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 Recession.
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 Broyhill Letter:
Nassim Nicholas 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 Bonds:
- 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 happen.
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 again.
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.
Our interpretation, in laymen’s terms – Buy Bonds!
Disclosure: At the time of publication, the author was long US Government Bonds, although positions may change at any time.