In the world of finance, few things matter more than the narrative. Stories frame why investors are buying or selling a particular security. Stories drive price and the perceptions of value. In real time, stories justify
Until quantitative easing, the story in the US Treasury market was that inflation expectations drove US Treasury yields. Moreover, bonds were cheap or expensive when expectations and prices diverged too much.
Over the past three years, the story for Treasury yields has shifted from inflation expectations to the expectations of the Federal Reserve. First, the story was how many Treasury bonds the Fed would buy. Then the story was whether the Fed would buy or not buy additional securities. Over the past year, though, even that story has changed as the expectations of the Federal Reserve have shifted from “if” to “when” the purchases will end. The Treasury story today might best be called “The Taper Caper” -- a guessing game of end dates.
But I’d offer that even the "taper" story today is not fully embraced by all Treasury bond buyers. Some financial pundits are now suggesting that while the end of QE is contributing to the rise in rates, what is really pushing bond prices lower is economic expansion and the inevitable rise in inflation.
Stories drive price.
While the justifications described above are interesting to me, I am afraid that not only do they reflect misguided perceptions of cause and effect, but they are also completely missing the most obvious and profound story for Treasuries today: Demand has peaked. And at the risk of over-extrapolation, let me be even more encompassing: Demand for fixed income overall has peaked.
As I have offered before
, in investing, peak demand occurs at the peak price. Investors want more of a security as prices rise. This having been shown to be true over time, the story becomes more and more compelling as prices increase. And at the top, even the most strident holdouts capitulate and join the buying frenzy, with retail investors inevitably the last to succumb to the Sirens’ song.
So if the demand for bonds has truly peaked, let me offer the five threads, which, when woven together, created the most compelling story for US fixed income in history.
The perception of increasing competence/strength of the Fed –
In September 1981, in the same week that 10-year US Treasury rates peaked, newly appointed Fed Chairman Paul Volcker told Congress, "Americans have not seen for many years a successful fight on inflation, or balanced budgets, or so massive a tax reduction. A lot of bets on the future are still being hedged against the possibility that you, and we, will not carry through."
Talk about a statement on public confidence (or the lack thereof) in the Fed and Washington in general! Investors were openly betting against the Federal Reserve and Volcker knew it. But please consider where we were just thirteen months ago. Not only were bond investors certain of what the Fed would do and its effectiveness, but there was also no hedge against the possibility that the Fed would not follow through . In fact, bond investors were front-running the Fed. Rates bottomed two months before
Chairman Bernanke’s “to infinity and beyond” Buzz Lightyear moment.
While it clearly wasn’t a straight path from 1981's underconfidence to last summer's overconfidence, I can’t emphasize enough the role that increasing faith in the Federal Reserve has played in the 31-year decline in long-term US interest rates. (Moreover, I hope that the correlation between rising long-term rates and declining confidence in the Federal Reserve over the past thirteen months is clear. The public’s perception of Board of Governors' unity and the clarity and consistency of the Fed’s message have both declined as rates have risen.)
But please appreciate all of the various ways that the low interest rate consequences of high confidence in the Federal Reserve have rippled through the economy. From higher corporate profit margins, to lower bank deposit costs, to cheaper hedging costs of everything from foreign exchange to commodities, the Fed "confidence effect" has been staggering. And then there is the whole cascade of economic benefits that arise from the public’s perception of "managed" low long-term inflation rates and the Fed "put" on asset prices. For our overleveraged, financialized economy, I’d offer that confidence in the Federal Reserve may be the least appreciated economic variable out there.
Just pause for a moment to think about what buyers of 10-year US Treasuries yielding 1.40% last summer must have been assuming about the long-term stability of our economy and financial system and the omnipotence of the Federal Reserve! The long-term effects
I don’t mean to beat this first point to a pulp, but there are two other very important (and I believe woefully underappreciated) long-term consequences of increasing confidence in the Federal Reserve and lower interest rates.
The first is low corporate and consumer default rates. Overleveraged borrowers’ ability to repeatedly refinance debt at lower and lower interest rates has significantly reduced bank and bond investor credit defaults. But please appreciate how at this point, banks, banking regulators, the rating agencies, and bond investors all believe that the loss rates of the past twenty years are "normal." I can’t emphasize enough how much this benefits both corporate spreads and consumer borrowing rates today, which in turn benefits...
Finally, and on a related note, without the perception of stable interest rates and consumer credit losses, the securitization of consumer loans would have been impossible. And having witnessed it firsthand, I can’t emphasize enough what this meant (and continues to mean) for consumer spending, automobile manufacturing, and, of course, housing.
US rule of law and the rights of creditors –
I believe a second long-term confidence component to last year’s low in interest rates is the perceived stability and strength of the US bankruptcy system. While hundreds of thousands of companies failed and millions of consumers filed for bankruptcy from 1981 to 2012, there was a clear and compelling framework for creditors. Rights were well-documented and the court system regularly reaffirmed those rights. What's more, particularly in consumer lending, bankruptcy laws were rewritten to further benefit creditors.
