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Katrina Lamb, CFA
Head of Investment Strategy & Research
Katrina Lamb’s international investment industry career spans more than 25 years and includes both buy and sell side experience. She specializes in the research, analysis, and evaluation of the capital markets opportunities that... Full Bio
They conferred in elegant conference rooms in the classical-style École des Beaux Arts building that houses the Federal Reserve Board, to discuss the problems created by years of pumping cheap money into the economy. The need for that cheap money is no longer a present day reality, they said. In anticipation of a resumption of economic growth we must raise interest rates from the recent low levels that have never been seen in the history of our Republic – a 1.6% yield on the 10 year Treasury! The policymakers acted accordingly, and a 30 year macro bear market for interest rates ensued.
Coming Full Circle
No, that is not a speculative musing about the future, but a recitation of actual US economic history. The year was 1951. The cheap money was the legacy of an economic depression and, more recently, the cost of financing the country’s involvement in the Second World War. The US was the world’s sole economic superpower and its only viable source of growth, but the monetary policymakers of the day knew that real growth could not come on the back of cheap money. No free lunch they said, rates have to rise. And rise they did, with the 10-year yield going from 1.6% after the war to 15.4% by 1981.
Now we have come full circle. After five years of historically cheap money investors are looking at the bond market, and nightmarish visions of that 1951 Treasury Accord are dancing in their heads. With one day left in the second quarter the Barclays US Aggregate Bond index has returned -2.43% since April 1. The exit doors are jammed with fleeing moneyfolk – in the last four weeks $23.7 billion has left the bond market via net mutual fund outfllows, the most since the days of indiscriminate panic selling in October 2008. By comparison the S&P 500 is up by 3.4% for the quarter even after the recent 5.8% correction.
The Gathering Storm?
That frenetic selling is not helping bonds regain ground. When investors pile out of an asset the managers who run funds holding those assets have to sell to redeem the exiting investors. That selling drives prices down further, leading to more investors getting out, and a vicious circle ensues. There’s a bit of that going on now – quite honestly there is not a compelling case to make on the basis of economic fundamentals for the 10 year yield to jump from 1.6% to 2.6% in just five weeks. We imagine it likelier than not that cooler heads will prevail in the near term. But we have glimpsed the shadow of the bear, if not yet the bear itself.
Unfortunately there’s not much in the way of safe houses in today’s environment. Bonds are down, stocks are off their highs, commodities are faring poorly and there is great carnage in emerging markets. If we are headed towards renewed growth, as we continue to believe is the likeliest scenario, then presumably this too will pass. But it’s not a good time for the queasy or the faint of heart.
Bond rates are rising. This week the Fed met and the world learned the true meaning of “tapering”: not a slip of the tongue, but a stated willingness on the Fed’s part to contemplate a phasing out, over time, of the QE programs that have kept assets afloat through the near-crises of the past several years, from the Eurozone turmoil to Washington’s repeated fumbling of its role on the world economic stage. The 10 year yield as of this writing is just under 2.5%, about 50% higher than where it was at the beginning of May. Bond traders are smelling the end of an era, battening down their durations and searching for ways to be low-correlated to the Barclays US Aggregate.
Here’s what else is not finding favor in the current environment: commodities of all stripes from gold to industrial metals to energy. It’s a far cry from the distant days of the last period of sustained rising interest rates in the mid-late 1970s, when gold rushed to an all time (inflation-adjusted) high and real-return or “hard” assets generally were the only bright spot in investment markets. Gold is down by more than 10% since the beginning of May and more than 30% off the nominal highs reached in late 2011. Households notice that gas prices haven’t been jumping in typical fashion as the summer driving season gets underway. Prices of copper, aluminum, natural gas and other commodities are similarly depressed.
…With Subdued Inflation
There are some good reasons why commodities are in a slump, first and foremost of which is that inflation is not a high-level threat in the near term. Real assets tend to do well when inflation is high and the US dollar is weak, neither of which is a present reality. Rising rates aren’t driving investors to real assets because the rising rates – for now anyway – have little to do with inflation and lots to do with a long journey back from the artificial low-rate policy regime of QE. Simply put, even after the recent run-up rates are historically low and thus even in the absence of inflation more prone to rise than fall.
