Guggenheim Partners On The "Urban Legend Of The Bond Bubble"
Even as today's POMO is helping risk assets, but doing nothing for rates (and leading to a flattening of the curve), leading some to speculate that the bond market is getting very nervous about what the FRBNY's intervention may mean for rates, there are some who believe that the Fed will continue to influence the curve favorable, leading to ongoing tightening (and flattening) of the yield curve. One of these, of course, is David Rosenberg. Another, as presented below, is Guggenheim's Scott Minerd, whose previous insights on markets have always been controversial and certainly though provoking. To wit: "I don’t believe in the urban legend of the bond bubble. On the contrary, I believe the yield on the 10-year note will continue its decline, to 2.0 percent, and possibly lower. The “old news” happening to a new economy will most likely be a prolonged period of low long-term interest rates and low yields. While the idea of a sustained low-yield environment may be unfamiliar to the current generation, it’s not unfamiliar to the former one – just ask anyone who remembers the 1940s, a time when the average yield on 10-year U.S. Treasuries was 1.99 percent, for the entire decade." Then again, the 1940s were a rather simpler time, in which the rate framework did not define about $1 quadrillion of interest-rate derivative products. The reverse feedback loops created now are so unpredictable and confusing that anyone who claims they know what might happen in either extreme case is certainly full of it. Amusingly, even Minerd realizes this, and in his outlook for the long-term (beyond five years) he acknowledges that the endgame is afoot: "Nonetheless, just as a broken clock is right twice a day, the economy
will inevitably reach a point where interest rates will rise. When they
do, I believe they will rise for a long, long time. What happens after
that? The ultimate end game, I believe will be a paradigm shift for
First, Minerd does a comparative historical analysis.
‘A Page out of the 1940s’
Given that the U.S. economy is recovering from the worst financial collapse since the 1930s, the decade after the Great Depression should be of extreme interest to investors today. Looking back to the period immediately following the United States’ entrance into World War II, the Fed and the U.S. Treasury held a series of meetings wherein the Fed essentially agreed to acquire all 10-year U.S. Treasury securities at a rate of 2.25 percent or more. The Fed took such an unconventional step at the request of the Treasury in order to keep the borrowing costs of the federal government low to finance the War efforts. This understanding was announced to the public. As a result, the Fed actually purchased a surprisingly small amount of Treasuries because investors believed that there was a “put” option on Treasuries and naturally stepped in and bid down yields any time they approached 2.25 percent.
Things grew more interesting at the end of the War, however, when War-time price controls were repealed and inflation set in. In 1945, the yield on the 10-yearTreasury was 1.67 percent and inflation was just 2.2 percent. By 1946, inflation had jumped to over 18 percent, but still the Fed stood by its commitment to keep rates low – the yield on the 10-year note in 1946 was just 1.82 percent, resulting in real yields of negative 16 percent. The Fed then grew anxious to raise interest rates, which obviously conflicted with its entangled agreement with the Treasury under the Truman administration.
The administration, in effect, said that the Fed had blown it in the 1930s when it tightened its policy and unemployment skyrocketed from 14 percent in 1936 to 19 percent in 1937. (See my September 1 commentary on the Great Depression.) In the latter part of the 1940s, the U.S. was in the midst of a baton-pass from a War-time economy fueled by government spending to a peace-time economy where consumers and businesses needed to take the reins (a similar situation to the current baton-pass that Chairman Ben Bernanke has referenced from government spending and inventory rebuilding to the U.S. consumer). In the estimation of the Truman administration, if the Fed raised rates during this transition period, it would cause the same problem it did in the 1930s, and that was not worth risking.
Despite inflation of 18 percent in 1946 and 9 percent in 1947, and deficit-to-GDP ratios double that of today, the Fed acquiesced and continued to uphold its policy of purchasing Treasuries in order to keep long-term interest rates low. Even though the real returns were negative, the Fed continued its practice of keeping rates artificially low until the Treasury Accord of 1951. The result of the Fed’s posturing during the 1940s was an average 10-year note yield of 1.99 percent for the entire decade. It is worth noting that the Fed pulled this off in the face of rampant inflation, negative real rates, and massive government deficits.
The moral of the 1940s allusion is that history has proven the Fed can keep long-term interest rates low for an entire decade if it believes it is warranted in order to ensure the viability of long-term economic recovery. Today, with the recent commitment to another round of quantitative easing (“QE2”), I sense the Fed preparing to use monetary policy as a blunt instrument once again. If the Fed is indeed committed to keeping rates low as long as necessary for the economy to recover, which I believe they are, it would once again mean higher yields are not on the horizon anytime soon.
Another argument for demand is that the baby boomers will have no choice but to keep buying fixed income, a phenomenon witnessed for 27 straight weeks in the funds flow arena.