The fact that lenders took -- and most still take -- the system for granted says it all about our level of confidence. But please appreciate what a tailwind that level of certainty was for the credit markets.
Asset allocation –
A third long-term confidence component to the decline in interest rates from 1981 to 2012 was modern portfolio theory and the empirical work done by folks like Brinson, Hood, and Beebower. Bonds mitigated risk and boosted long-term returns. As more investors adopted formal asset allocation guidelines, institutional portfolio management all but guaranteed that there would be natural buyers for bonds, irrespective of price.
But note what happened at the bottom of the banking crisis in 2009. Large numbers of institutional investors bought bonds -- particularly high-yield bonds -- rather than equities, due to the belief that bonds offered equity-like returns with superior creditors’ rights should bankruptcy then occur. For many institutions, bonds became a significantly overweighted asset class; needless to say, those overweights grew as bond prices ripped higher as perceptions of the economy improved and confidence in the Fed soared.
Finally, I believe there were two shorter-term elements that helped pushed bond prices to record highs.
Prolonged weak confidence –
While institutional investors overweighted bond positions in 2009 based on thoughtful risk/return frameworks, retail investors, having sold equities at the bottom, began to move into bonds due to continuing low consumer confidence. Having lost significant money in equities twice in less than ten years, bonds were about as far out on the risk spectrum as retail investors were willing to go. But please appreciate, too, how as long-term interest rates continued to fall, their decision was validated. Like their institutional brethren, they, too, earned equity-like returns.
But consider how, as long-term interest rates were then crushed, these same retail investors then turned to riskier and riskier bond alternatives. Bonds were safe, so why not go further and further out on the credit and maturity spectrum?
Finally, please consider what low confidence combined with central bank liquidity meant for bank balance sheets. As the Federal Reserve charts below show, bank treasurers piled into fixed income and even 30-year mortgage loans at the very peak in prices in an effort to stem net interest margin compression coupled with weak organic loan demand.
The relative strength of the US –
As to the particular summer of 2012 peak in bond prices, I think Greece and the European debt crisis all but put the cherry on the top. As the best house in a bad neighborhood, the US debt markets attracted global flows. With secession/break-up rumors swirling, 1.40% 10-year Treasury rates were better than any kind of euro-denominated debt.
And again, I can’t emphasize enough how important the global perceptions of the Federal Reserve were at that time. In many ways, the US was the best house in a bad neighborhood because the Fed had been the most aggressive national central bank during the 2008; Chairman Bernanke knew
the Great Depression and how not to repeat it again; and, relative to the ECB, the Federal Reserve was unencumbered by bickering national political leaders.
In the storm, the US was the best place to seek refuge. Coming together as they did, I believe that the confidence embedded in these five long-term and short-term variables formed the peak in bond prices last summer. Everything that could be a tailwind was.
While I am sure there are other factors that you may want to add to the list, and/or that you may want to reweight the factors as to their relative importance, I think that what happens now with regards to these five factors will drive the future of interest rates.
As I noted above, in the past year, we have already seen signs of deteriorating confidence in the Federal Reserve. For some time, I have cautioned that the bankruptcies of GM
(NYSE:GM) and Chrysler would matter as far as creditors’ rights. Now Detroit, Michigan, and Richmond, California, are raising even more questions. Needless to say, what happens next will frame America’s relative positioning among global investors.
Remember, mood drives changes in laws, not the other way around. As I noted above, near the peak in confidence, consumer bankruptcy laws were changed to favor creditors. With falling mood, the pendulum will shift to the other direction. Just consider the changes made to "loosen" student loan default practices over the past two years.
I believe that all five of the tailwinds described above have already turned to headwinds. But please appreciate how much confidence and trust were implicit in each one. Confidence takes a long time to form but just moments to destroy. While it took thirty-one years for 10-year US Treasury yields to fall from 16% to 1.4%, I expect that the speed of the rate rise will be jaw-dropping.
Confidence in bonds is fading -- and if you think investor confidence in equities matters, multiply that geometrically, if not exponentially, for bonds. Bonds are the ultimate confidence game. If there were ever a shorthand story for bond investors, it would be "bonds = safe." As we saw in Europe, if that is no longer true, it is game over.
Today bond investors believe that the rise in rates is a function of the taper and an improving economy. So long as that story holds true, the rise in rates will be contained.
I don’t believe that story. To these eyes, the
story in fixed income is falling demand -- and it is the only story that matters. I would pay extremely close attention to the five variables listed above. As they go, so go rates and the US economy.
Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
“Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the ‘me, here, and now’ behavioral tendencies of the post-crash world.” —Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation