The Economy and Bond Market (May 21, 2012)

Saturday, May 19th, 2012

The Econ­omy and Bond Mar­ket (May 21, 2012)

Trea­suries ral­lied this week, send­ing long-term yields sharply lower. With head­lines tout­ing bank runs in Greece and Spain, the risk-off trade was in full swing this week as both gold and the U.S. dol­lar ral­lied along with Trea­suries. Ten-year Trea­sury yields hit the low­est level in 60 years this week and Ger­man 10-year bonds hit new record lows as part of the risk-off/fear trade.

Strengths

• The con­sumer price index for April was unchanged and the trend in infla­tion data is lower.
• Hous­ing starts rose 2.6 per­cent in April as the hous­ing mar­ket remains a bright spot.
• Cen­tral banks remain sup­port­ive as the Fed min­utes released from the April Fed­eral Open Mar­ket Com­mit­tee (FOMC) meet­ing hinted at more mon­e­tary eas­ing if the econ­omy slows. The Bank of Eng­land echoed sim­i­lar thoughts and the mar­ket sees higher chances of addi­tional quan­ti­ta­tive easing.

Weak­nesses

• The Con­fer­ence Board Lead­ing Eco­nomic Index fell 0.1 per­cent in April.
• Chi­nese power pro­duc­tion rose a mod­est 0.7 per­cent, the small­est gain since May 2009.
• Euro­zone indus­trial pro­duc­tion fell 0.3 per­cent in April; expec­ta­tions were for a gain of 0.4 percent.

Oppor­tu­nity

• Bonds con­tinue to grind higher and appear to be fore­cast­ing benign infla­tion and slow growth.
• The Fed­eral Reserve appears will­ing to increase mon­e­tary accom­mo­da­tion if nec­es­sary, which would be a boost to the bond market.

Threat

• China’s econ­omy is slow­ing faster than expected and gov­ern­ment pol­icy mak­ers appear com­fort­able with this dynamic.
• Europe remains a wild­card with aus­ter­ity pro­grams under pres­sure, cre­at­ing sig­nif­i­cant uncertainty.

Tags: 10 Year Bonds, Austerity Programs, Bank Of England, Bond Market, Central Banks, Chinese Power, Consumer Price Index, Economic Index, Eurozone, Federal Open Market Committee, Full Swing, Government Policy Makers, Housing Market, Housing Starts, Inflation Data, Open Market Committee, Record Lows, Term Yields, Treasuries, Treasury Yields
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The Economy and Bond Market Radar (May 14, 2012)

Sunday, May 13th, 2012

The Econ­omy and Bond Mar­ket Radar (May 14, 2012)

Trea­sury yields have had a slight down­ward bias again this week, which has become a per­sis­tent pat­tern over the past few weeks. With global eco­nomic data exhibit­ing a weak trend recently and Euro­pean con­cerns back on the front page it is not sur­pris­ing that trea­suries have been ral­ly­ing recently. This time last year there was con­sid­er­able con­cern regard­ing ris­ing infla­tion but that dynamic has com­pletely changed. Both the import price index and the pro­ducer price index were reported this week. As the chart below shows, both are in an unde­ni­able down­trend which val­i­dates the Fed­eral Reserve’s pol­icy to stay the course with easy mon­e­tary policy.

Strengths

• Con­sumer bor­row­ing jumped $21.4 bil­lion in March indi­cat­ing that con­sumers feel com­fort­able enough to bor­row again after sev­eral years of retrenchment.
• Ger­man indus­trial pro­duc­tion jumped 2.8 per­cent in March, well ahead of expec­ta­tions and indi­cat­ing sur­pris­ing strength.
• The National Fed­er­a­tion of Inde­pen­dent Busi­ness small busi­ness opti­mism index hit a 14 month high in April.

Weak­nesses

• Eco­nomic data out of China this week showed con­tin­ued slow­down as indus­trial pro­duc­tion and retail sales disappointed.
• Brazil­ian con­sumer prices rose 0.64 per­cent in April, ahead of fore­cast and the biggest increase in a year.
• British retail sales fell 3.3 per­cent in April. The U.K. econ­omy fell into an offi­cial reces­sion recently as first-quarter GDP fell 0.2 per­cent after falling 0.3 per­cent in the fourth quarter.

Oppor­tu­nity

• Bonds con­tinue to grind higher and appear to be fore­cast­ing a benign infla­tion and slow growth.

Threat

• China’s econ­omy is slow­ing faster than expected and gov­ern­ment pol­icy mak­ers appear com­fort­able with this dynamic.
• Europe remains a wild­card with aus­ter­ity pro­grams under pres­sure, cre­at­ing sig­nif­i­cant uncertainty.

Tags: Austerity Programs, Bond Market, Business Optimism, Chart Below Shows, Economic Data, European Concerns, Federation Of Independent Business, Government Policy Makers, Import Price Index, Market Radar, Monetary Policy, National Federation Of Independent Business, Persistent Pattern, Producer Price Index, Quarter Gdp, Retail Sales, Retrenchment, Slowdown, Treasuries, Treasury Yields
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The Economy and Bond Market Radar (May 7, 2012)

Monday, May 7th, 2012

The Econ­omy and Bond Mar­ket Radar (May 7, 2012)

Trea­sury yields have had a slight down­ward bias the past cou­ple of weeks and that trend accel­er­ated this week as yields fell across the board. U.S. eco­nomic data con­tin­ues to be a mixed bag. The unem­ploy­ment report was released on Fri­day which was lack­lus­ter at best with non-farm pay­rolls grow­ing a mod­est 115,000. The recent trend does not inspire a lot of con­fi­dence as can be seen in the chart below. The Fed­eral Reserve remains in play and may enact addi­tional quan­ti­ta­tive eas­ing or other stim­u­la­tive pol­icy mea­sures if the econ­omy does not improve.

Strengths

• The ISM Man­u­fac­tur­ing Index rose to 54.8 in April, show­ing sur­pris­ing strength amid weak­en­ing man­u­fac­tur­ing data in many parts of the globe.
• The HSBC Pur­chas­ing Man­agers Index (PMI), which is a gauge of China man­u­fac­tur­ing, also improved but still indi­cated con­trac­tion.
• Aus­tralia cut inter­est rates by 50 basis points as infla­tion expec­ta­tions moved lower.

Weak­nesses

• Non-farm pay­rolls only rose a mod­est 115,000 and the recent trend has been disappointing.
• April same-store sales have dis­ap­pointed as the con­sumer appears to have slowed down after a sev­eral months of beat­ing expectations.
• The Euro­pean Cen­tral Bank indi­cated that addi­tional eas­ing is not likely.

Oppor­tu­nity

• Bonds con­tin­ued to grind higher and appear to be fore­cast­ing a benign infla­tion and slow growth.

Threat

• Europe remains a wild­card with aus­ter­ity pro­grams under pres­sure, cre­at­ing sig­nif­i­cant uncertainty.

Tags: Austerity Programs, Basis Points, Bias, Bond Market, Contraction, Economic Data, Federal Reserve, Gauge, Inflation Expectations, Ism Manufacturing Index, Market Radar, Non Farm Payrolls, Parts Of The Globe, Pmi, Policy Measures, Purchasing Managers Index, Quantitative Easing, Treasury Yields, Unemployment Report, Wildcard
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The Economy and Bond Market Radar (April 30, 2012)

Sunday, April 29th, 2012

The Econ­omy and Bond Mar­ket Radar (April 30, 2012)

Trea­suries were more or less unchanged for the sec­ond week in a row. U.S. eco­nomic data offered a mixed bag and the Fed essen­tially stayed the course with regard to mon­e­tary pol­icy. First quar­ter GDP was released on Fri­day and the econ­omy grew 2.2 per­cent, mod­estly below esti­mates. The key take­away from the report is that the econ­omy is not strong enough for the Fed to seri­ously con­sider shift­ing pol­icy but it is weak enough to keep the pos­si­bil­ity of addi­tional QE or other stim­u­la­tive mea­sures alive.

Strengths

• The hous­ing mar­ket con­tin­ues to show signs of life as new home sales and pend­ing home sales trend higher. In addi­tion, months of sup­ply of new homes has fallen to 5.3 months, back to 2006 levels.
• The HSBC China flash PMI index improved to 49.1, still indi­cat­ing con­trac­tion but mov­ing in the right direc­tion and ris­ing for the fourth month in a row.
• With the econ­omy still show­ing tepid growth, the Fed will remain accommodating.

Weak­nesses

• The U.K. econ­omy con­tracted by 0.2 per­cent in the first quar­ter and is now tech­ni­cally back in recession.
• Weekly ini­tial job­less claims remain ele­vated at 388,000 this week, con­tin­u­ing the recent trend of higher readings.
• Con­sumer con­fi­dence indi­ca­tors ticked lower in April even as gaso­line prices fell.