‘The Boomers Enter the Fray’
The backdrop of rising global demand for long-duration Treasuries is occurring at the same time that there is a big demographic shift occurring among U.S. investors. The Baby Boomer generation is now in their late 40s to early 60s. They’ve experienced a lost decade in the equity market, with the average annual return for the S&P 500 at just 0.89 percent over the past 10 years. A recent CNBC poll showed that 67 percent of investors have lost faith in equities. Baby Boomers, in particular, are increasingly concerned with the need to preserve monthly income. The shift is moving from capital gains and capital appreciation toward securities that pay stable monthly coupons – in other words, from equities toward fixed income (which, just for the record, I do not believe is an appropriate rebalancing of asset allocation).
So how do all these seemingly competing forces play out? Central banks around the world are accumulating long-duration Treasuries and pulling duration out of the fixed income market. Investors who sell their holdings of long-duration Treasuries to central banks will have to turn around and buy some other long-duration asset, competing with the Baby Boomer demand for stable fixed income returns. What will inevitably happen is credit spreads will start to collapse, which means any credit product that is money good will see its rate of interest fall faster than the rate of interest on Treasuries. This will make finding strong yields more and more difficult in the future, but it also represents a capital appreciation opportunity to be captured in long-duration assets today. Once again, however, I find that evidence for increasing rates is conspicuously absent.
Regardless if correct or not, here are how the author views the implications of what may happen if the UST bubble continues inflating.
‘What This Means for Investments’
Now, let’s bring this all home and look at what this could mean for investments over the next three to five years. First, let me clarify that this whole discussion isn’t intended to be about comparative value between stocks and bonds. My purpose in writing this piece was to debunk the urban legend of a bond bubble. I believe stocks are cheap in the current environment and should provide annualized returns in the neighborhood of 7 to 10 percent over the next decade. When Treasuries were at 4.0 percent in April, I advocated adding to positions. Today, at 2.5 percent, I don’t recommend loading up on Treasuries, even though I believe rates will continue to fall to 2.0 percent or possibly lower.
In general, the main opportunity for investors today is to take advantage of the rising tide of liquidity that will lift asset prices in stocks, bonds, and commodities and will not be immediately inflationary. In fixed income, both Treasuries and corporate debt have already seen price appreciation. Eventually, I believe it will spill over into municipal bonds and other sectors of fixed income. It has already spilled over into the equity market, and although there will be setbacks, equities should generally rise over the next six to twelve months. In the commodities market, gold and silver will generally continue to appreciate. The only assets that aren’t rising are the boats that have holes in them. Residential real estate, for example, is so badly damaged that it just sits there even as liquidity rises all around it. Real estate is cheap, but until the market clears the glut of housing supply it will stay cheap. There will be an opportunity to purchase residential real estate, but not for at least another five years. The places to invest today are those areas where liquidity is flowing: bonds, commodities, and equities.
With the broad theme painted, I will attempt to speak more specifically to opportunities in fixed income (especially since this is a commentary focused on the bond market). Given the demographic shift of the Baby Boomer generation toward fixed income, as well as all the demand for long-duration fixed income securities to come from the Fed and other central banks, there is an opportunity for investors to purchase fixed income assets today at spreads that are still attractive that also afford the opportunity for price appreciation.
In particular, the opportunities I’m most enthusiastic about in this new world of low rates are in fixed income asset classes that have fallen out of favor, such as asset backed securities (ABS) and select high yield and municipal bonds. The spreads relative to Treasuries are historically wide in these sectors, especially in investment grade municipal bonds, because the markets have effectively thrown the baby out with the bath water. In fact, I have to remind people all the time that “ABS” is not a four-letter word and all municipalities are not the next Vallejo, CA or Harrisburg, PA. In the high-yield market, spreads have contracted the most for the “brand name” issuers that appear in the popular indices, but there is a lot of value if you can do the credit research on lesser-known, illiquid names that have attractive risk-adjusted returns. So, I still believe there is a lot of opportunity out there in fixed income, but investors need to do more credit work and be savvier than in years past, which is exactly the way it should be.
And aside from investment choices, here is how Minerd views the general implications of record high bond prices in perpetuity:
‘What this Means for the Long Run’
A lot of the policy decisions today will have long run consequences that may not be very palatable. But one of the things I remind people about the long run is what John Maynard Keynes said, “The long run is a misleading guide to current affairs. In the long run we are all dead.”
To give you my view beyond the next three to five years, I would reference back to the story of what the Fed pulled off between 1942 and 1951. When you come to the end of the story in 1951, interest rates rise for 30 years. Today’s economy is not analogous to 1951 – it’s a lot closer to 1941, or perhaps even earlier, like 1935. So, for the next few years I see the inevitability of low interest rates and view the so-called bond bubble as little more than an urban legend. Nonetheless, just as a broken clock is right twice a day, the economy will inevitably reach a point where interest rates will rise. When they do, I believe they will rise for a long, long time. What happens after that? The ultimate end game, I believe will be a paradigm shift for money. But don’t worry, that’s not for a while and it’s also not something new. In fact, the United States has witnessed no fewer than five monetary paradigm shifts in its brief history, which is something I hope to write about in a future commentary.
Full Guggenheim note link.