from the beaten-down lows, fast money had been leaning on breakevens again and pushing them inexorably lower. How do I know it was fast money? Because 10-year breakevens are up 11bps in a freaking hour, after a mild adjustment in the “dots.” That isn’t the sort of move that reflects long-term planning.

I continue to be flabbergasted at how the Fed maintains its credibility. We all know that the Fed has been considerably worse than the average economic forecaster over a long period of time. But it even seems to have trouble with current data. On the tape right now, the Chairman is saying that the “residual effects” of the financial crisis are restraining credit. Really? The chart below shows commercial bank credit. Does that look restrained to you? It is rising at better than an 8% pace y/y, the fastest level since May 2008. And it’s 10%-11% annualized on a q/q basis.

cbcredit

Sometimes I want to echo that commercial for Esurance. “That’s not how it works. That’s not how any of this works.”

When market rates go higher, and/or the dollar weakens because our domestic inflation starts being appreciably more than that of our trading partners, then the Fed will get serious about tightening. But it will have to be serious enough to handle the downward adjustment in securities prices that will happen when they begin to do so. I can’t foresee a time when that’s particularly likely. The Fed eschewed tightening over the last few years with an economy that had good momentum (see the first chart above). How likely is it that the Fed will get ambitious about hiking rates in the late stages of an expansion that is long in the tooth? With this Chairman? I wouldn’t hold your breath.

Categories: Bond Market, Federal Reserve, Rant Tags:

Winter Is Coming

February 10, 2015 5 comments

Sometimes being a value investor, amid overvalued (and ever more so) markets, feels a bit like being a Stark in Westeros. The analogy will be lost on you if you do not follow Game of Thrones, but the Starks hold the largest of the sub-kingdoms in Westeros. This kingdom also happens to be the coldest, and the sober Starks are always reminding people that “Winter is coming.”

I should observe that winter in Westeros is a much more serious affair than it is around here; it comes at odd intervals but can last for years. So being prepared for winter is really important. However, getting people to prepare for winter during the long “summer” is very difficult.

Sound familiar? The thing to keep in mind is that the Starks are always right, eventually, and they’re the ones who come through the winter in the best shape. Such is the case with value investors. (Some people might prefer calling value investors who are bearish on stocks right now “Chicken Littles” but I prefer being compared to Ned Stark, thanks. Although both of them have been known to lose their heads on occasion.)

Fortunately, it does not appear that winter is coming to the U.S. very soon. Friday’s Employment report was strong, despite the beginnings of downsizing in the oil and gas extraction businesses. The chart below shows the Baker Hughes oil and gas rig count, which is falling at a rate every bit as fast as it did in the credit crisis.

rig count

Yet, the U.S. economy as a whole generated 267,000 new jobs last month, which was above expectations. It is unlikely that this pace will continue, since the extraction (and related industry) jobs will be a drag. But in 2008, this happened when every other industry was being squeezed, and in the current case other industries are being squeezed by the strong dollar, but only mildly so. I think this will actually serve to increase the labor force participation rate, which has been in a downtrend for a long time – because laid-off oil workers will still be in the labor force looking for work, while other jobs will be getting filled by (sometimes) discouraged workers coming off the sidelines. So we may well see the Unemployment Rate rise even as jobs growth remains reasonable, even if less robust than the most recent figures.

Winter, though, is still coming.

In the near-term, winter is coming to Europe. Unusually, it is moving from the south to the north because Greece appears to be finally heading for the denouement that has been utterly unavoidable from the beginning. I wrote this in June 2012 (and I wasn’t the only one saying such things – the only real question has been how long it would take before the Greeks decided they’d had enough of sacrifice to hold together the Eurozone for the elites):

Greece will still leave the Euro. Government or no government, austerity or no austerity – the fiscal math simply doesn’t make sense unless Europe wants to pay for Greece forever. In principle, the Greeks can dig themselves out of trouble if they work harder, retire later, pay more taxes, and receive fewer government services. I do believe that people can change, and a society can change, under pressure of crisis. Remember Rosie the Riveter? But the question is whether they can change, whether they will change, do they even want to change, if the benefit of the change flows not to Greece’s people but to the behemoth European institutions that have lent money to Greece?

If a person declares bankruptcy, and the judge declares that he must pay all of his wages for the next thirty years, after deducting enough for food and shelter, to the creditors…do you think that person is going to go looking for a 60-hour workweek?

Am I sure that Greece is going to leave the Euro in a week, or a month, or a year? Not at all. The institutional self-preservation meme is very strong and I am always amazed at how long it takes obvious imperatives to actually happen.[1] But I am quite confident that Greece will eventually leave the Euro, and it does seem as if parties on all sides of the negotiating table are coming to that conclusion as well.

One question that authorities have had to come to peace with first was whether Grexit is really Armageddon. I have argued that default and an exit from the Euro is not bad for Greece, at least when compared to a multi-year depression.

And it’s probably not even horrible for Europe, or the world at large, at least compared to the credit crisis, despite all protestations that this would be “Lehman squared.” Again, this is old news and as I lay out the reasoning here there is no reason to repeat myself.

But it won’t be a positive thing. And it is likely to bring on “winter,” economically. Helpfully, the world’s central banks not only remain in easing mode but are increasing the dovishness of their stance, with the ECB foremost among the central banks that are priming the pumps again. M2 money growth in the Eurozone was up to 4.5% y/y in December (latest data available), with the highest quarter-over-quarter growth rate (8.3%, annualized) in money since the end of 2008! Meanwhile the Fed, while it is no longer adding to reserves, is still watching the money supply grow at 6% y/y with no good way to stop it. For all the talk about the FOMC hiking rates by mid-year, I think the probable rise in the Unemployment Rate discussed above, plus the weak inflation readings (with the notable exception of Median CPI), plus the fact that all other central banks are easing and likely to continue doing so, plus the probability of turbulence in Europe, makes it very unlikely that this Committee, with a very dovish makeup, will be tightening any time soon.

The likely onset of some winter will not help hold down inflation, however. Upward pressures remain, and the fact that the ECB is now running the pumps makes higher prices more likely. Yes, we care about money supply growth in Europe: the chart below shows the M2 growth of the US and Europe combined, against core CPI in the US. The fit is actually better than with US CPI alone.

m2prices

Now, some markets are priced for winter and some are not. We think that real interest rates in Europe are far too low compared to real rates in the US, and stock prices in the US are too high compared to stock prices in Europe. The first chart below shows the spread of 10-year real rates in the US minus Europe (showing US yields are high compared to European yields); the second chart shows the ratio of the S&P 500 to the Eurostoxx 50.

realratespreadUSEU

spxeurostoxx

You can see in the latter chart that the out-performance of the S&P has proceeded since 2009, while the under-performance of US inflation-linked bonds has only happened since 2012, so these are not simply two ways of looking at the same trade. In both cases, these deviations are quite extreme. But the European economy and the US economy are not completely independent of one another; weak European growth affects US corporate entities and vice-versa, and as I suggest above the growth of European money supply tends to affect US inflation as well. We think that (institutional) investors should buy TIPS and sell European linkers, and also buy European stocks against US stocks. By doing both of these things, the exposure to currency flows or general trends in global equity market pricing is lessened. (Institutional investors interested in how we would weight such a trade should contact us.)

[1] As another example, take the shrinking of Wall Street. It was obvious after 2008 that it had to happen; only recently, however, as banks and dealers have been forced to become more and more like utilities have we started to see layoffs while stocks are rising, which is very unusual. But Wall Street defended the bloated structures of the past for more than six years!

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