Oppor­tu­nity

• After a dis­ap­point­ing first quar­ter GDP result, the Chi­nese are likely to ease mon­e­tary pol­icy as soon as this quarter.

Threat

• Ris­ing oil and gaso­line prices com­bined with liq­uid­ity impli­ca­tions of global eas­ing, led by Europe, may raise the prospect of a reap­pear­ance of higher infla­tion going forward.

Tags: Bond Market, Consumer Confidence, Contraction, Economic Data, Gasoline Prices, Home Sales Trend, Housing Market, Hsbc, Initial Jobless Claims, liquidity, Market Radar, Monetary Policy, Moving In The Right Direction, Pmi, Qe, Quarter Gdp, Recession, Signs Of Life, Takeaway, Treasuries
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The Intersection of Bonds and Equities

Tuesday, April 24th, 2012

by Guy Lerner, The Tech­ni­cal Take

Fig­ure 1 shows a weekly chart of the SP500. In the lower panel is an ana­logue chart of our bond trad­ing model. This bond model has been bull­ish for 3 weeks now.

Fig­ure 1. SP500 v. Bond Model/ weekly

Note how the bond model turned bull­ish back on March 26, 2010 and on March 11, 2011. Not only did these sig­nals coin­cide (more or less) with an equity mar­ket top, but these time peri­ods also sig­naled the end of active mon­e­tary inter­ven­tion by the Fed­eral Reserve. This was the end of QE1 and QE2, respec­tively. Now we have the lat­est incar­na­tion of QE end­ing — Oper­a­tion Twist. Inter­est­ingly enough, the equity mar­ket appears to be top­ping out once again as the bond model has turned positive.

So why is the bond model pos­i­tive? Despite the low yields, bonds could be viewed as a safe haven from a frag­ile macro envi­ron­ment. While this may be true to some extent, I believe the equity weak­ness or bond strength (in this case) is a reflec­tion and early sign of eco­nomic weak­ness. In par­tic­u­lar, the 2011 mar­ket top coin­cided with notice­able dete­ri­o­ra­tion in the eco­nomic data that was clearly point­ing towards reces­sion. Of course, the Fed came to the res­cue with Oper­a­tion Twist and the “dreaded” reces­sion was avoided.

So in sum­mary, a top­ping equity mar­ket appears to be a sign of an econ­omy that has peaked as well. This has been her­alded by strength in bonds. Most likely, this is sig­nal­ing fur­ther quan­ti­ta­tive eas­ing as the Fed­eral Reserve inter­venes in the bond mar­ket to prop up the econ­omy and the equity markets.

Tags: Analogue, Bond Market, Bond Strength, Bond Trading, Bonds, Deterioration, Economic Data, Economic Weakness, Federal Reserve, Figure 1, Guy Lerner, Incarnation, Macro Environment, March 11, Qe, Qe1, Recession, S&P500, Safe Haven, Time Periods
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Volatile or Not? (Tchir)

Sunday, April 22nd, 2012

From Peter Tchir of TF Mar­ket Advisors

Volatile or Not?

It is strange to start a weekly update and not be sure whether the week was volatile or not.  North Amer­i­can stock indices ranged from –0.4% for Nas­daq to 0.6% for the S&P.  Not much to look at there.

U.S. fixed income fin­ished with small weekly gains.  The 10 year trea­sury was 2 bps bet­ter.  Fixed income ETF’s like TIP, TLT, LQD, HYG, JNK, and MUB all had small gains.  Even the CDS indices, IG18, and the under­per­form­ing HY18 saw some small spread tight­en­ing over the course of the week.

Look­ing at Europe and we start to see some more volatil­ity and diver­gence.  The DAX was up 2.5% will the IBEX was down 2.9%.  Span­ish bond yields were mixed to bet­ter on the week, but Ital­ian yields were worse.  In a week of obvi­ous attempts by gov­ern­ments and cen­tral banks and the IMF to calm mar­kets, they had lim­ited suc­cess with the smaller and more eas­ily manip­u­lated Span­ish bond mar­ket, and failed in Italy.  One scary under­tone devel­op­ing in the mar­ket is the con­cern about France and the poten­tial impact of the French elec­tion.  French 10 year yields moved 14 bps, and it wasn’t because the sit­u­a­tion was improv­ing, because Ger­man 10 year yields moved 3 tighter on the week.  Ger­many con­tin­ues to have a flight to qual­ity bid, but France, not so much.

Maybe it is the activ­ity in Europe that made the mar­kets feel more volatile than the weekly changes show.  Or maybe it was that the futures traded in an almost 3% range – from 1,359 to 1,390 with sev­eral 0.5% swings dur­ing the course of most days.  Mar­ket dar­ling Apple isn’t help­ing calm the mar­ket either.  That can reverse on a moment’s notice, or a great earn­ings release, but the momen­tum that was drag­ging more and more hedge funds into the trade, is now work­ing in reverse as stop losses are being triggered.

So often lately, the bulls are able to point to a decent tape in face of weak data and no stim­u­lus, and this week ended with the oppo­site.  Bulls will be ner­vous that decent earn­ings and a mega-plan from the IMF failed to pro­vide strength to the market.

So, it was a strange week that was more volatile than the weekly changes show, and where some real cracks are being exposed.

Politi­cians and the Markets

In a week where the Birkin wield­ing head of the IMF went from G-20 del­e­ga­tion to del­e­ga­tion ask­ing for them to com­mit their taxpayer’s money to another illu­sory fire­wall, it is impor­tant to focus on what was accom­plished and what wasn’t.

By all accounts, the IMF has received com­mit­ments to increase the “fire­wall” by some amount, pos­si­bly as much as $500 bil­lion.  The politi­cians expect the mar­kets to be excited about this “heroic” effort and the guar­an­tee that no debt prob­lem is too big that it can’t be solved with more debt.  In spite of the head­lines, I’m being asked

How will the coun­tries honor their com­mit­ments?
Where will the money come from?  Espe­cially the Euro­pean por­tion?
How would the money be used?  For coun­tries?  For banks?
If com­mit­ments made in 2010 haven’t been approved, what good are these com­mit­ments?
What does this do to help the coun­tries that are in trou­ble?  Why does the IMF think it is safe to lend when real investors won’t lend?
The list is long, but is also accurate.

The entire IMF Fire­wall is being run as though it was an elec­tion.  The lead­ers use the same slo­gans over and over.  They say the money is needed to avoid calamity.  They say the money will help.  No evi­dence of either is pro­vided, but who needs evi­dence when you are just run­ning a cam­paign.  So they cam­paigned, and in their view, they “won” the elec­tion, by get­ting these commitments.

That is the big dis­con­nect.  Politi­cians are sit­ting around Wash­ing­ton con­vinced that they have won.  They fought a hard cam­paign to con­vince peo­ple that the Fire­wall was needed and would be good, and they got the job done.  What they haven’t done, is seen how the mar­ket will react.

Unlike a real elec­tion, the mar­ket doesn’t give the win­ner a free pass for a cer­tain amount of time.  You haven’t won until the next elec­tion, you have merely won until the mar­ket tests your resolve.

That test will come quickly, quite likely this week.  Mar­kets will likely put pres­sure on Span­ish and Ital­ian yields, and pos­si­bly French yields depend­ing on the elec­tion results.  Noth­ing about the fire­wall changes a thing about the cur­rent sit­u­a­tion these coun­tries find them­selves in.  That is the key.  If the fire­wall actu­ally did some­thing for these coun­tries, we might be able to stage a strong rally, but the fire­wall doesn’t have an imme­di­ate impact.  The fire­wall just ensures that these coun­tries can bor­row more money.  That when the mar­kets shut down on their abil­ity to bor­row, the IMF will lend to them.  Your best hope as a cur­rent lender, is to hope you own short enough dated bonds that the IMF is still being gen­er­ous and lend­ing to the coun­try to pay you back, rather than hav­ing gone into PSI mode.

Spain and Italy need to reduce the cur­rent inter­est bur­den, the total debt, make long term adjust­ments that while tech­ni­cally aus­ter­ity, can have min­i­mal near term impact, and they need to embark on some growth poli­cies.  A debt restruc­tur­ing can accom­plish the first two items.  Pol­icy and some IMF money can help on the all impor­tant growth issue.  With­out some form of PSI, the fire­wall at best will shift who coun­tries owe money to, and at worst will dis­cour­age banks from lend­ing to any­one other than sovereigns.

The mar­kets will test the resolve of the EU, ECB, and IMF this week.  They will see how read­ily “com­mit­ments” turn into “actions”.  Once again, the smug vic­tory speeches being made by the politi­cians are likely to look very wrong, and pos­si­bly before they have even fin­ished their vic­tory tour.

Last chance to QE?

