It is important to note that in the near term,
the contraction in private sector credit combined with the threat of
fresh credit concerns ahead, will likely keep a lid on inflation
pressures. This view is perhaps where we differ most from today’s
consensus thinking, where many expect an immediate and permanent
increase in inflation levels. We aim to capitalize on this departure
from consensus later in the year, but importantly, the difference is
simply one of timing.
The excerpt above
is from our year-end letter to investors. Importantly, “later in the
year” is now!
Sparked by a growing recognition of sovereign
risk originating from the Eurozone, investors flocked to the relative
safety of US Treasuries last week, driving yields on the 30 Year Bond
to 4.28% and the 10 Year Treasury to 3.43% at Friday’s close. We
expect this move out of risk assets and into government bonds to
accelerate in the period ahead. As we explained in our Fourth Quarter
Investor Call, a multi-decade decline in interest rates has led to a
massive bubble in debt at home and abroad. But contrary to popular
belief, we cannot borrow our way to wealth and prosperity. At some
point, borrowers must pay the piper and the zero hour appears to be fast
approaching. According to research by Ned Davis, in the current
decade, $1 of debt has only produced $0.17 of GDP growth (versus $0.59
to $0.73 in the fifties through the seventies), suggesting a severe
strain on our nation’s balance sheet.
Given our massive debt
bubble, even minor rises in interest rates create enormous difficulties
in debt service. This is illustrated in the chart below taken from
our Fourth Quarter Investor Call slides. The “choking point” of rising
rates on the economy has become lower and lower over time. In other
words, greater and greater levels of debt act as larger and larger
speed bumps for economic growth. Put simply, with an ever increasing
weight of debt on our shoulders it takes successively smaller hiccups
in yields, to break the economy’s back. In 1989, when rates rose to
9.5%, they popped the commercial real estate bubble and caused the
S&L crisis. In 1999, the tech bubble busted as rates approached
6.5%. And in June of 2006, interest rates at 5.25% triggered a
collapse of the residential property market and brought about the Great
We believe the next “choking
point” for the economy is likely to be significantly lower than the
previous ones, given the massive surge in public and private sector
debt loads and the looming threat of debt deflation. This is
particularly worrisome given the mortgage reset schedule that has just
begun, unwinding fiscal stimulus, and the deflationary spiral just
kicking off in the Eurozone. We had initially suggested that 10 Year
Treasury Bonds yielding 4% – 4.5% would offer investors an attractive
hedge against deflation (particularly when held as a barbell with
gold). But given the growing macro risks on the horizon and the
shortening fuse on those risks, we are comfortable buying here and hope
to continue buying on any weakness. We covered our Treasury shorts as
yields spiked in late March and became buyers shortly thereafter as our
conviction increased that both leading indicators and CPI are set to
peak in the immediate term, potentially cutting short the tactical
back-up in yields we envisioned.
This has been by far our most
out-of-consensus call for 2010. We measure this analytically by how
many times we are laughed at, yelled at, or called idiots by our friends
and family. Believe us, we understand the long term risks in
government debt, as we described in detail in the Fourth Quarter
Taleb, author of “The Black Swan,” said “every single human being”
should bet U.S. Treasury bonds will decline, citing the policies of
Federal Reserve Chairman Ben S. Bernanke and the Obama administration. Aside
from the occasional flight-to-safety rallies driven by periodic credit
fears in the near term, we concur. Like Treasuries, the
dollar should benefit from the same intermittent credit pressures
related to ongoing deleveraging, but the long term trend remains
lower for the tallest midget in the room.
Emphatically, this is one of those “occasional flight to safety
rallies.” It is likely to be a doozy!! Here are Ten Reasons to Buy
- Core inflation historically falls after the end
of a recession. In the 11 recessions from 1950 through July 2009, the
end of recession was followed by declining inflation, with CPI
bottoming on average, about 29 months after the recession ended.
Longer term inflation concerns are warranted, but there are more
immediate threats in front of us.
- With core inflation
declining and nominal economic growth rates weak in the aftermath of
financial crisis, bond yields should trend lower in coming quarters.
Investors looking to purchase long-term inflation hedges, should see
more attractive entry points in the period ahead. Be patient.
- The average long term Treasury rate since 1870 is 4.3% and the
average annual CPI is 2.1%. If inflation trends toward zero (before
moving much higher later in the decade), then long term bond yields
could naturally fall toward 2%.
- A near term deflationary
environment bodes very well for long term bonds. Long term Treasury
rates dropped from 3.6% in 1929 to 1.9% in 1941. Interest rates in
Japan fell from 5.7% in 1989 to 1.1% in 2008 while the Nikkei dropped
77.2% over the entire period.
- The most common argument from
Bond Bears is higher levels of debt must lead to higher yields. The
reality is that the economic cycle still dominates intermediate swings
in bond prices – a growing list of leading indicators are pointing to
slowing economic growth ahead.
6. The velocity of money is
falling at the same time money growth has come to an abrupt stop.
Monetary policy is effectively pushing on a string.
7. Nearly 80% of money managers in
Barron’s Big Money Poll say they are bearish on Treasuries. When
everyone agrees that rates are headed higher, something else is bound to
8. Similarly, retail investors
are once again, near their highest allocation to equities at the
market’s highs. I believe some call this Predictably Irrational. The
last time bullish sentiment was this high was back in December 2007
when the S&P 500 was trading at 1500!
9. Greek default and contagion risks
across the Eurozone periphery. Cascading disruptions throughout the
European banking system. This risk will not go away anytime soon.
News will get worse before it gets better. Think back to how subprime
was “contained” or how the Bear Stearns rescue marked the “panic lows”
for the markets. Greece is a pebble in the Euro Pond. The ripples it
causes will ultimately be very messy.
10. Read number nine
Admittedly, we are not fixed income experts, so we always
find it helpful to defer to those that are. The good folks at PIMCO,
the world’s largest bond shop, had this to say in a recent article
titled, Understanding the Greek aftershocks:
Several countries, led by the US, stand to
benefit from a reallocation of capital away from the eurozone as
investors react to both the deterioration in sovereign risk and the
surge in volatility. These flows are already happening. They will
become even more pronounced in the weeks and months ahead as
institutional investors revise their investment guidelines to exclude
highly volatile government exposures from their “interest rate” bucket.
But there is an important qualifier here. Since Greece is part of a
general phenomenon of bloated public finance and higher systemic risk,
we should also expect a generalised and volatile step-increase in risk
premia around the world. Capital will thus be more selective in terms of
destination, as it opts for liquidity over returns and for safe
government bonds over equities.
interpretation, in laymen’s terms – Buy Bonds!
At the time of publication, the author was long US Government Bonds,
although positions may change at any time.