A scientist renowned for delivering speeches exciting and inspirational had been travelling from city to city with his chauffeur. After the speech was finished and the audience clapped and rose to their feet, the chauffeur spoke with some irritation to the scientist:
“You know, I listen to you give these same speeches, night after night, and you say them exactly word for word! I bet I could deliver your speech at our next venue.”
The scientist, a bit miffed, replied:
“Okay, why don’t we exchange clothes, and I will drive you to the next venue, and you, my chauffeur, can deliver my speech.”
Sure enough, the chauffeur – dressed as the scientist – delivered an extraordinary speech and once again the audience stomped and applauded. However, this time the moderator stood and said, “Wow – amazing speech. But I think we have some time for questions.”
A man in the audience rose and inquired about an esoteric point.
The “chauffeur” stared at the man and said, “Well, that has to be about the stupidest question I have ever been asked. And just to show you how stupid it is, I am going to have my chauffeur – standing in the back over there – answer that for you!”
Hall of Mirrors in Versailles, France. The Opulence of Versailles Did Not Reflect the Underlying “Fundamentals” of France as a Nation
So far, the Fed’s “audience” of investors have clapped and cheered every pronouncement of central bank support for the capital markets.
But, like the man in the audience with the “stupid” question, we have one of our own: how does “forever” suppressing rates incentivize the changes that are needed to realign asset prices with the real world economy? Much has changed: millions work from home, e-commerce has vastly expanded in scope and scale, Starlink is promising connectivity to all, everywhere, and mRNA technology accomplished in 66 days what took polio researchers 20 years. Surely, resource use must adapt and asset prices must eventually reflect those adaptations.
In short, the Fed’s pursuit of favorable outcomes for the investor has enabled dissonances between fundamental reality and capital market prices that you could drive an SUV through, if you could buy one! Consider the mismatch between (conventionally) measured inflation and that of the rock bottom yield of the 10-year Treasury:
CPI YoY vs. U.S. 10-Year Treasury Yield
While negative real yielding Treasuries are not exactly new, we have not seen this degree of negative rates since the 1970s. Perhaps it’s all just a one-time thing, a “transitory” happening. Yet, with fiscal stimulus “all in” even while labor, semiconductor chips, container capacity, etc. remain in short supply, any reasonable observer can at least acknowledge that declaring inflation dead may be premature. And, as the Treasury market serves as the bedrock of valuation for all risk markets, the bet that today’s high asset prices remain supportable rests on the unproven assumption that the Fed can go on repressing Treasury yields without risking an inflation “breakout.”
Low rates and high asset prices have almost banished credit defaults. Witness the almost shockingly low level to which high yield bond defaults have fallen. Indeed, while not shown on this chart, July 2021 saw not even one bond default.
High-Yield Bonds Long-Term Average Default Rate: 3.3%
Well, who could possibly be on the side of more business failure, you say? Yes, but failure “avoided” by artificially propitious financing really means that failure is just “postponed.” The reality of change in the economy at large necessarily means that “churn” (adaptation) should be happening. When conditions change, there are always winners and losers, and indeed, it was the late, great economist Milton Friedman who stated that private enterprise is not a profit system, but rather a profit and loss system. Nothing like a plummeting stock price or upset lenders to focus the mind of a management team! Yet, with the capital market fields flooded with central bank liquidity and fertilized by the greatest Federal borrow and spend program since 1945, the imperative to adapt with the times is attenuated.
Federal Spending As Percent of GDP is at Post-WWII High
Source: The White House, measuringworth.com, TCW
Global Monetary Stimulus Driving Global Equity Prices
In short, the bounty being reaped in the capital markets is the fruit of the financial experiment that is Modern Monetary Theory (MMT). With “organic” income and profits in short supply, public largesse provides what is “needed.” Perhaps this is not exactly news to anyone, but it does highlight what may well be the most critical observation about bond strategy today: the Fed and policy actions generally are “paying” the investor to align portfolio strategy with this temporary if not unstable MMT environment.
For now, it is true that the commitment to MMT is solid enough so as to give the alert investor “free lunch” opportunities. One example of this pertains to “arbitraging” the Fed’s massive QE program targeting Fannie, Freddie, and GNMA mortgage backed securitizations. As it stands today, the Fed is buying nearly $5 Billion worth of these every business day, all in the forward TBA market. The consequence of this has been that the investor has been handed a “gift” in the form of abnormally low implied financing rates in the TBA market, courtesy of a price insensitive Fed that buys ‘em, rain or shine. And, while it is the case that mortgages have generally underperformed in 2021, the benefit from this strategy accrues in the form of a “safe” spread over Treasuries for owning the mortgage exposure plus an additional 50-75 basis points of annual yield that comes from owning the “out month” TBA contracts.
Production Coupon Roll Specialness Represents Annualized Excess Yield Made Possible by Sub-Market TBA Financing Rates
Source: Citi, TCW
Another budding opportunity that may flower from today’s MMT distortions may prove out in the commercial real-estate market. For instance, while some reality in the form of elevated delinquencies has pierced through the retail and hotel segments (though perhaps not yet enough!), we find it striking that office delinquencies have barely budged from their pre-pandemic levels. Can office valuations and the cash flows associated with office leases fully ride the change wrought by the “work from home” tide? Surely, office CRE cash flows must adjust as must CRE valuations.
Retail and Hotel CRE Delinquencies
Source: Bank of America, Intex, TCW (based on CMBS conduit data)
Source: Bank of America, Intex, TCW (based on CMBS conduit data)
During these pandemic years, the Fed has “tendered payment” to those who have aligned their strategies with that of the central bank. All well and good, where a free lunch is on offer, take it! That said, investment success is not just about “today,” but rather predicated on an awareness that the investor’s zeitgeist can – and will – change. When it does, no warnings are issued. So preparing for this ultimate redirection using a value framework must be adhered to.
Experimentation is occurring at a breakneck pace. The blasé assumption that the Fed knows where we are heading and that policy will never be successfully challenged by that “man” in the audience is wishful thinking. One of the powerful lessons of financial history is that fundamental realities have a way of upending the best and brightest policy-makers. Whether that future break comes in the form of higher real rates, higher default rates, or both, strategies that prospered with Fed policy will find themselves left out in the cold. No time like the present to prepare, and remain adaptable.