I think we have one group within the Fed that is des­per­ate to do QE and wants to do it now.  There is another group that believes the econ­omy should be left alone, unless the data dete­ri­o­rates sig­nif­i­cantly.  As we head towards the elec­tion in Novem­ber, the hur­dle of what con­sti­tutes “weak” eco­nomic data will increase.  Right now, Benyellen might be able to argue “only” 120,000 NFP jobs is enough to launch QE.  I don’t think they would have a chance of launch­ing in August with NFP num­bers like that.

So, Benyellen will push hard at this meet­ing.  I think they will still face too much resis­tance.  It is only one bad NFP num­ber and 2 bad “ini­tial claims” num­bers.  Not enough for the last defend­ers of any­thing resem­bling a free mar­ket at the Fed.  Hous­ing has been weak too, but again, per­mits were up, and although not bounc­ing, there does seem to be some sta­bil­ity return­ing to the hous­ing market.

I don’t expect QE this week.  I think the state­ment will be slightly more dovish than the last one, but that is priced in as the mar­ket does often seem to take the “bad news” as good news path.  Real­is­ti­cally, the next meet­ing is the most likely one to see QE announced since it would only take a few more data items con­firm­ing recent ones to let Benyellen rail­road the rest into one more round.

Earn­ings, just how good?

I was frus­trated and dis­ap­pointed with BAC and MS.  They aren’t the only ones (GS and C did accounted for things sim­i­larly), but for what­ever rea­son, they caught my eye, and con­vince me that this is what is wrong with the market.

Last year, when DVA and FVO were big pos­i­tives, those num­bers were not only included in the head­line, but in the case of Gor­man at MS, were trum­peted as he pounded his chest that MS beat GS in Q3 2011.  The qual­ity and wis­dom of DVA account­ing has been ques­tion­able at best and the FVO adjust­ments are stag­ger­ing in the ratio of the mag­ni­tude of the amounts ver­sus the amount of disclosure.

I would much rather have seen head­line num­bers con­sis­tent with 2011.  Then we could focus on how they did that quar­ter. What the busi­ness out­look is.  Instead, it looks like they are try­ing to trick the media and investors and make the story bet­ter than it is.  Investors aren’t stu­pid.  They will do the work.  They will fig­ure out the dif­fer­ences in how Q3 2011 and Q1 2012 were reported.  Then, not only will they be dis­ap­pointed with what the firms tried to trick them on, they will ques­tion what else is being done.  If you are will­ing to “mas­sage” (sounds bet­ter than manip­u­late) the way you report each quarter’s earn­ings to make it seem the best, what else are you will­ing to “mas­sage”?  Banks are opaque.  On 100’s of bil­lions of assets, what’s a bp or two here or there?

All com­pa­nies should lay it on the line.  Report what hap­pened in the way they always do, then rely on them­selves and their con­fer­ence calls and good ana­lysts to fig­ure out the longer term pic­ture.  Com­pa­nies have to trust in the intel­li­gence of investors and investors will have trust in the companies.

Copy­right © TF Mar­ket Advisors

Tags: 10 Year Treasury, American Stock, Bond Market, Bond Yields, Bps, Central Banks, Divergence, Earnings Release, Fixed Income, French Election, Hedge Funds, Hyg, Jnk, Lqd, Mub, Stimulus, Stock Indices, Tlt, Undertone, Volatility
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The Economy and Bond Market Radar (April 23, 2012)

Sunday, April 22nd, 2012

The Econ­omy and Bond Mar­ket Radar (April 23, 2012)

Trea­suries were more or less unchanged this week. U.S. eco­nomic data was broadly in line with esti­mates and Trea­suries didn’t move around much this week. One inter­est­ing data point that was released this week was hous­ing per­mits, which rose faster than expected to 747,000 (sea­son­ally adjusted annu­al­ized rate). This can be eas­ily seen in the chart below and has finally bro­ken out of the range that it occu­pied for the past three years. This appears to be a very favor­able devel­op­ment, as new hous­ing activ­ity looks as if it is finally pick­ing up.

Strengths

• As men­tioned above, hous­ing is show­ing some signs of life and appears to be pick­ing up.
• India’s cen­tral bank cut inter­est rates this week and China has indi­cated a will­ing­ness to ease mon­e­tary pol­icy in the near future. The global eas­ing cycle continues.
• Retail sales rose a very strong 0.8 per­cent in March, well ahead of expec­ta­tions and with broad-based strength.

Weak­nesses

• Span­ish 10-year bond yields rose above 6 per­cent this week as the mar­ket rotates through south­ern Europe, with the cur­rent focus on Spain.

• Weekly ini­tial job­less claims rose to 386,000 this week, con­tin­u­ing the recent trend of higher readings.

• The Bank of Canada has become more hawk­ish and indi­cated that rates may be headed higher on better-than-expected eco­nomic growth and higher inflation.

Oppor­tu­nity

• After a dis­ap­point­ing first-quarter GDP result, the Chi­nese are likely to ease mon­e­tary pol­icy as early as this quarter.

Threat

• Ris­ing oil and gaso­line prices com­bined with liq­uid­ity impli­ca­tions of global eas­ing, led by Europe, may raise the prospect of a reap­pear­ance of higher infla­tion going forward.

Tags: Bank Of Canada, Bond Market, Bond Yields, Economic Data, Economic Growth, First Quarter, Gasoline Prices, GDP, inflation, Initial Jobless Claims, liquidity, Market Radar, Monetary Policy, Quarter Gdp, Retail Sales, S Central, Signs Of Life, Southern Europe, Treasuries, Willingness
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How Rising Rates Will Affect Stocks (Koesterich)

Wednesday, April 18th, 2012

by Russ Koes­terich, iShares

While recent mar­ket weak­ness, and the accom­pa­ny­ing bond mar­ket rally, has tem­pered fears of an immi­nent bond mar­ket melt­down, many equity investors are still con­cerned about the poten­tial impact of ris­ing rates on US and global stocks.

This year, I expect long-term rates to rise mod­estly as they appear too low. Assum­ing the US econ­omy con­tin­ues to sta­bi­lize over the course of the year, the yield on the 10-year Trea­sury will likely rise to around the 3% level, roughly where it was last summer.

How­ever, in my opin­ion, this prob­a­ble grind higher is not a major threat to US and global stocks this year for two reasons:

Low Start­ing Point: It’s impor­tant to put the cur­rent yield envi­ron­ment in con­text.  Exclud­ing the period of unusu­ally high nom­i­nal yields in the 1970s and 1980s, the long-term aver­age nom­i­nal yield for the 10-year note is still 5.25%, more than twice today’s level. As such, any rise in rates will be com­ing from his­tor­i­cally low lev­els. And a rise in rates from the absurdly low to the merely low has not, at least his­tor­i­cally, hurt stocks. Equity val­u­a­tions do con­tract when rates are ris­ing, but this rela­tion­ship typ­i­cally breaks down when rates are this low.

The Dri­ver of Ris­ing Rates: In the past, the rea­son behind why rates rise has been as impor­tant for stocks as how much rates rise. Look­ing for­ward, the com­ing rise in rates will likely be dri­ven by higher real rates, not by higher infla­tion expectations.

When inter­est rates are ris­ing due to height­ened infla­tion expec­ta­tions, stock mul­ti­ples tend to con­tract. How­ever, when ris­ing inter­est rates are due to a rise in real, or after-inflation, rates in the con­text of a strength­en­ing econ­omy, mul­ti­ples have not been hurt. In fact, over the long term, there hasn’t been a sta­tis­ti­cally sig­nif­i­cant rela­tion­ship between real yields and mul­ti­ples. If any­thing, in recent years — which have gen­er­ally been char­ac­ter­ized by too lit­tle growth, rather than too much — stock mul­ti­ples have risen with real rates.

To be sure, none of above sug­gests that equi­ties have become imper­vi­ous to higher rates. While higher real yields prob­a­bly won’t hurt mul­ti­ples, a high enough rise could dampen earn­ings. But in my opin­ion, any rate rise this year should be mod­est and likely won’t neg­a­tively impact val­u­a­tions. Look­ing for­ward, the real threat to stocks in 2012 is weak eco­nomic growth, not higher rates.

Source: Bloomberg

Copy­right © Black­Rock, Inc. , iShares

Tags: 10 Year Treasury, 1970s, 1980s, Bond Market, Economy, Equity Investors, Fears, Global Stocks, Inflation Expectations, Inflation Rates, Ishares, Market Meltdown, Market Rally, Market Weakness, Nbsp, Nominal Yield, Relationship, Rising Interest Rates, Russ, Valuations
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The Economy and Bond Market Radar (April 16, 2012)

Sunday, April 15th, 2012

The Econ­omy and Bond Mar­ket Radar (April 16, 2012)

Trea­suries ral­lied this week, send­ing yields sharply lower. The non­farm pay­rolls report that was released on Good Fri­day dis­ap­pointed and with neg­a­tive rum­blings out of Europe, it was a “risk off” week. China reported first quar­ter GDP growth below expec­ta­tions, which increases the like­li­hood of addi­tional pol­icy accom­mo­da­tion from the Chi­nese author­i­ties in the near future.

Strengths

• Nat­ural gas fell below $2 this week, pro­vid­ing con­sumers with some relief to higher gaso­line prices.
• Sev­eral infla­tion data points were released this week and were over­all in line with expec­ta­tions. This is gen­er­ally sup­port­ive of the exist­ing Fed­eral Reserve policies.
• Whole­sale inven­to­ries rose 0.9 per­cent in Feb­ru­ary, indi­cat­ing con­tin­ued restock­ing that should boost first quar­ter GDP in the U.S.

Weak­nesses

• March non­farm pay­rolls grew a mod­est 120,000, well below mar­ket expectations.

• Weekly ini­tial job­less claims jumped to 380,000 this week, the high­est read­ing since January.

• Spain remains in the spot­light as yields spike higher and investors remain ner­vous about long-term solu­tions for the country’s finan­cial woes.

Oppor­tu­nity

• The weak Chi­nese GDP num­ber implies that the cur­rent global eas­ing poli­cies are likely to remain in place for the fore­see­able future.

Threat

• Ris­ing oil and gaso­line prices, com­bined with liq­uid­ity impli­ca­tions of global eas­ing led by Europe, may raise the prospect of higher infla­tion going forward.

Tags: Bond Market, Chinese Authorities, Federal Reserve, Financial Woes, Gasoline Prices, GDP, GDP Growth, Good Friday, Inflation Data, Initial Jobless Claims, liquidity, Long Term Solutions, Market Expectations, Market Radar, Nonfarm Payrolls, Quarter Gdp, Reserve Policies, Rumblings, Treasuries, Wholesale Inventories
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Has the Bear Market for Bonds Begun? (Schwab)

Monday, April 9th, 2012

April 5, 2012

by Rob Williams, Direc­tor of Income Plan­ning, Schwab Cen­ter for Finan­cial Research, and

Has the Bear Mar­ket for Bonds Begun?

Why are inter­est rates still so low? The econ­omy is recov­er­ing, unem­ploy­ment is falling, gaso­line prices are ris­ing and the stock mar­ket has dou­bled in value in the last three years. We’ve noted the com­men­tary lately about an end to a 30-year bull mar­ket in bonds, and whether investors are at sig­nif­i­cant risk for losses if rates rise. The ten­dency, as we’ve seen it, is to worry about these broad con­cerns with a mix of skep­ti­cism and fear. While we think that inter­est rates will con­tinue a mod­est increase over the rest of this year, we’re less con­vinced that we’ll see a sharp, uncon­trolled spike in rates or decline in investor demand. We see other long-term struc­tural sup­ports, with a few of the larger ones high­lighted here.

• De-risking sup­ports demand for bonds. The sim­plest expla­na­tion for why rates are so low is that investors—individual and institutions—are still ‘de-risking.' For indi­vid­ual investors, the expla­na­tion for the propen­sity to favor bonds over stocks is pretty straight­for­ward. Since 2000, indi­vid­ual investors, in aggre­gate, have gone from prince to pau­per one too many times. After a period of low volatil­ity dur­ing the 1990s, we’ve moved to a period of excep­tion­ally high volatil­ity. Not only have returns from the stock mar­ket been volatile, but net worth has been volatile as well thanks to the drop in home prices. Aging investors may sim­ply want to hold on to more of what they have, sup­port­ing demand for bonds.
• More impor­tantly, insti­tu­tional investors are de-risking as well. We focus on indi­vid­ual investors, of course, but the U.S. bond mar­ket has been dri­ven, by-and-large, by large insti­tu­tions such as pen­sion funds, insur­ance com­pa­nies, global banks and inter­na­tional sov­er­eigns. This is an enor­mous mar­ket, and they are de-risking as well. In our view, pen­sion funds, insur­ance com­pa­nies and oth­ers with lia­bil­i­ties to fund have been, and will likely con­tinue, to reduce expo­sure to riskier assets in favor of bonds. Here are a few statistics:

1. Accord­ing to Ned Davis and the Fed­eral Reserve, in 1953 bonds accounted for 84% of assets invested in U.S. insur­ance and pen­sion funds. The per­cent­age has fallen steadily since then, to 40% of $15.7 tril­lion in global assets as of the end of 2011. (Yes, tril­lion.) Over the same period, the allo­ca­tion to stocks rose from under 8% in 1953 to peaks of over 42% in the late 1990s and mid-2000s before falling back to under 34% today with the rest allo­cated to bonds and other investments.
2. Accord­ing to Mil­li­man, a pen­sion fund con­sult­ing com­pany, cor­po­rate pen­sion funds are under-funded by $372 bil­lion. Munic­i­pal pen­sions are under-funded by tril­lions more. After dis­ap­point­ing returns from equi­ties, many are shift­ing slowly back to a more tra­di­tional method of match­ing fixed assets with future lia­bil­i­ties. On the mar­gins of this multi-trillion dol­lar mar­ket, a one-percentage point move is a big deal.
3. Insur­ance com­pa­nies face sim­i­lar met­rics. Many will need to add more fixed income to match future lia­bil­i­ties. Accord­ing to Mer­cer, an insur­ance con­sul­tant, demand for fixed income secu­ri­ties from insur­ance com­pa­nies could run in the range for $500 to $600 bil­lion annually.

• Demo­graph­ics are also chang­ing. It's no secret that the U.S. pop­u­la­tion is aging and that the first wave of "baby boomers" is retir­ing. Some have been pushed into early retire­ment while oth­ers have cho­sen to stop work­ing. It’s our sense that many investors may remain less inclined toward extra risk with the money they have to live on for the next few decades, for a grow­ing por­tion of their port­fo­lios. Return of cap­i­tal, in nom­i­nal terms, may be as impor­tant as return on it, at least for money that doesn't have as much time to recover from volatil­ity in other markets.
• And then there's the Fed. The other big fac­tor hold­ing down yields, of course, is the Fed. Over the past year, the Fed has pur­chased 61% of new Trea­sury issuance, keep­ing a cap on rates. With the fed funds rate at zero and the Fed buy­ing long-term bonds, yields are likely to remain low as long as those poli­cies are in place. Right now, the Fed is indi­cat­ing that the pol­icy is expected to last another year or more. We’ll know more when they meet next in late April to see if they com­mu­ni­cate any change in tone. But for now, state­ments from Fed Chair­man Bernanke and oth­ers show that the Fed remains cau­tious about the strength of recent eco­nomic num­bers, still wor­ried about slow­ing growth in Europe and China, and believes that unem­ploy­ment needs to be lower before they are close to ful­fill­ing their mandate.
• This analy­sis is not meant to say that inter­est rates will stay low for­ever or that long-term Trea­sury bonds are attrac­tively val­ued. At some point, when the econ­omy appears to be on firmer foot­ing and/or infla­tion expec­ta­tions rise sub­stan­tially, the Fed is expected to begin to unwind its pro­grams and inter­est rates are likely to move higher. We've already seen a mod­est rise in rates off lows in late March, and we'd expect to see a slowly ris­ing trend through the rest of the year. We look for­ward to the time when rates begin to move up a bit, actu­ally, because it’ll mean that the econ­omy is health­ier and investors face addi­tional options for return on their sav­ings. How­ever, we don't know when that time will arrive, and we're not in the camp that sees rates ris­ing dra­mat­i­cally any­time soon for many of the rea­sons we've cited above. Still, we think it’s a good time to look at your allo­ca­tion to dif­fer­ent types of bonds, by credit risk and matu­rity. It's dif­fi­cult to pre­dict inter­est rates, and you can’t con­trol them. But you can con­trol what you hold in your portfolio.

Q1 2012 Sec­tor Performance

The wide range of per­for­mance between dif­fer­ent sec­tors of the global bond mar­ket, by matu­rity and level of credit risk, reminds us that the bond mar­ket defies easy gen­er­al­iza­tion. Not all bonds are cre­ated equal. Dur­ing the quar­ter, there was a sharp price-driven appre­ci­a­tion in ‘riskier' assets, such as cor­po­rate, high yield and emerg­ing mar­ket bonds, while long-term Trea­sury bonds fell as yields rose. Over­all, we expect we'll see sim­i­lar per­for­mance by sec­tors through much of the rest of 2012, with yields ris­ing mod­estly for Trea­suries on improved eco­nomic data, with peri­ods of volatil­ity and re-trenching if we see weaker data or con­cerns about global growth.

