“Listen to what the market is saying about others, not what others are saying about the market.”- Richard Wyckoff
I must admit to being less than bullish these past few years, and feel fortunate to have missed the bulk of pain that Mr. Market has inflicted on many others. Recently, I wrote a piece that compared today’s economic landscape to that of a hurricane that I thought would soon make landfall.
And while I think the body of the hurricane is here (as discussed in my piece a few weeks ago in Credit Hurricane To Make Landfall
), I now worry about the severity of the storm and if I am, indeed, positioned cautiously enough as it relates to the maturity and duration of my fixed income holdings. You must be positioned for something that hasn’t been seen before on our shores. Hurricanes are reasonably commonplace events in the U.S., particularly in the Southeast part of the country.
But what do we not
have very often in the U.S., something of an ‘outlier event’, or what many in this industry would define as a very low probability event (‘tail risk’)?
A tsunami, defined by American Heritage Dictionary as: "A very large ocean wave caused by an underwater earthquake or volcanic eruption." It's one huge problem that leads directly into another.
I have often, in private, compared the financial mess hitting the U.S. to a rare tsunami hitting a lonely shore where someone is standing, armed only with a small bucket to try to stop it.
In the case of financials, the initial problem or underwater earthquake could be the undermining of a multi-decade credit build-up across most of the U.S. economy and the esoteric instruments that go along with the debt.
While some may find it a strange analogy, it is how I feel about our markets, the tools being utilized by the Federal Reserve, the ECB and other regulatory bodies. They are overmatched for what they are facing and, worse yet, they helped create the mess in the first place by being far too easy with money and debt creation.
As I speak with businesspeople around the country, from small business owners to those in "big business," I come across a very common refrain, one that has changed my view from possible hurricane to that of a possible tsunami. The common thread that I come across is that of prices, otherwise known as inflation. As a businessman, once your inputs, particularly oil, gas, and food (those pesky items that the U.S. government doesn’t include in its inflation reports as they are too volatile), increase you have two choices.
First, you can choose to pass along your costs, which shrink your profit margins and make you earn less money, which could result in laying off employees to shrink costs.
Second, you can pass along your costs to the consumer, who then has a couple of choices of their own, namely to pay a higher price or, more likely, buy less of your product. Whether it is anecdotal or statistical evidence, I see inflation everywhere, and this is where the financial tsunami comes in.
A battered, over-indebted consumer, if forced to retrench, could create even more problems for the banking system as loan delinquencies would begin to rise even further. As seen on the chart below, all sorts of delinquencies are rising, not just sub-prime. This is now a systemic issue.
Click to enlargeThe Interest Rate Problem
There are many parts of the interest rate spectrum, even the most vanilla parts of the spectrum, forgetting for a moment the esoteric garbage cooked up by Wall Street alchemists in recent years. Consider this for a moment. When Bear Stearns
nearly collapsed in March, 2 year Treasury notes spiked down as low as 1.40%, but note that with the financial system as fragile as ever, 2 year yields are now at 2.93%.
What on Earth is going on? Shouldn’t short-term Treasuries yield less than they did at the nadir of the Bear Stearns debacle? Conventional thinking would say "yes," but this market and financial system are far from conventional. In fact, the world we live in is so unprecedented that perhaps we must now think in a new way, in a world where there is a razor's edge between inflation and deflation.
The deflationary crowd would like you to believe that short term rates and long term rates should be uniformly low (a flat yield curve at 1% a la Japan) and the inflationary crowd would like you to believe that all rates should be high.
But what if we experienced a financial tsunami, where we get the worst of both worlds? In other words, where deflationary fears and credit market troubles are expressed in the very front end of the yield curve (Federal Funds and Treasury Bill rates) remain very low as they are the main most influential tool in the Fed’s Toolbox, but the longer end of the Treasury curve reflects the inflationary concerns that are at the least, mispriced relative to actual inflation?
Could the Fed have painted itself in a corner, a corner where it can't raise rates as ‘option-ARM’s’ are about to begin to reset and would crush those borrowers, leading to even more delinquencies? But if it lowers rates, this could harm the dollar further, stoking even higher commodity prices and more inflation fears?
