Last week, in Part I of "That Was The Weak That Worked," we reviewed the equity markets in an attempt to see how equity investors managed to scamper through 2013 with the friskiness of puppies when all about them lay doubt and potential disaster.
We found the answer in quantitative easing — of course.
This week we will take a look at how the bond market managed to navigate the same 12-month period and see what can be learned about 2013 in order to forecast for 2014.
Let's begin by considering the subject of logical fallacies — an endeavor rendered more obsolete with each passing day.
(Deus Diapente): The study of logical fallacies is useful in learning how to think instead of what to think. In learning how to deconstruct an argument, you learn how to efficiently construct your own thoughts, ideas, and arguments. You learn how to find fallacies in your own line of reasoning before they're even presented, which is a valuable methodology for learning how to think. Which is a lot more honest, liberating, and possibly more objective than simply regurgitating what society, teachers, parents, preachers, friends, or politicians tell us...
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"Learning how to think instead of what to think"?
The very idea is enough to send many into an Austen-like swoon, and yet within this relatively simple construct lies a principle that, if it were applied to today's markets, would have every rational investor rushing headlong into the hills.
Allow me to demonstrate using everyone's favourite logical structure: the syllogism.
A syllogism is classified as a point-by-point outline of a deductive or inductive argument. Syllogisms normally contain two premises followed by a conclusion:
Premise 1:Miley Cyrus is the most talented musician of her generation.
Premise 2:The most talented musician of every generation achieves legendary status.
Conclusion:Miley Cyrus is a legend.
Simple.
The conclusion, from a purely logical standpoint, holds water. The problem comes when either of the first two premises is not accepted by the person to which they are proposed.
At that point, the argument starts to fall apart.
The common term for this kind of flawed argument is a "non sequitur," which literally means "it does not follow."
So let's apply the syllogistic approach to the concept of quantitative easing and see how we go:
Premise 1:Central banks have been printing money like lunatics.
Premise 2:Their printing of money hasn't had any ill effects.
Conclusion:Printing money doesn't have any ill effects.
Right then. There's our syllogism. Do you want to go first, or shall I?
Oh... ok.
Quantitative Easing IV (or "QE IV" — so-called because it was injected directly into the veins of the monetary system) was unveiled on December 11, 2012, when Ben Bernanke announced, as Operation Twist expired, that in addition to the ongoing QE3 program (which committed the Federal Reserve to buying $40 bn in MBS every month) he would sanction the additional buying of $45 bn in long-term Treasury securities. Every month. Forever. Until further notice.
The rest, as they say (whoever "they" are), is history.
The effect on the Fed's balance sheet is plain to see:
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Source: Bloomberg
That's a very steady, predictable line; and markets, as we have discussed, LOVE steady and predictable. The consistency of this curve underpinned the strength in equity markets this year, as I demonstrated last week. But in Bondville? Well, that's another story...
Below is a chart I've used before that has been helpfully updated by Goldman Sachs (courtesy of Barry Ritholtz). It shows the coupon on the US 10-year Treasury going back to 1790 and highlighting every peak, trough, and major catalyst along the way.
My advice is to bookmark it for 2014.
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The only thing that ISN'T included on the chart is the average coupon over the last 224 years, which is a hair below 6%.
But the world is a very different place now than it was in 1790, obviously, and so it may seem unfair to take an average that goes back quite so far in time. So truncate the same chart to the period between 1962 and 2013 in the hope that a 50-year window is more palatable to grapple with. The beauty of that window is that it encapsulates both the high and the low prints for the entire 224-year span.
What do we find when we zoom in for our close-up (next page)? Well, we find that the average rate over the last 50 years was ... wait for it ... 6.58%.
OK, so as we attempt to disprove our original syllogism, we have established that somewhere between 6 and 6.5% is probably a fairly representative rate for the US to be paying to borrow 10-year money from the rest of the world. Now, let's head back to the dictionary:
(Free Dictionary): Regression toward the mean
Noun1. The relation between selected values of x and observed values of y (from which the most probable value of y can be predicted for any value of x).