• Flat line on returns for the tax­able bond index. The Bar­clays US Aggre­gate Bond Index turned in a mea­ger per­for­mance over the first quar­ter, deliv­er­ing 0.3% in total return on the com­bi­na­tion of coupons and a mod­est drop the price of the index as yields for gov­ern­ment bonds rose sharply in March. For those focused on income, the index is now yield­ing north of 2.2% with an aver­age dura­tion (i.e. the weighted aver­age tim­ing of inter­est and prin­ci­pal pay­ments, and a mea­sure of inter­est rate risk) of just under 5 years. We expect that income will drive returns for much of the rest of this year, with a range on inter­est rate risk most likely through year-end.
• Invest­ment grade cor­po­rate bonds, includ­ing finan­cials, out­per­formed. High-grade cor­po­rate bonds were the pri­mary ben­e­fi­ciary of increased risk-appetites and yield-chasing, a theme that's con­tin­ued from late 2011 into 2012. But per­for­mance was not spread out evenly across asset classes. The finan­cial and bank­ing sec­tor, a lag­gard as recently as Q3 2011, beat util­i­ties and indus­tri­als over the last three months. This is thanks in part to improv­ing mar­ket con­di­tions and no real neg­a­tive sur­prises in the Fed's recent bank stress tests. Few investment-grade sec­tors look cheap now, a con­cern for investors who have been look­ing for yield and pour­ing money into cor­po­rate bonds. We're more cau­tious at the moment, given the strong recent run. It may make sense to look for oppor­tu­ni­ties when they present them­selves at more attrac­tive lev­els. The cycle, to us, still favors credit.

Q1 2012 Sec­tor Performance

Source: Bar­clays, as of March 30, 2012. Shown above are total returns for cor­re­spond­ing Bar­clays indices. Past per­for­mance is not indica­tive of future results.

• High-yield returns show the shift in sen­ti­ment toward yield and risk. More return poten­tial means more risk, of course. We think the cycle still favors credit, as we've said, with high yield beat­ing the pack with a 5.3% return for the quar­ter plus a 5+% yield pre­mium over Trea­suries. With cor­po­rate bal­ance sheets gen­er­ally appear­ing strong, it looks like investors are being ade­quately com­pen­sated for risk, rel­a­tive to the alter­na­tives. An impor­tant con­sid­er­a­tion, as always, is not to push the invest­ment the­sis too far, tilt­ing too far away from the more con­ser­v­a­tively invested core bond port­fo­lio in the search for yield.
• Euro-zone risk eases, boost­ing inter­na­tional per­for­mance. Euro­zone trou­bles are far from over, but two rounds of liq­uid­ity injec­tions and orderly Greek ‘restruc­tur­ing' did help to tem­per uncer­tainty so far in Q1. For­eign bonds ben­e­fited, while emerg­ing mar­kets ben­e­fited more, due pri­mar­ily to the improved appetite for risk assets. Emerg­ing mar­ket debt mir­rored U.S. high yield for a 5.9% total return. In the cur­rent low-rate cli­mate, a com­bi­na­tion of emerg­ing mar­ket and U.S. high yield bonds may still make sense for the more ‘aggres­sive' sleeve of a more risk-seeking portfolio.

Mea­sur­ing Inter­est Rate Risk

We started the con­ver­sa­tion in this newslet­ter with thoughts on the bull mar­ket for bonds. Is it over? More impor­tantly, is the bear mar­ket for bonds under­way? If rates rise, what risks do you face? Mea­sur­ing risk is bet­ter than guess­ing, in our view. Duration—the weighted aver­age time until pay­ment of inter­est and prin­ci­pal on bonds—is one measure.

• The U.S. tax­able bond mar­ket has a dura­tion today of 5 years. The aver­age matu­rity is around 7 years. The ten­dency is to look at and refer to the 10-year or 30-year Trea­sury as a bench­mark or bell-weather for the larger mar­ket for bonds. But it's worth remem­ber­ing that the mar­ket as a whole has shorter matu­ri­ties on aver­age. Longer-term bonds are riskier, if rates rise. But long-term bonds are part, not all, of the entire mar­ket. If you hold a port­fo­lio with a mix of short– to intermediate-term bonds, you may not have much expo­sure to long-term bonds. A port­fo­lio focused on short– to intermediate-term bonds, with matu­ri­ties between 1 and ten years, is good place to start, in our view, for most investors.
• A tax­able bond mar­ket with dura­tion of 5 would be expected to fall roughly 5% in value if rates rise 1%. This esti­mate is a rule of thumb, using dura­tion as a mea­sure of risk. It assumes a 1% increase in rates across the yield ‘curve'—meaning at every matu­rity, and for every bond. If rates across the curve rise 2%, from 2.2% to 4.2% on the 10-year Trea­sury, for exam­ple, and at every other matu­rity from one out to 30 years or more, the value should fall 10%. This is rough, but gives a sense of how much dam­age an investor might feel if invested in a broadly diver­si­fied port­fo­lio of short– and intermediate-term bonds or funds. Shorter-maturities are less sen­si­tive, gen­er­ally, if rates rise, than longer-maturity bonds. Bonds with higher coupons are gen­er­ally less sen­si­tive also, com­pared to bonds (Trea­suries, for exam­ple) where coupons tend to be lower. The income paid by bonds in the form of coupons off­set a por­tion of these price changes, espe­cially if inter­est is rein­vested at higher yields and com­pounded over time.
• The cur­rent bench­mark dura­tion of 5 is also around the aver­age dura­tion for the aver­age intermediate-term bond fund. Intermediate-term bond funds have dura­tions of 3.5 to 6 years (or, if dura­tion is unavail­able, aver­age effec­tive matu­ri­ties of four to ten years), using the def­i­n­i­tion that Morn­ingstar uses to define mutual fund cat­e­gories. “These port­fo­lios are less sen­si­tive to inter­est rates, and there­fore less volatile, than port­fo­lios with longer dura­tions,” says Morningstar.
• Short-term bond funds have a dura­tion of one to 3.5 years, on aver­age, accord­ing to Morn­ingstar. So if short-term rates rose 1%, short-term funds would be expected to fall in value by 1% to 3.5%. We gen­er­ally sug­gest short-term bonds or funds for money needed within 1 to 3 years, with cash invest­ments or bonds that are near­ing matu­rity for money needed sooner. Short-term rates will rise, ulti­mately. But it seems less likely that they will until the Fed changes poli­cies and says that they will, to us. The Fed can gen­er­ally drive short-term rates more directly than they can long-term rates using tra­di­tional mon­e­tary pol­icy includ­ing the Fed funds rate.
• In con­trast, long-term bond funds, espe­cially those with heavy Trea­sury expo­sure, involve the high­est risk if rates rise. Dura­tions for long-term funds are gen­er­ally 6 years or longer, often con­sid­er­ably longer. This is where investors who have ben­e­fited from strong cap­i­tal appre­ci­a­tion in long-term bonds or funds can look to take some ‘dura­tion' off the table, re-positioning a por­tion of strong gains by short­en­ing dura­tion back to bench­mark. It may not be the most attrac­tive place, in our view, for most investors to think about adding money now.
• You can tar­get dura­tion, using lad­ders or funds. As a place to start, we think investors should con­sider a mix of short– and intermediate-term bond funds, for a mix of lower inter­est rate sen­si­tiv­ity (in short-term funds) and income poten­tial with mod­er­ate risk (intermediate-term funds). It may sound like a bro­ken record, we know, but we still like bond lad­ders with a mix of matu­ri­ties from ready-to-mature out to around 10 years. When inter­est rates rise, there will be short-term bonds matur­ing to rein­vest for higher yields. And lad­ders can help reduce the over­all volatil­ity in the bond port­fo­lio. This kind of port­fo­lio helps with a plan to man­age inter­est rate risk proactively.

Please visit www.schwab.com/onbonds for more fixed income per­spec­tive from the Schwab Cen­ter for Finan­cial Research. If you have ques­tions or con­cerns about the issues raised in this pub­li­ca­tion, please speak to your Schwab representative.

Impor­tant Disclosures

Tags: Bear Market, Bond Market, Bond Markets, Bonds, Fixed Income, Gasoline Prices, Global Bond, Individual Investors, Interest Rate Risk, Investor Demand, Net Worth, Pauper, Propensity, Schwab, Skepticism, Stock Market, Strategist, Structural Supports, Volatility, Well Thanks
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The Economy and Bond Market Radar (April 9, 2012)

Sunday, April 8th, 2012

The Econ­omy and Bond Mar­ket Radar (April 9, 2012)

Trea­sury yields changed lit­tle this week, but the gen­eral direc­tion was down as global eco­nomic data was weaker than gen­er­ally expected. Euro­pean con­cerns resur­faced this week as 10-year Span­ish gov­ern­ment bond yields spiked to the high­est level this year on tepid demand at this week’s auc­tion. Spain has become the focus in the mar­kets with a dif­fi­cult bud­get sit­u­a­tion and already high unem­ploy­ment. This is a reminder that many of the dif­fi­cul­ties fac­ing the mar­kets have not been resolved and are likely to sur­face again as we move through the year.

Strengths

• The ISM Man­u­fac­tur­ing Index rose in March and was ahead of expec­ta­tions, indi­cat­ing con­tin­u­ing eco­nomic expan­sion in the man­u­fac­tur­ing area.
• The non-Manufacturing ISM Index fell in March, but remains well into expan­sion mode.
• The four-week aver­age for the weekly ini­tial job­less claims con­tin­ues to make new lows and is viewed as a pos­i­tive lead­ing indi­ca­tor for the over­all economy.

Weak­nesses

• Global man­u­fac­tur­ing data dis­ap­pointed as euro­zone PMI remained weak and con­tin­ued to indi­cate con­trac­tion in manufacturing.
• Con­struc­tion spend­ing fell 1.1 per­cent in Feb­ru­ary even as weather was con­ducive to growth.
• Euro­zone retail sales fell 0.1 per­cent in Feb­ru­ary as aus­ter­ity and high unem­ploy­ment take their toll.

Oppor­tu­ni­ties

• Over the past cou­ple of weeks, bonds have staged as investors reassessed the global growth out­look. That trend appears likely to con­tinue as long as China is com­fort­able with slower growth.

Threats

• Ris­ing oil and gaso­line prices com­bined with liq­uid­ity impli­ca­tions of global eas­ing, led by Europe, may raise the prospect of a reap­pear­ance of higher infla­tion going forward.

Tags: Austerity, Bond Market, Budget Situation, China, Contraction, Economic Data, Economic Expansion, European Concerns, Expansion Mode, Gasoline Prices, Global Growth, Government Bond, Growth Outlook, Initial Jobless Claims, Ism Index, Ism Manufacturing Index, Leading Indicator, Lows, Market Radar, Spanish Government, Treasury Yields
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The Economy and Bond Market Radar (April 2, 2012)

Sunday, April 1st, 2012

The Econ­omy and Bond Mar­ket Radar (April 2, 2012)

Time to Pay the Piper

If you haven’t filed your 2012 fed­eral income taxes yet, the clock is tick­ing. Begin­ning Mon­day, you will only have 11 busi­ness days to get them in by the fil­ing dead­line of April 17, 2012.

Like many nation­wide debates, Amer­i­cans are nearly split down the mid­dle when it comes to taxes. Recent data from Gallup shows 50 per­cent of Amer­i­cans believe fed­eral taxes are too high while 43 per­cent believe they’re about right. Note: the responses are “about right” and “too high;” I don’t believe there are many in the “should be higher” camp. How­ever, after 11 years of the Bush Tax Cuts, it looks like America’s tax rate struc­ture will shift upwards next year. Five of the six tax brack­ets will increase with the largest earn­ers pay­ing nearly 40, up from 35 per­cent currently.

One way investors can off­set higher tax rates is through munic­i­pal bonds. In gen­eral, inter­est gen­er­ated from munic­i­pal bonds is exempt from all fed­eral income taxes and some state and local taxes (depend­ing on your state).

While munic­i­pal bonds carry a greater amount of risk than Trea­sury bonds, tax advan­tages and higher yields make them extremely attrac­tive to Trea­suries on a rel­a­tive basis. The yield on gov­ern­ment debt is cur­rently in the dol­drums just above 3 per­cent while the yield on the Bond Buyer 40 Index of munis is above 4 percent.

This gap gets even greater when you con­sider tax exempt income. The tax equiv­a­lent yield on a tax­able invest­ment (such as U.S. Trea­suries) would need to be more than 6.5 per­cent in order to out­pace the muni bond index cited above. This means the yield on U.S. Trea­suries needs to roughly dou­ble from its cur­rent level in order to be attrac­tive to munis on a rel­a­tive basis.

If you’re one of those investors writ­ing Uncle Sam a big check this year, you should con­sider adding tax-free bond funds to your port­fo­lio. Explore our Near-Term Tax Free Fund (NEARX) and Tax Free Fund (USUTX).  How­ever, invest­ments and tax plan­ning is com­pli­cated and each investor’s sit­u­a­tion is unique—you should con­sult a tax advi­sor to deter­mine whether or not muni bonds are right for you.

This infor­ma­tion does not con­sti­tute tax advice and is pro­vided for infor­ma­tional pur­poses only. Please con­sider speak­ing with a legal or a tax adviser regard­ing your indi­vid­ual sit­u­a­tion.

Strengths

• Feb­ru­ary durable goods orders in the U.S. rose 2.2 per­cent, bounc­ing back after a weak January.
• Ger­man unem­ploy­ment fell to 6.7 per­cent in March and to the low­est level since reuni­fi­ca­tion in 1990.
• Japan­ese retail sales rose 3.5 per­cent in Feb­ru­ary, well ahead of expec­ta­tions and the best growth since August 2010.

Weak­nesses

• With ris­ing gas prices lift­ing infla­tion con­cerns and drag­ging down future expec­ta­tions, the Con­sumer Con­fi­dence Index fell in March.
• Pend­ing home sales were expected to increase in Feb­ru­ary but data released this week showed a decline.
• Ini­tial job­less claims edged higher this week but noth­ing too con­cern­ing just yet.

Oppor­tu­ni­ties

• Bonds have staged a rally the past cou­ple of weeks as investors reassessed the global growth out­look. As long as China is com­fort­able with slower growth, that trend appears likely to continue.

Threats

• Ris­ing oil and gaso­line prices com­bined with liq­uid­ity impli­ca­tions of global eas­ing may raise the prospect of reap­pear­ance of higher infla­tion going forward.

Tags: Bond Buyer, Bond Funds, Bond Index, Bond Market, Doldrums, Federal Income Taxes, Federal Taxes, Government Debt, Market Radar, Muni Bond, Municipal Bonds, Munis, Relative Basis, Tax Brackets, Tax Equivalent Yield, Tax Free Bond, Tax Rate Structure, Taxable Investment, Time To Pay The Piper, Treasury Bonds
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Overcoming Objections to Equities (Doll)

Tuesday, March 27th, 2012

March 27, 2012

Ris­ing Bond Yields: A Concern?

Stocks sank last week, but the focus for investors has been on devel­op­ments in the bond mar­ket. Within equi­ties, the Dow Jones Indus­trial Aver­age lost 1.2% to 13,080 and the S&P 500 Index declined 0.5% to 1,397, while the Nas­daq Com­pos­ite man­aged to post a 0.4% gain to 3,067.

The yield on the bench­mark 10-year Trea­sury had been trad­ing at around the 2.0% level for a period of sev­eral months before mov­ing sharply higher in recent weeks. The yield rose to above 2.35% last week before set­tling at around 2.25% by the end of the week (bond prices move inversely to yields). The sell­off in bonds has caused some to won­der whether we are at the fore­front of a bond bear mar­ket. Addi­tion­ally, it raises ques­tions about what yield move­ments mean for the stock market.

First, as we indi­cated last week, we would not be sur­prised to see addi­tional upward moves in yields, at least in the short term. Eco­nomic news has been rel­a­tively good over the past few months and as long as that trend con­tin­ues, yields should retain an upward bias. This is not to say, how­ever, that a bond bear mar­ket is upon us. Typ­i­cally, bond bear mar­kets hap­pen dur­ing peri­ods of inter­est rate pol­icy tight­en­ing. While the Fed­eral Reserve has indi­cated that eco­nomic trends have been improv­ing, there is almost no evi­dence to sug­gest that the United States is enter­ing into an infla­tion­ary envi­ron­ment, and the cen­tral bank has main­tained its for­ward guid­ance that short-term inter­est rates are set to remain low for some time.

Addi­tion­ally, we do not believe that higher bond yields by them­selves will act as an imped­i­ment to the stock mar­ket. While it is true that any sharp and sud­den moves in yields have the poten­tial to unnerve investors, such effects are likely to be tem­po­rary. Over the longer term, we do not believe that mod­estly higher yields should be a source of con­cern for stocks, espe­cially since we believe that the rise in yields is com­ing as a result of improved eco­nomic conditions.

Eco­nomic Trends Remain Mar­ket Friendly

So what are some of the improved eco­nomic con­di­tions that have been push­ing yields higher? We have devoted quite a bit of space in recent weeks to dis­cussing the improve­ments in the labor mar­ket, and while jobs growth is cer­tainly among the most impor­tant eco­nomic indi­ca­tors, there are other fac­tors that have been show­ing signs of improve­ment as well.

Debt delever­ag­ing remains a source of con­cern, but we have been see­ing progress on that front. Indi­vid­u­als have been pay­ing down their debt over the past few years and house­hold debt lev­els have been falling notice­ably. Sim­i­larly, the hous­ing mar­ket has long been a sig­nif­i­cant source of weak­ness, but that sec­tor of the econ­omy does appear to be in the midst of a long-term bot­tom­ing process and may be enter­ing into some sort of recovery.