The Slow Return to Market Economics
Low inflation and the Fed’s desire for an orderly transition from QE mean that the road to higher rates will more likely play out over time than overnight (the one big caveat being an excessively negative momentum cycle in bonds exacerbated by high frequency trading programs). Eventually rates should fall in line with real economics: how much money is coming into the economy and how much output (goods and services) is being created to meet that demand. When too much money chases too few goods inflation will result, rates will rise and real return assets will offer value. Then activity will slow, rates will fall, borrowers will take advantage of lower rates and the cycle will begin again. That’s how the system is supposed to work. It will be a refreshing change to get back to it after the looking-glass world of QE.
The doctors may be at odds about how and when to start reducing the morphine treatment, but the patient is having none of it. When Dr. Bernanke chose to use the word “tapering” during the Fed’s May 22 meeting, carry trade investors of all stripes heard the flow of their daily stimulus fix (the low rates that finance their profitable adventures into risk assets) threatening to slow down to a measured drip-drip. We won’t go, go, go they chorused as prices on US stocks and emerging markets bonds and global REITs and much else besides jagged to and fro in increasingly volatile trading sessions.
It’s still all about the Fed. When the S&P 500 jumped up by 1.5% on Thursday of this week it was an unconfirmed report in the Wall Street Journal implying that the Fed wouldn’t be backing off its QE3 operations any time soon that set the bulls on the charge. Whether yesterday’s sudden burst of optimism sets the pace for a sustained push back towards the index’s May 21 high water mark of 1,669 probably depends more than anything else on how Bernanke chooses to articulate the central bank’s current thinking at the forthcoming Board of Governors meeting this next week. Here’s a thought: It is rather unlikely that the word “tapering” will venture forth again from his calm and measured lips.
An Interim QE Report Card
With the myopic focus on day to day movements in asset prices it is sometimes easy to lose sight of the fact that the Fed’s policy tool of choice, quantitative easing, is primarily aimed at the more pressing objective of bringing the economy back to health – as defined by growth in economic output, income and especially employment. The theory underpinning QE is that by driving asset prices up, monetary policy engineers can encourage the wealth generated from the higher values to spill over into the economy at large. That theory may prove valid in the end, but the jury is still out.
So far the post-2009 recovery has failed to produce a single full calendar year of 2.5% growth, which is a benchmark level for sustainable (albeit moderate) job-creating growth. The unemployment rate has fallen from a high of 10% year-on-year reached in October 2010 to 7.5% in April 2013 (ticking up again slightly in May as more out of work adults came back into the market looking for jobs). That is an improvement though the pace is slow. After the recession of the early 1980s unemployment fell from 10% to 5.5% by the second half of the decade. At current GDP growth rates that will be tough to match.
Look Ma, No Hands
Recent news has given reason for optimism, though. Payroll numbers have been trending up as of late, consumer confidence is resurgent and housing price gains are shoring up household balance sheets. Perversely, it’s the optimism of recent data points that have added to investors’ funk. It’s when signs of better health appear that the doctor starts to wean the patient from the treatment. At least for now the patient is not ready, and it’s unlikely that the doctor is going to push him out the door too quickly. That’s probably the right thing to do. But the concern is that when the body gets too used to the treatment, the treatment becomes less and less effective. And that in turn could call into question the course of the recovery. Dr. Bernanke has a fine line to walk this coming Tuesday, and both his policy choices and his verbal acuity need to be sharp as a tack.
For most of this year Japanese equity markets have been on a roll, but the unusual run of good news for chronically underperforming Japan did a massive about-face a couple weeks ago. On May 23rd the Nikkei 225, a broad index of Japanese stocks, took a 7.3% plunge from the commanding heights it had scaled – a 47% run-up since the New Year – and the downward momentum has snowballed since. The index is now more than 18% below the 5/23 high. Clearly things are not quite right in the Land of the Rising Sun.
Cherry Blossoms and Abenomics
Japanese stocks had been on this spectacular rally largely due to Prime Minister Shinzo Abe’s brash push for monetary expansion to vanquish deflation, as well as his other policies intended to kickstart the economy out of its decades-long funk. Economists have been referring to this bundle of policies as “Abenomics”, and the springtime buzz has been palpable in the retail high streets of Osaka and the trading rooms of global securities firms alike. Relative to the size of Japan’s economy, Abenomics is a more turbo-charged program than even the massive QE3 stimulus architected by US Fed chairman Ben Bernanke.