Put in a slightly less mathematical way:
(Wikipedia): In finance, the term mean reversion has a different meaning. Jeremy Siegel uses it to describe a financial time series in which "returns can be very unstable in the short run but very stable in the long run." More quantitatively, it is one in which the standard deviation of average annual returns declines faster than the inverse of the holding period, implying that the process is not a random walk, but that periods of lower returns are systematically followed by compensating periods of higher returns.
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Source: Bloomberg
What that also means is that periods of lower rates are systematically followed by compensating periods of higher rates, which isn't great news as we continue to move inexorably higher from the lowest print in history.
Just because there HAVEN'T been any ill effects from QE doesn't prove there WON'T be. There goes our syllogism. Sorry.
As you can see from the downward-sloping trendline above, we have reached a somewhat crucial juncture.
Back in May, when Ben Bernanke provoked the Taper Tantrum, rates on the US 10-year Treasury were at their all-time lows of 1.6255%. Since then, almost imperceptibly, rates have climbed higher ... and higher ... and higher still, to the point where they have almost doubled since Ben let the cat out of the bag on that fateful day in May:
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Source: Bloomberg
Ah yes, I hear you say, but it's not as though 3% is a steep interest rate for a country carrying a $14 trillion deficit to pay to finance its debt — and you're right. The problem comes with that whole regression to the mean thing — and more specifically, the tendency for these moves in interest rates to overshoot.
Back in late April, before the first taper trial balloon was floated, Bloomberg had this warning for bond investors:
(Bloomberg): If rates rise, the market value of government bonds in particular — and all bonds in general — could be hurt significantly. For example, if the federal funds rate rises to 3%, a longer-term Treasury bond might lose as much as a third of its market value.
For every 1% increase in interest rates, expect the 10-year U.S. Treasury bond to lose 8.96% in price.
Historically, the 10-year Treasury bond returned a long-term average real rate of return and yield of 4.4%, according to Don Riley, chief investment officer of the Wiley Group. If the 10-year yield rose from 1.66% today to 4.4%, the price of that bond would fall 21 percent.
If and when interest rates rise again, are bond owners going to keep 10-year or 30-year Treasury bonds in their portfolios until those bonds mature? Very likely not. Who would want a 1.5% or 2.5% return for a decade?
And in October, after the last-minute pullback from the edge that all but shredded whatever credibility the Fed had left, the FT weighed in with some alarming statistics from our old friends the IMF:
(FT): Monetary tightening in the US threatens to expose financial excesses and vulnerabilities that could wipe trillions of dollars off bond markets, the International Monetary Fund warned on Wednesday.
If the Federal Reserve's likely move to start scaling back its asset purchases or fallout from a possible US failure to lift its ceiling on public debt raise long-term interest rates by 1 percentage point, the IMF's Global Financial Stability Report (GFSR) estimates that the market losses on bond portfolios could reach $2.3tn.
Well, since May, when all this taper nonsense began, rates have made sizable moves in the wrong direction, all the way along the curve:
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... and in the two holiday-affected weeks since the Fed's "Taper Lite" announcement, they've shown no signs of stopping:
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Source: Bloomberg
With the Fed now slowing their purchasing of Treasuries, the spectre of the loss of a free backstop has sent investors barreling back into high-yield debt as a means to supplement their loss of interest income and capital losses on government bond portfolios; and that move has given us one of those charts you just have to love for the glaring disconnect that seems not to matter to anybody:
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Source: Sober Look
Clearly, something is amiss here, but why worry about it now — just chase the yield. There will always be a greater fool to sell your position to, and if things get really sticky the Fed will probably ride to the rescue.
Right?
Maybe.
Meanwhile, it probably makes sense — seeing as the Fed is buying $40 bn in Treasuries and $35 bn of MBS every month in order to stabilize the market and keep rates down and the housing market "recovery" bubbling away — to take a look at what effect, if any, these rising rates are having on the aforementioned "recovery." To do that I'll enlist the help of my great friend Greg Weldon, whose chart work really is second to none.
Continue reading:Â http://www.mauldineconomics.com/ttmygh/that-was-the-weak-that-worked-part-ii