An addi­tional issue on the minds of many investors is the US fis­cal sit­u­a­tion. The end of this year marks sev­eral impor­tant dead­lines, includ­ing the sched­uled expi­ra­tion of the Bush-era tax cuts and tem­po­rary incen­tive mea­sures as well as the begin­ning of sched­uled spend­ing cuts. Fore­cast­ing exactly what will hap­pen on the fis­cal front is com­pli­cated due to this November's elec­tions, but our guess is that there is prob­a­bly a 50% chance (maybe mar­gin­ally higher) that some sort of tax com­pro­mise is enacted either later this year or early next year. The like­li­hood of a bipar­ti­san com­pro­mise on enti­tle­ment reform would be less likely.

Look­ing Past Down­side Mar­ket Risks

There are a num­ber of angles that could be taken if one wanted to empha­size poten­tial down­side mar­ket risks. In addi­tion to con­cerns over ris­ing yields, we could point to eco­nomic and debt prob­lems in Europe, con­cerns over growth in China, rel­a­tively mod­est lev­els of global eco­nomic growth, weak­en­ing trends in cor­po­rate prof­its and esca­lat­ing geopo­lit­i­cal ten­sion in the Mid­dle East.

While all of these con­cerns are real, we would argue that the cur­rent strong run for equi­ties has mostly been a result of macro risks reced­ing. We argued at the begin­ning of the year that as long as fun­da­men­tals were at least decent, that should be good enough for risk assets. We never believed that solid mar­ket per­for­mance would require a sig­nif­i­cant turn­around in global eco­nomic growth con­di­tions and a con­tin­ued envi­ron­ment of mod­estly pos­i­tive fun­da­men­tals should remain a market-friendly one.

In our view, stocks still remain attrac­tively val­ued and the mar­ket is still dis­count­ing a more neg­a­tive envi­ron­ment than what we expect. Cor­po­ra­tions remain flush with cash and are poised to engage in a num­ber of shareholder-friendly activ­i­ties. From an indi­vid­ual investor per­spec­tive, a large num­ber of peo­ple are still under­weight stocks and we have yet to see sig­nif­i­cant moves into equity mutual funds. As such, we believe we have not yet seen the end of the market's upward moves.

About Bob Doll

Bob Doll is Chief Equity Strate­gist for Fun­da­men­tal Equi­ties at Black­Rock^® a pre­mier provider of global invest­ment man­age­ment, risk man­age­ment and advi­sory ser­vices. Mr. Doll is also Lead Port­fo­lio Man­ager of BlackRock's Large Cap Series Funds. Prior to join­ing the firm, Mr. Doll was Pres­i­dent and Chief Invest­ment Offi­cer at Mer­rill Lynch Invest­ment Managers.

You should con­sider the invest­ment objec­tives, risks, charges and expenses of any fund care­fully before invest­ing. The funds' prospec­tuses and, if avail­able, the sum­mary prospec­tuses con­tain this and other infor­ma­tion about the funds, and are avail­able, along with infor­ma­tion on other Black­Rock funds by call­ing 800–882-0052. The prospec­tus and, if avail­able, the sum­mary prospec­tuses should be read care­fully before investing.

The infor­ma­tion on this web site is intended for U.S. res­i­dents only. The infor­ma­tion pro­vided does not con­sti­tute a solic­i­ta­tion of an offer to buy, or an offer to sell secu­ri­ties in any juris­dic­tion to any per­son to whom it is not law­ful to make such an offer.

Sources: Black­Rock, Bank Credit Ana­lyst. This mate­r­ial is not intended to be relied upon as a fore­cast, research or invest­ment advice, and is not a rec­om­men­da­tion, offer or solic­i­ta­tion to buy or sell any secu­ri­ties or to adopt any invest­ment strat­egy. The opin­ions expressed are as of March 26, 2012, and may change as sub­se­quent con­di­tions vary. The infor­ma­tion and opin­ions con­tained in this mate­r­ial are derived from pro­pri­etary and non­pro­pri­etary sources deemed by Black­Rock to be reli­able, are not nec­es­sar­ily all-inclusive and are not guar­an­teed as to accu­racy. Past per­for­mance is no guar­an­tee of future results. There is no guar­an­tee that any fore­casts made will come to pass. Reliance upon infor­ma­tion in this mate­r­ial is at the sole dis­cre­tion of the reader. Invest­ment involves risks. Inter­na­tional invest­ing involves addi­tional risks, includ­ing risks related to for­eign cur­rency, lim­ited liq­uid­ity, less gov­ern­ment reg­u­la­tion and the pos­si­bil­ity of sub­stan­tial volatil­ity due to adverse polit­i­cal, eco­nomic or other devel­op­ments. The two main risks related to fixed income invest­ing are inter­est rate risk and credit risk. Typ­i­cally, when inter­est rates rise, there is a cor­re­spond­ing decline in the mar­ket value of bonds. Credit risk refers to the pos­si­bil­ity that the issuer of the bond will not be able to make prin­ci­pal and inter­est pay­ments. Index per­for­mance is shown for illus­tra­tive pur­poses only. You can­not invest directly in an index.

Black­Rock is a reg­is­tered trade­mark of Black­Rock, Inc. All other trade­marks are the prop­erty of their respec­tive owners.

Pre­pared by Black­Rock Invest­ments, LLC, mem­ber FINRA.
NOT FDIC INSURED / MAY LOSE VALUE / NO BANK GUARANTEE

Tags: 10 Year Treasury, Bear Market, Bear Markets, Bond Market, Bond Prices, Bond Yields, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Economic News, Economic Trends, Impediment, Inflationary Environment, Interest Rate Policy, Nasdaq Composite, Overcoming Objections, Selloff, Sudden Moves, Term Interest, Upward Bias
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Bill Gross: Investment Outlook (April 2012)

Tuesday, March 27th, 2012

The Great Escape:
Deliv­er­ing in a Delev­er­ing World

by William H. Gross, PIMCO

April 2012

• When inter­est rates can­not be dra­mat­i­cally low­ered fur­ther or risk spreads sig­nif­i­cantly com­pressed, the momen­tum begins to shift, not nec­es­sar­ily sud­denly, but grad­u­ally – yields mov­ing mildly higher and spreads sta­bi­liz­ing or mov­ing slightly wider.
• In such a mildly reflat­ing world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Trea­sury bills, then you must take risk in some form.
• We favor high qual­ity, shorter dura­tion and inflation-protected bonds; div­i­dend pay­ing stocks with a pref­er­ence for devel­op­ing over devel­oped mar­kets; and inflation-sensitive, supply-constrained com­mod­ity products.

About six months ago, I only half in jest told Mohamed that my tomb­stone would read, “Bill Gross, RIP, He didn’t own ‘Trea­suries’.” Now, of course, the days are get­ting longer and as they say in golf, it is bet­ter to be above – as opposed to below – the grass. And it is bet­ter as well, to be deliv­er­ing alpha as opposed to delev­er­ing in the bond mar­ket or global econ­omy. The best way to visu­al­ize suc­cess­ful deliv­er­ing is to rec­og­nize that investors are locked up in a finan­cially repres­sive envi­ron­ment that reduces future returns for all finan­cial assets. Break­ing out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.

The term delev­er­ing implies a period of prior lever­age, and lever­age there has been. Whether you date it from the begin­ning of frac­tional reserve and cen­tral bank­ing in the early 20th cen­tury, the debase­ment of gold in the 1930s, or the ini­ti­a­tion of Bret­ton Woods and the coör­di­nated dol­lar and gold stan­dard that fol­lowed for nearly three decades after WWII, the trend towards finan­cial lever­age has been ever upward. The aban­don­ment of gold and embrace­ment of dol­lar based credit by Nixon in the early 1970s was cer­tainly a lever­ag­ing land­mark as was the dereg­u­la­tion of Glass-Steagall by a Demo­c­ra­tic Clin­ton admin­is­tra­tion in the late 1990s, and else­where glob­ally. And almost always, the pri­vate sec­tor was more than will­ing to play the game, invent­ing new forms of credit, loosely known as deriv­a­tives, which avoided the con­cept of con­ser­v­a­tive reserve bank­ing alto­gether. Although there were acci­dents along the way such as the S&L cri­sis, Con­ti­nen­tal Bank, LTCM, Mex­ico, Asia in the late 1990s, the Dot-coms, and ulti­mately global sub­prime own­er­ship, finan­cial insti­tu­tions and mar­ket par­tic­i­pants learned that pol­i­cy­mak­ers would sup­port the sys­tem, and most indi­vid­ual par­tic­i­pants, by extend­ing credit, low­er­ing inter­est rates, expand­ing deficits, and dereg­u­lat­ing in order to keep economies tick­ing. Impor­tantly, this com­bined fis­cal and mon­e­tary lever­age pro­duced out­sized returns that exceeded the abil­ity of real economies to cre­ate wealth. Stocks for the Long Run was the almost uni­ver­sally accepted mantra, but it was really a period – for most of the last half cen­tury – of “Finan­cial Assets for the Long Run” – and your house was included by the way in that cat­e­gory of finan­cial assets even though it was just a pile of sticks and stones. If it always went up in price and you could bor­row against it, it was a finan­cial asset. Secu­ri­ti­za­tion ruled supreme, if not subprime.

