Weekly Recap & Outlook – 06.07.13

Tower Private Advisors

Below

  • Capital markets recap
  • Why interest rates are NOT going up any big way any time soon

Capital Markets Recap

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Interest Rates (remember those?)

If you don’t want to read the rest of this, here’s the gist of it:

Interest rates aren’t going up because:

  1. There is virtually no inflation
  2. We can’t afford higher rates; too much goes badly if rates rise. Housing ceases its rebound. The US’s debt service will consume an ever larger part of GDP
  3. The Fed said (it’s going to keep rates low; see #2, above). Take it at its word.
  4. Too many people expect rates to go higher.

Interest rates are not going up anytime soon. There, I said it. Don’t take that as investment advice. Don’t go telling someone what Tower Bank or Tower Trust Co. said about interest rates–especially if they do go up–it’s just my opinion, and this is just a blog.

Our clients are becoming increasingly skittish about the prospect for rising interest rates–and over some time horizon they and you probably should be scared. Many seem to think, though, that the big increase in interest rates is lurking just around the corner. I’m here to tell you that it’s not.

My “analysis” that follows will look at the 10-year Treasury note and 30-year U.S. Treasury bond as a proxy(ies) for interest rates. Treasury securities are typically the basis for, if not the sole representation of, the risk-free rate of return. Naturally, there is at least one risk with Treasuries, and it’s interest rate risk, so over and above interest rate risk, Treasuries are considered risk free. For Glenn Beck and others who advise one to buy food insurance programs, however, there are default risks with government bonds, but to normal people it’s assumed that the government will always pay its debt, as it has a machine called a printing press. There are other risks embedded in non-Treasury securities, risks such as political risks (e.g. will the tax exemption on municipal bond interest continue), event risk (e.g. an unexpected merger), etc. Also, in investment parlance, the 30-year Treasury is the bond; i.e. when some speaks of “the bond,” it’s the 30-year. Ten-year Treasuries are referred to as 10s.  

Here’s some context for the discussion that follows, a history of the rates. In each, I’ve indicated the high, low, and current yields, as well as the length, in quarters, of the current secular bull market in bonds (technically speaking, yields have been in a bear market, as they’ve fallen.) I’ve included the maximum history that Bloomberg shows, and I do not know why the 30-year history only goes back to 1980. It’s possible that’s when the current version of the bond was issued; in the ’70s, for example, the bond was callable, meaning it could be redeemed prior to maturity.

Here’s the 10-year

10

And here’s the bond…

30

The decline in interest rates, or the bull market in bonds, has persisted for 31 years and nine months by the reckoning of these charts (I had to switch to quarterly readings to get this amount of history.) That’s a long time for a trend to be in place; trends end; and this is one of the reasons that make folks think that rates are going to go back up. Fair enough, “you can’t keep a good man down,” and all that.

But just because “they can’t stay low forever” doesn’t mean they will be going up any time soon. So, one can’t predict a rise–certainly of the imminent type–with this argument or statement of fact.

The next argument trotted out in support of the idea that rates are headed up is inflation, which is followed or preceded by the mention of “the government’s printing all of this money.” We’ll get to the second one in due time. For now, let’s concern ourselves with just the inflation angle. There are several ways we can look at inflation. First, if we look at the prices of the most-commonly purchased goods in isolation–which is to say, gasoline and food–one might argue that there is inflation, but we need to be concerned with more than just food and gasoline prices. The most pernicious kind of inflation comes in the form of wage inflation; that’s what really gets a Federal Reserve Bank President’s blood pressure up. I haven’t experienced wage inflation. If I had, I’d probably have a pretty good chance of popping a squat in the boss’s office and telling him I need more pay. ‘Do that now, and I’d better have a box ready to pack up my stuff. ‘Bought a house lately? Experienced house inflation? Didn’t think so. Anecdotally, when we think about a broad range of goods and services, inflation really isn’t a factor.

Second, let’s look at the official government statistics on inflation. Here is the Consumer Price Index, seasonally adjusted, for all items–none of that conspiratorial excluding-food-and-energy stuff.

cpi

This chart looks at the 12-month change in prices for a basket of goods and services. A year ago, it read 2.3%; last month it read 1.1%. The Federal Reserve prefers the PCE Deflator, which comes as part of each Gross Domestic Product. It’s preferred because, among other things, it allows for goods substitution (e.g. steak is expensive; I’ll buy chicken instead.) Exact same result…last month it was 1.1%. So the government statistics show little inflation.

Third, the government is deceitful and can’t be trusted. For an unjaundiced view of inflation we can turn to the public markets. The government issues both nominal bonds (what you see is what you get) and inflation-compensating versions of the same things (i.e. they’re adjusted for inflation.) The latter are called TIPS, Treasury Inflation Protected Securities. Since both bonds are risk free and of the same maturity, the difference between the yields is the inflation compensation investors expect and require. We call these breakeven rates; i.e. if you buy the inflation protected bonds and inflation equals the inflation that’s priced in, one breaks even and should be indifferent between which bond he or she bought. The chart below shows the breakeven inflation rates for the 10s and the bond.