The Skeptics Weigh In
Like those ephemeral cherry blossoms, though, the euphoria over Abenomics may prove to be short lived. Rising Japanese government bond yields are fueling concerns: higher yields may mean rising inflation expectations which could mean that the country will have trouble paying its debt (currently more than twice the size of its economy). Rising inflation is one of Abe’s primary goals, but Japanese economist Richard Koo argues that a rise in inflation before the economy truly begins to recover could do more harm than good. Mr. Koo states: “This is clearly an unfavorable rise in rates driven by concerns of inflation, as opposed to a favorable rise prompted by a recovery in the real economy and progress in achieving full employment.” (Business Insider, 06/04/13)
Meanwhile, In the Real Economy…
Japan’s monetary problems, serious as they may be, are not the whole story. The once dynamic economic superpower that produced Toyota, Sony and just about every trendy management fad of the 1980s has long been a subdued shell of its former self. The story in Asia these days is much more about China, a recently resurgent Korea and emerging consumer giants like Indonesia. Decisions in Japanese corporate boardrooms are neither nimble nor bold, and companies from Suntory (beverages) to Daiei (retail) to Orix (financial services) have squandered opportunities for regional market share growth as a result. The Nikkei’s ongoing woes may be more than anything else about doubts among investors that this state of affairs will be changing any time soon.
For the past three years the dominant paradigm in investment markets has been “risk on, risk off”. You know – if it’s Tuesday it must be gold and the Japanese yen, but come Thursday animal spirits are back and it’s full-on into small caps and frontier equities. Over this time the market has seemed bipolar as it pinballed back and forth between riskier exposures and perceived safe havens.
Where have all the havens gone?
As we approach the midpoint of calendar year 2013 that paradigm seems to be fading fast. What’s missing is the safe haven, a designation that seems to apply to fewer and fewer asset types. Currencies and precious metals – well, in truth they were never all that safe to begin with, and the recent gyrations of gold and the yen provide a clear demonstration of this. But it’s the fixed income market – the traditional epicenter of safety and predictability – that is the real story today.
Volatility in the bond market
Consider the past week. After reaching a record high of 1669 on May 21 the S&P 500 has seen higher than average volatility and by the close of trading on May 30 the index was a bit less than 1% off the 5/21 high. That’s typically perfect weather for the risk-off flight to the safest of fixed income assets. Not this time. The yield on the 10-year Treasury note – a bellwether for interest rate trends – shot up from just under 1.95% on May 21 to 2.1% on May 30. The total return for IEF, an exchange traded fund (ETF) that tracks the Barclays 7-10 Year Treasury Index, was -1.4% for the same period. Risk here, risk there, risk everywhere.
Taste of things to come?
Now, a nine day calendar stretch is not the defining word on where markets are headed in the immediate future. We think it is more likely to be a small taste of a larger problem that we may be dealing with for some time to come. That problem has a name – interest rate risk. The thing about bond market macro trends is that they tend to be very long. Here’s a little history to make the point: since the 1950s we have had only two such macro trends.
From Cheap Money to Credit Crunch
In 1945 the 10-year Treasury reached a low of 1.7% - its lowest yield since, literally, the founding of the Republic after the Revolutionary War. This was a result of deliberate monetary engineering – sound familiar? – to finance America’s involvement in the Second World War. After the war policymakers realized they had to bring an end to the era of cheap money in light of inflationary pressures. This decision was formalized in the Treasury Accord of 1951. From that point interest rates began a long, steep climb that lasted 30 years until the 10-year yield, reflecting punitively harsh credit conditions, reached an all-time high of just under 16% in 1981.
From Credit Crunch to Cheap Money
Now, 32 years later, that yield is again just over 2% after plummeting below 1.5% in 2012. The Fed is still printing cheap money, but the minutes of recent Fed meetings make clear that this policy is under pressure. We don’t know when we will see “Treasury Accord 2.0” – when the policymakers decide they have to formally acknowledge changing course. It may be awhile yet. But this is the giant elephant in the room, and we believe it is going to present a major challenge to portfolio managers. This challenge will require an innovative, active and flexible approach to managing risk.