Saturday, October 23, 2010

Bond Risks and Opportunities

"This was a great nation until the robo-signers came."

Following a run-up in response to prospects for further Fed asset purchases, the bond market has turned more cautious. Perhaps this caution is in response to prospects of an intensified round of currency devaluations, with its implications for domestic inflation, or maybe the advance was just getting ahead of itself. Let's look at what people are saying about bonds.

Portfolios Shift Out of Short Term Treasuries

On October 8 PIMCO's Bill Gross gave in interview on Bloomberg television, in which he described how the advance in parts of the Treasury curve had caused him to adjust his portfolios. I watched part of the interview of Bloomberg Surveillance, where Gross said the yields of 2-, 3-, and 4-year Treasuries are getting so low that alternatives are now preferable in terms of taking on a little more duration or credit risk in return for more yield. In fact, he found no advantage for 2-4 year Treasuries over the money market. Instead, traders are moving out to the "belly" of the curve, and Gross said they should buy 5-, 6-, or 7-year maturities if they buy Treasuries.

"Look, Timmie, Someone Spent a Dollar!"

This move seems consistent with the prevailing pubic view that the Fed has gone as far as is practical in lowering yields in the shortest maturities, and that we can expect to see the Fed gradually walk its way out the yield curve, lowering rates in longer and longer maturities until the curve is flat.

Seeing the End of the Bond Rally

Then on October 14 Bloomberg summarized an interview with Douglas Hodge, the COO of PIMCO, about recent changes in their portfolios. The basic message was a little stronger than Gross's earlier statements, and Hodge warned that the strong bond gains of recent months are unlikely to continue:

“From where we sit, it’s very hard to suggest there’s going to be that kind of price appreciation that we’ve seen in bonds over the last 12 to 24 months.”

“Even if the QE process is large and rates decline further, in our view we’re approaching the end of the bond market rally.”
Hodge reinforced Gross's earlier message about the portfolio implications, saying that “We have reduced our Treasury holdings, the lowest yielding instruments.” Hodge mentioned that increased positions included emerging markets, such as India, China, and Brazil, with infrastructure debt looking particularly attractive. They are buying high-quality corporate bonds in India and are making investments in China via the non-deliverable forward market.

"This meeting of the Federal Open Market Committee will come to order!"

Seeing Increasing Credit Risks

In an email to Bloomberg, Bill Gross described the strategy underlying these portfolio changes, which involves much more than simply moving out the Treasury yield curve:

“Pimco Total Return currently is employing what we call a ‘safe spread’ strategy, which seeks to identify sovereign countries best able to handle a new normal global economy that envisions slower growth and therefore increasing credit risks in fixed-income markets.”

Perhaps PIMCO is expecting the Fed to keep the world's financial bubble primed through eternal quantitative easing.  As ridiculous as that sounds, maybe we should consider the possibility that the Fed is not going to let the US slip back into recession, no matter the inflationary consequences.

He also remarked that this has definite implications for portfolio allocation:  It looks like they are moving gradually away from the US to where the growth and improving creditworthiness may lie. This would be a good strategy if the emerging markets are not hurt when the economy of the developed world again takes a dive, which seems likely at some time in the next few months or years. Unfortunately, emerging economies like China are still extremely dependent on their more developed customers.

"The printing press is out of control!"
The worrying part of these pronouncements is that Gross's email emphasized the "increasing credit risks in fixed income markets" in a world of low growth. They still have a lot of their portfolio in the low growth US, but the percentage of the money there has been gradually reduced in recent months, particularly in the Treasury component. Many people are worried that high government debt problems will eventually catch up with the US and other advanced economies, and it would appear that PIMCO is starting to adjust its portfolios incrementally in that direction.

Buying Mortgage Backed Securities

If you look at PIMCO's most recent portfolio statistics, the message is a little different from that given by Hodge. Bloomberg published an article an article about this just the past week. You see that they still have large amounts of Treasuries, but the relative mix has been shifting in the past few months in favor mainly of mortgage-backed securities, which are the largest category in their funds (and which Hodge did not mention). Increases in emerging markets were much smaller.  This move is quite consistent with Bill Gross's statement that Treasury yields are so low as to be unrewarding in some parts of the curve, and that it is necessary to look elsewhere.  Apparently their thinking is that, with the US government backing them, agency-issued MBS offer more yield reward with only little more risk than Treasuries.

"These oddballs are ruining the neighborhood."

There is another, more speculative issue with MBS.  The general press is that QE II will focus on purchasing Treasuries somewhere out the curve, extending the flattening of yields that has already occurred at the short duration end. However, the Fed may have reasons for including considerable amounts (a billion or so) of MBS in QE II, especially now that there is a crisis brewing with rotten MBS that the big banks sold to investors at the height of the mortgage boom. With so many investors pressing the banks to make good on their agreements to buy back such rotten MBS, there is some increased level of risk to the survival of some of the big banks, and the profitability of others. The Fed may want to help the banks get rotten stuff off their balance sheets sooner rather than later, so as to avoid another possible financial crisis. Just maybe we might see some mortgage backed securities included in the Fed's asset purchases during QE II.

Timing the End of the Bond Bull

Bloomberg published a worrying article on October 21. It reported that Mark Kiesel, global head of corporate bond portfolios at PIMCO, said in a CNBC television interview that he sees interest rates going higher. He also said that PIMCO is increasing its stakes in investment grade companies. There was no word about whether this was a cyclical or secular rise.

