Tuesday, March 22, 2011

Not Yet the End of the Bull Market in Bonds

PIMCO Total Return Eliminates Government Bonds

A couple of weeks ago there was considerable angst in the press over the announcement that the PIMCO Total Return Fund had totally eliminated its exposure to US government bonds during the month of January. Total Return raised its cash position by a corresponding amount.

In an interview on Yahoo Tech Ticker, PIMCO guru Bill Gross advised investors to stay clear of “bonds in dollar denominated terms” and to be “wary of higher interest rates going forward.” Bloomberg reported: "Gross believes that interest rates on U.S. Treasuries are way too low right now and that they will start going up when the Federal Reserve ends the current round of quantitative easing in June."

Should We Be Worried?

Well, if you believe that rates will rise precipitously when QE II ends, I don't blame you for selling bonds and going to cash. You might even believe, as Zero Hedge wrote, that the "cost of capital could go up by at least 150bps while input costs are rising, margins are compressing and liquidity drying up." In that situation, it might even make sense to "get the hell out of Dodge in all asset classes."

But is there reason to be so greatly worried about rising rates, especially at the end of QE II in June? I certainly agree that the US faces persistent, multi-year problems with interest rates and the dollar. However, it isn't exactly clear that we should have a particularly elevated level of worry about the purported forthcoming event "when the Federal Reserve ends the current round of quantitative easing in June," as Gross says we should. There are differing opinions about the market impact that the end of QE II may have, if it does end then, and we might profit by at least listening to some other opinions.

What Happened to Bond Yields the Last Time?

Cullen Roche, the author of the blog Pragmatic Capitalism, looked at Gross's track record and concluded: "I am not sure there is much, if anything, that we can read into this move by Mr. Gross. He has been talking about some form of bear market in bonds for over 10 years now." For example, ten years ago Gross wrote in 2001 "We are at the end of the secular bull market in bonds," which hardly turned out to be the case then.

Roche also pointed out that Federal Reserve history is against Gross's pronouncement that QE II will lead to a rise in bond rates. When QE I ended last year, and the Fed contracted its balance sheet, interest rates did the opposite of what Gross expected, that is, they dropped.

Of course, the Fed's move was advertised in advance, and bond yields did rise during much of the lead-up to the event.  Also, the context is different this time. There is more public awareness now of the risks of a declining dollar, and attention to the growing US government debt has also increased in the past year. Perhaps it is best to admit that argument from a single anecdote is impossible, and not dismiss Gross's worries simply on that basis.

What Else Happened Last Time?

If we want to use historical analogies, the only time that the Fed previously cut back on a program of quantitative easing was last year. Interest rates fell after that cutback, but what else happened? A full examination of the historical record shouldn't be restricted to a single dimension, bond yields, even if that is the issue that Bill Gross focused on.

In John Maldin's latest column, he quoted from a list that was originally published by David Rosenberg. To quote those two, during the period from late April to late August last year, when the Fed contracted its balance sheet by 12 percent, the markets saw asset price changes that included the following:

The S&P 500 sagged from 1,217 to 1,064….

The S&P 600 small caps fell from 394 to 330….

Baa spreads widened +56bps from 237bps to 296bps…

CRB futures dropped from 279 to 267….

Oil went from $84.30 a barrel to $75.20….

The VIX index jumped from 16.6 to 24.5….

The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5….

The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%…

Among commodities, the exception to the overall decline was gold which "acted as a refuge at a time of intensifying economic and financial uncertainty" by rising to $1,235 an ounce from $1,140.

If the end of QE II follows the same pattern as the end of QE I, perhaps there is reason to worry about the short-term impact, because there were price drops across a wide range of asset classes. But the price declines last time did not include the one that Gross identified, namely a drop in bond prices.

The Difficulty of Interpreting History and Statistics

In his Yahoo Tech Ticker interview, Gross said that America's debt level is nearing a breaking point after years of reckless spending, and that we can no longer depend on foreigners for funding. A critical question, of course, is when the breaking point will arrive. Gross cited the work of Ken Rogoff and Carmen Reinhart in This Time Is Different when he said: “When a country reaches a certain debt level, confidence in that country’s ability to repay that debt becomes jeopardized.”

Now, we must be careful here, because timing is everything in investing. Certainly, high national debt levels can be dangerous, but has the US reached a critical level of debt?  Do we expect the US to experience a major bond market dislocation this year, as Gross seems to imply?