BE

Neither 10-year or 30-year inflation compensation seems very high at 2.14% and 2.2%, respectively. Until we start seeing higher inflation in the form of Consumer Price Index or breakeven inflation rates in TIPS, I don’ t think we need to worry much about inflation pushing interest rates higher.

Before we get to the technical stuff, here’s what I think is one of the most compelling arguments against higher interest rates, YOU. How did you get so smart?, is what my five-year old son asked me recently I think there is a near-universal consensus that interest rates are heading higher (see item four in the last enumerated list, below); we’ll call that the consensus: rates are heading higher. This is when I trot out the quotes from famous people about consensus. These are all paraphrases because I’m running out of time on this Friday afternoon.

  • Warren Buffett: one pays a high price for a [rosy] consensus
  • Charles Mackay: people come to their senses one by one, but go mad as a crowd
  • Ned Davis: markets inflict the maximum pain on the largest group of investors
  • Bob Farrell: When all the experts and forecasts agree – something else is going to happen, and the public buys the most at the top and the least at the bottom

And now is when I climb on the shoulders of others and hope they aren’t guarding copyrights too zealously.

Here is a list of items cited by fixed-income investments shop Loomis Sayles in its recent piece, “economic climate change & and the long-term view on yields.” Some of these items are interwoven with some observations above, but all support yields that are not headed up. I have also included its list of things that could push yields higher, in the interest of playing fair.

  1. Deficient demand – too much slack in economies to push up inflation. This is the same reason I can’t go into Gary Shearer’s office and demand a raise. There are innumberable qualified folks ready to do my job, and probably do it better. 1 of 10 persons is unemployed. That’s slack.
  2. Deleveraging – debt levels are still too high; “in the US, total public and private debt as a share of GDP has risen from 150% in 1980 to more than 350% today.”
  3. Demographics – advanced economies are aging and working less. Think Japan.
  4. Savings – we can’t continue with the entitlement nonsense. Something has to give–or take. We’re going to need to save more, and those savings will ultimately make their way into bond markets, supporting high prices and lower yields.
  5. Shortage of high-quality assets – savers and banks are increasing their capital, and they’re not doing it by buying junk bonds. They need safety, and the shortage of high-quality bonds is going to keep a strong bid under existing Treasuries.
  6. Globalization & technology – these forces of productivity will push the prices of manufactured goods lower.
  7. The Fed is on hold and won’t be raising rates – Loomis Sayles thinks through 2016.

On this last point, the Federal Reserve says it won’t tighten before unemployment goes bel0w 6.5%–and they mean for it go below 6.5% on a sustainable basis. While the unemployment rate has gone down, it’s largely been a result of a smaller workforce. If we had the same workforce as we did pre-crisis, the unemployment rate would be 10%! ‘Think the Fed doesn’t know that?

On the other side of Loomis Sayles’ ledger:

  1. Housing rebound
  2. Household net worth has been restored – households could begin to feel comfortable borrowing again
  3. Pent-up demand may drive investment – “fixed investment as a share of GDP has fallen 25% since the crisis and is now lower than at any time in the last 60 years.”
  4. These forces may push unemployment lower
  5. With a reduced labor force–Social Security disability rolls are quite high; ‘think those people are chomping at the bit to go back to work?–we may be closer to full employment than we think. Yeah, the Federal Reserve has probably thought of that.

Here are some others that argue for continued low rates. The data is out there to support these. It’s sort of like having to provide a citation after saying a tiger has stripes. These things are widely accepted, if their implications are not.

  1. All of the money printed is sitting on deposit the Federal Reserve. It won’t cause inflation until it starts getting loaned up.
  2. The supply of money (M2) has increased, but that’s only to counter the falling velocity of money. It’s the Quantity of Theory of Money. The money supply multipied by the number of times the supply gets turned over equals GDP (MV = PQ). With the V (velocity/turnover) down, the government has had to increase the supply of money just to keep the economy propped up.
  3. The Federal Reserve is purchasing $85 billion per month of government securities. Link that with the first item #5 from Loomis Sayles, and one can see the pressure on available high-quality assets. BTW, 12 x $85 billion is one of those figures one can hardly fathom. If you stack $1,000 bills until you get to $1 trillion, the stack would be 67.9 miles high, etc.
  4. Bloomberg regularly surveys economists as to their views about everything. A recent one about interest rates by year end showed unanimous–not near-unanimous…unanimous–agreement that rates will be higher. That’s not only consensus, but it’s consensus amongst economists
  5. Too much is riding on low interest rates. Put differently, too much goes badly with higher rates. The consequence is that the government can’t afford to have rates go higher.

I welcome your feedback.

Graig P. Stettner, CFA, CMT
Chief Investment Officer
Tower Private Advisors

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5 Responses to “Weekly Recap & Outlook – 06.07.13”

  1. Kevin Noll says:

    Nice job taking a hard stance.

  2. Jason F. says:

    Brilliant as usual, Greg.

    Another quote along those lines–”Whenever you find yourself on the side of the majority, it is time to pause and reflect.” Mark Twain

  3. Jason F. says:

    Graig…sorry.

  4. No problem. Thanks for the Twain quote. Gonna add it to my repertwah.

  5. Pat M. says:

    Graig,
    Well thought out, researched, and presented. Thank you.

    I am however having difficulty grasping the visual of “popping a squat in the boss’s office”.

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