This is the double-edged sword that no one wants, present company included. The last thing that we need now is a sickeningly steep yield curve, but that is exactly what the market seems to be signaling to us.
I keep thinking that short term yields "should" be lower, as if the market actually cares what I think is right. What strikes me is that Treasury yields, while lower than historical standards are still higher than we have come to expect of late. Just for fun, let’s take a look at where year 2 and 10 Treasury yields have been over past decades. For old-timers like me, yields are low or high, depending on one’s perspective, but my sense is that yields, in the back-end of the curve, want to move higher, perhaps significantly so. What might be the reason?
Perhaps foreign investors see the U.S. as a weakening powerhouse and demand higher yields for holding our paper, much like a corporate bond investor demands higher yields for lower rated credits. The implications of a significant "bear steepening" trade are very negative for the economy.
Suffice to say, however, that, we must always plan for the worst and hope for the best.
When we compare 10 year Treasuries to year-over-year PPI and CPI, we see that yields are somewhere between 235 basis points too low in the case of CPI to 330 basis points to low in the case of PPI. The thought of a 7 handle 10 year note gives me the shivers. Year-Over-Year PPI minus 10 Year Treasury Yields
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So what could cause a change in attitude in Treasury yields? Simply put, I do not own any 10 Year Treasury Notes because I do not feel that I am properly compensated for taking the risk of inflation that I know exists. The real issue is that foreign investors own the U.S. Period. They now own 56% of all of the U.S.' marketable Treasuries. What if they decided to say, "Sell, Mortimer, sell"?
Who would buy them? Given current inflation rates, certainly not I. Would you? I can't answer that question, but I can guess that 4.12% for the next ten years with 7.2% year-over-year producer prices and 4.2% for year-over-year consumer prices are far from awe-inspiring. 10 year Treasury note Yield less Year-over-Year CPI
Click to enlargeForeign Ownership of U.S. Treasuries
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Let’s take a deeper look into who owns the U.S.' debt by country. If any one of them "pulled the trigger" and sold, we would surely be facing higher rates. And the last thing an over-indebted country, chock full of over-indebted populace, needs is higher rates. Even if foreign investors simply stopped buying Treasuries as American deficits continue unabated, yields would go higher on their own.
Worse yet, what if a political problem starts with China, or if China’s economy slows dramatically, as I expect, and China decides to jettison its half trillion dollars of Treasuries? Ouch
Here's a look at major foreign holders of U.S. Treasury securities
.Summation: Are Rates High or Low?
Again, it depends on one’s perspective. Having lived through rates from 17% to 1.7%, to me, I suppose, I could make a case for either: That is, rates are high or rates are low. Sadly, I am leaning towards longer term rates having much more upside than downside and we must position ourselves accordingly. As usual, if I'm wrong, I'll have lost opportunity, not capital. Long Term Chart of 10 Year Treasury Yields
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Finally, here is a graph of 10 year minus 2 year yield curves going back some 30 years. If markets operated in a vacuum, and there were rules that were upheld, we could dependably feel content that the same results would hold true in this environment.
The problem, in my view, is that the tsunami is quickly approaching and we must think "outside the box." Consider how difficult it would be for the housing market to get off the mat if Treasury rates and mortgage rates were to rise. Delinquencies would rise even further, causing pain for those that hold CDO’s that are a derivative of the mortgages themselves.
The CDO’s are held by banks, investment banks, municipalities, money managers, mutual funds and hedge funds. This leads to more capital raising, more dilution and so on and so on. Below I show a very simple CDO structure. The key takeaway should be that the "Assets" are nothing more than a bunch of loans. If the loans do not perform, the "Liabilities" do not perform. Rising rates leads to more delinquencies which leads to worse performance and mark-downs/write-offs for those that own them. Basic CDO (Collateralized Debt Obligation) Structure 2 Year-10 Year Spread
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Is there another Bear Stearns out there?
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