"Is this the food stamp line?"

Other PIMCO pronouncements convey a different slant and suggest that the bond bull still has some chances of continuing in their opinion. Just prior to Kiesel's comments, a senior VP of PIMCO, Tony Crescenzi, said on Bloomberg television that bonds will suffer only when bankers start to lend money and when businesses and individuals ask for loans. Further, a "Keynesian endpoint" will really come only when all major economies "max out" their balance sheets. Given the likelihood that this event is some years in the future (albeit highly uncertain), the time for bond suffering is evidently not just around the corner.

The Risk of a Liquidity Trap

Perhaps a more serious threat to bonds is the threat posed by the Fed itself. Or, more properly, the threat is that the financial crisis has only been patched over, and could arise again to drag the economy and the financial system down in a deflationary liquidity trap.

This past weekend's New York Times carried an article on the dangers that the Fed sees with deflation, which the article referred to euphemistically as "persistently low inflation."  It is widely expected that the Fed will respond to this risk by attempting to lower long term interest rates. It is also expected that the Fed will do this by announcing of another asset purchase program -- QE II -- at its meeting in November.

The problem may be worse than generally appreciated until recently. Charles L. Evans, president of the Chicago Fed, said plainly at a recent conference that the economy is in a "liquidity trap." He announced his support for a strategy known as “price-level targeting,” in which the Fed would permit inflation to run at higher-than-normal rates in the future to make up for inflation being lower than desired today. In other words, Evans was proposing inflation targeting.

"Don't pull on your leash, Timmie."

Evans did not say how the Fed would accomplish this at a time when no one wants to spend money, and it seems unlikely that ordinary monetary policy (or asset purchases) could do this. However, even an official Fed statement saying that it is targeting higher inflation rates would raise considerable fears in the bond market that the Fed might embark on reckless actions.  Unfortunately, such actions would be self-defeating to the Fed's goals of keeping credit easy and cheap.

The Risk of Repressive Monetary Policy

Many commentators have commentated on the likely fruitlessness of further quantitative easing, which raises the question of what happens next. Maybe it is just idle speculation, but some of these commentators raised the possibility that the Fed will eventually be forced to turn to more repressive measures to force people to spend their money. By "repressive" they mean such things as motivating banks to charge their depositors for holding funds at the bank, rather than giving them interest on deposits. (Perhaps the Fed would charge a fee for holding banks' required reserves.) This means that the Fed would force negative short-term interest rates on the public and business.

There's nothing like seeing your money disappear before your eyes to motivate people to convert their money into real things, like cars, houses, or gold bullion. Would this restart the economy? It seems doubtful. But it would get money moving.  Money would flee the country and go to places that have saner central banks.

"We'll get those lazy bums off Social Security and Medicaid!"

Repressive monetary policy seems unlikely from today's perspective. The majority of observers seem to think that the Fed will simply continue with QE until it debases the dollar, and the recent drop in the dollar seemed to be tied to that worry. That would be another way of targeting inflation, which gets us back to the stopping problem of when to sell bonds and dollars ... and presumably buy gold and wheat.

Betting on the Inevitable

Not everyone is convinced that the Treasury bull is over. Gary Shilling, for example, still expects years of a deflationary environment and a continuing Treasury rally at the long end of the curve. David Rosenberg of Gluskin-Sheff has a similar view. Rosenberg believes in deflation, and he remarked in a recent newsletter that, despite all of the Fed's intervention, consumer prices have continued to fall, and core inflation is at four-decade lows. His reasoned:

"Therefore, it would make sense to assume that once we get pass this bump in the form of a weaker U.S. dollar and surging commodity prices, the risks of deflation will intensify again."
"Right now, the long bond yield provides a 150 basis point premium over 10-year Treasury notes at the price of taking on nearly nine extra years of modified duration. Sounds like a handsome trade-off ... a 3% real yield still looks fairly attractive from our lens."

"This wll give us exactly 3% inflation."

The Prospect of Fiscal Prudence Next Year

A problem with the deflationary argument is that many forces point to a different environment next year: That's when questions of fiscal austerity will start to come to the fore, and when we can expect real discussion of how to cut back on the US fiscal deficit. If this results in fiscal prudence, we can look forward to a slowing economy but perhaps also to a relaxing of worries about government debt, which could be good for the dollar and the long bond. On the other hand, if a Republican win in the elections should produce a political stalemate, there arises the prospect of a Congress unable to do much to reduce the fiscal deficit. A continuation of the present trajectory of budget deficits would heighten worries about the US, weaken the dollar and the bond, and raise again the specter of increasing inflation.

What to make of this dichotomy?  One point of view is to go with the inevitable. What is the most inevitable, unstoppable force affecting our society today? Why, it's the faltering economy. And what is ailing the economy? Why, it's debt, of course. It is hard to argue with trillions of dollars in debt (manifested in foreclosures, unemployment, and budget cutbacks) as an inevitable force.  Particularly when the deleveraging of the consumer sector has hardly begun, and when banks are still constrained by bad debts.  Driven by the weight of all this debt on our collective backs (and by its political masters), what else can the Fed do than feed the asset bubble until it bursts ... again?

"They bought it.  Only billionaires can vote, now."