The really big problem with Gross's appeal to Rogoff and Reinhart is of course that, when he refers to "a certain debt level," he is referring to average results over a sample of national experiences. Referring a a sample average is misleading. The outstanding aspect of the data used by Rogoff and Reinhart is the variability in the experiences of different nations with respect to the conditions under which they had difficulties paying their debts. There is no way of saying that a nation will default when it reaches a given level of debt, however one defines the debt.

Also, it is myopic to focus attention on only a single variable, the nation's level of debt (presumably as a fraction of gross economic product). Other factors are also critical in determining a nation's ability to pay its debts, including its level of economic activity, prospects for growth, currency convertibility, trade relationships with creditors, and many others. There are good reasons that US creditors are willing to tolerate present debt levels and that the US currently experiences interest rates that are low to moderate in historical terms over the maturity span of the yield curve.

In fact, predicting a nation's ability to repay its debt is not a matter than anyone can achieve with any certainty. Is there risk to the US dollar? You bet. Could the dollar fall more this year? Sure. But will American's ability to repay its debt suddenly end this year? There are risks, but QE II does not seem especially likely to be the trigger for a massive event.

Years, Not Months

Setting a time for a bond blowup is impossible, but the real problem is probably more likely to lie sometime in the next decade, not over the next few months. That is because the big problem is the current high level of US government debt and the likely future growth of that debt, seemingly without limit. Current budgets are heavily in deficit, and entitlement programs —Social Security, Medicare and Medicaid—are set to add ever-increasing burdens that will throw the budget even more into the red. Given the reluctance of politicians to raise taxes to pay for these programs, or to cut entitlements, the national debt seems fixed on a doomsday trajectory that will grow without bound until disaster strikes.

A chart at The Economist is a good place to see the proportion of GDP spent on entitlements and interest, compared with the proportion of GDP that the government is expected to raise in the form of revenues. The data come from the Congressional Budget Office's "alternative fiscal scenario", which is based on today's underlying fiscal policy but also incorporates some widely expected changes, such as an increase in the threshold for the alternative minimum tax rate.  The expansion of entitlements to take up an ever-expanding proportion of the US budget is very striking.

The Economist pointed out that, according to this graph, entitlements and interest will absorb all government spending by 2025. Of course, a crisis will arise well before we reach that point. Not only will there be resistance to letting entitlements crowd other government programs, but the government budget will expand well before that time to comprise an unacceptably large percentage of our GDP. Other economic activity would be crowded out, but markets are certain to react well before that point to demand higher interest rates and pernicious currency exchange rates from the US. As confidence is lost in the US, the point will be reached where the economy falls into depression and the national debt cannot be serviced.

Clearly, the government debt situation poses a very big risk for bonds, interest rates, and the dollar.  In this respect Gross and PIMCO seem perfectly on track in their warnings, although that still leaves the question of timing.

When will the crisis be seen in the markets? Hard to tell, but it seems more likely that the real trouble will be a few years off, say, in the latter half of this decade, rather than at the end of QE II, if it ends this summer. Of course, there are many uncertainties. Determined political action could lead to meaningful cutbacks in government spending, or unexpected economic growth could bring greater tax revenues to the government to reduce annual deficits. Whether a crisis occurs or not, half a decade seems a more plausible period of uncertainty for an American interest rate crisis than does a restricted period like the few months attending the end of QE II, whenever that event actually comes.

Bill Gross's Argument

Gross's stated position on QE II is much more alarmist than the aforementioned historical interpretations would seem to support. He reminded readers in his March letter that the Fed is currently buying about 70 percent of all new US government debt, and he then asked: "Who will buy Treasuries when the Fed doesn't?"

There is no argument with Gross's recognition that "Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets." Without this "handoff and stability" the private sector may indeed be unable to issue debt at the low yields and narrow credit spreads seen in the markets at present.  It is difficult to disagree that this point.

As for the magnitude of the problem that the financial markets might experience if QE ends, we have Gross's estimate" that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%." Of course, in order to be really worried that QE II will end soon, you have to accept Gross's estimate of expected nominal GDP growth. Not everyone would agree that the economic prospect is so rosy.

Perhaps the biggest problem with Gross's alarm is that it posits an event that may not occur. Given the weakness of the economy and the reluctance of Congress engage in fiscal stimulation, it would seem more likely that the Fed will find it necessary to continue a policy of extraordinary monetary easing, rather than discontinue it. Current optimism about the economy seems overdone, and the Fed probably knows that.

There is no denying the existence of near-term risks, but the question is the magnitude of the risk and how it will evolve over time.  Based on this analysis, risks to the dollar and Treasuries should rise as deficit difficulties increase over time.  This isn't exactly the message of Gross's comments, but at least he has stated his arguments publicly, so that we can judge the extent to which we would like to share them.