As nom­i­nal and real inter­est rates came down, down, down and credit spreads were com­pressed through pol­icy sup­port and secu­ri­ti­za­tion, then asset prices mag­i­cally ascended. PE ratios rose, bond prices for 30-year Trea­suries dou­bled, real estate thrived, and any­thing that could be lev­ered did well because the global econ­omy and its finan­cial mar­kets were being lev­ered and lev­ered consistently.

And then sud­denly in 2008, it stopped and reversed. Lever­age appeared to reach its lim­its with sub­primes, and then with banks and invest­ment banks, and then with coun­tries them­selves. The game as we all have known it appears to be over, or at least sub­stan­tially changed – mov­ing for the moment from pri­vate to pub­lic bal­ance sheets, but even there fac­ing investor and polit­i­cal lim­its. Actu­ally global finan­cial mar­kets are only selec­tively delev­er­ing. What delev­er­ing there is, is most vis­i­ble with house­hold bal­ance sheets in the U.S. and Euroland periph­eral sov­er­eigns like Greece. The delev­er­ing is also rel­a­tively hid­den in the recap­i­tal­iza­tion of banks and their looka­likes. Increas­ing cap­i­tal, in addi­tion to hair­cut­ting and defaults are a form of delever­ag­ing that is long term healthy, if short term growth restric­tive. On the whole, how­ever, because of mas­sive QEs and LTROS in the tril­lions of dol­lars, our credit based, lever­age depen­dent finan­cial sys­tem is actu­ally lever­age expand­ing, although only mildly and sys­tem­i­cally less threat­en­ing than before, at least from the stand­point of a growth rate. The total amount of debt how­ever is daunt­ing and con­tin­ued credit expan­sion will pro­duce accel­er­at­ing global infla­tion and slower growth in PIMCO’s most likely outcome.

How do we deliver in this New Nor­mal world that levers much more slowly in total, and can delever sharply in selec­tive sec­tors and coun­tries? Look at it this way rather sim­plis­ti­cally. Dur­ing the Great Lever­ag­ing of the past 30 years, it was finan­cial assets with their expected future cash flows that did the best. The longer the stream of future cash flows and the riskier/more lev­ered those flows, then the bet­ter they did. That is because, as I’ve just his­tor­i­cally out­lined, future cash flows are dis­counted by an inter­est rate and a risk spread, and as yields came down and spreads com­pressed, the greater return came from the longest and most lev­ered assets. This was a world not of yield, but of total return, where price and yield formed the returns that exceeded the abil­ity of global economies to con­sis­tently repli­cate them. Finan­cial assets rel­a­tive to real assets out­per­form in such a world as wealth is brought for­ward and stolen from future years if real growth can­not repli­cate his­tor­i­cal total returns.

To put it even more sim­ply, finan­cial assets with long inter­est rate and spread dura­tions were win­ners: long matu­rity bonds, stocks, real estate with rental streams and cap rates that could be com­pressed. Com­modi­ties were on the rel­a­tive los­ing end although infla­tion took them up as well. That’s not to say that an oil com­pany with reserves in the ground didn’t do well, but the oil for imme­di­ate deliv­ery that couldn’t ben­e­fit from an expan­sion of P/Es and a com­pres­sion of risk spreads – well, not so well. And so com­modi­ties lagged finan­cial asset returns. Our num­bers show 1, 5 and 20-year his­to­ries of finan­cial assets out­per­form­ing com­modi­ties by 15% for the most recent 12 months and 2% annu­ally for the past 20 years.

This out­per­for­mance by finan­cial as opposed to real assets is a result of the long jour­ney and ulti­mate des­ti­na­tion of credit expan­sion that I’ve just out­lined, result­ing in neg­a­tive real inter­est rates and nar­row credit and equity risk pre­mi­ums; a state of finan­cial repres­sion as it has come to be known, that promises to be with us for years to come. It reminds me of an old movie star­ing Steve McQueen called The Great Escape where Amer­i­can pris­on­ers of war were con­fined to a POW camp inside Ger­many in 1943. The liv­ing con­di­tions were OK, much like today’s finan­cial mar­kets, but cer­tainly not what they were used to on the other side of the lines so to speak. Yet it was their duty as British and Amer­i­can offi­cers to try to escape and get back to the old nor­mal. They inge­niously dug escape tun­nels and even­tu­ally escaped. It was a real life story in addi­tion to its Hol­ly­wood fla­vor. Sim­i­larly though it is your duty to try to escape today’s repres­sion. Your liv­ing con­di­tions are OK for now – the food and in this case the returns are good – but they aren’t enough to get you what you need to cover lia­bil­i­ties. You need to think of an escape route that gets you back home yet at the same time doesn’t get you killed in the process. You need a Great Escape to deliver in this finan­cial repres­sive world.

What hap­pens when we flip the sce­nario or per­haps reach the point at which inter­est rates can­not be dra­mat­i­cally low­ered fur­ther or risk spreads sig­nif­i­cantly com­pressed? The momen­tum we would sug­gest begins to shift: not nec­es­sar­ily sud­denly or swiftly as fat­ter tail bimodal dis­tri­b­u­tions might warn, but grad­u­ally – yields mov­ing mildly higher, spreads sta­bi­liz­ing or mov­ing slightly wider. In such a mildly reflat­ing world where infla­tion itself remains above 2% and in most cases moves higher, deliv­er­ing double-digit or even 7–8% total returns from bonds, stocks and real estate becomes prob­lem­atic and cer­tainly much more dif­fi­cult. Real growth as opposed to finan­cial wiz­ardry becomes pre­dom­i­nant, yet that growth is stressed by exces­sive fis­cal deficits and high debt/GDP lev­els. Com­modi­ties and real assets become ascen­dant, cer­tainly in rel­a­tive terms, as we by neces­sity delever or lever less. As well, finan­cial assets can­not be ele­vated by zero based inter­est rate or other tried but now tired pol­icy maneu­vers that bring future wealth for­ward. Cur­rent prices in other words have squeezed all of the risk and inter­est rate pre­mi­ums from future cash flows, and now finan­cial mar­kets are left with real growth, which itself expe­ri­ences a slower new nor­mal because of less finan­cial leverage.

That is not to say that infla­tion can­not con­tinue to ele­vate finan­cial assets which can adjust to infla­tion over time – stocks being the prime exam­ple. They can, and there will be rel­a­tive win­ners in this con­text, but the abil­ity of an investor to earn returns well in excess of infla­tion or well in excess of nom­i­nal GDP is lim­ited. Total return as a super­charged bond strat­egy is fad­ing. Stocks with a 6.6% real Jeremy Siegel con­stant are fad­ing. Lev­ered hedge strate­gies based on spread and yield com­pres­sion are fad­ing. As we delever, it will be hard to deliver what you have been used to.

Still there is a place for all stan­dard asset classes even though betas will be lower. Should you desert bonds sim­ply because they may return 4% as opposed to 10%? I hope not. PIMCO’s poten­tial alpha gen­er­a­tion and the sta­bil­ity of bonds remain crit­i­cal com­po­nents of an invest­ment portfolio.

In sum­mary, what has the poten­tial to deliver the most return with the least amount of risk and high­est infor­ma­tion ratios? Log­i­cally, (1) Real as opposed to finan­cial assets – com­modi­ties, land, build­ings, machines, and knowl­edge inher­ent in an edu­cated labor force. (2) Finan­cial assets with shorter spread and inter­est rate dura­tions because they are more defen­sive. (3) Finan­cial assets for enti­ties with rel­a­tively strong bal­ance sheets that are exposed to higher real growth, for which devel­op­ing vs. devel­oped nations should dom­i­nate. (4) Finan­cial or real assets that ben­e­fit from favor­able pol­icy thrusts from both mon­e­tary and fis­cal author­i­ties. (5) Finan­cial or real assets which are not bur­dened by exces­sive debt and sub­ject to future haircuts.

In plain speak –

For bond mar­kets: favor higher qual­ity, shorter dura­tion and infla­tion pro­tected assets.

For stocks: favor devel­op­ing vs. devel­oped. Favor shorter dura­tions here too, which means con­sis­tent div­i­dend pay­ing as opposed to growth stocks.

For com­modi­ties: favor infla­tion sen­si­tive, sup­ply con­strained products.

And for all asset cat­e­gories, be wary of lev­ered hedge strate­gies that promise double-digit returns that are dif­fi­cult in a delev­er­ing world.

With regard to all of these broad asset cat­e­gories, an investor in finan­cial mar­kets should not go too far on this defen­sive, as opposed to offen­sively ori­ented sce­nario. Unless you want to earn an infla­tion adjusted return of minus 2–3% as offered by Trea­sury bills, then you must take risk in some form. You must try to max­i­mize risk adjusted carry – what we call “safe spread.”

“Safe carry” is an essen­tial ele­ment of cap­i­tal­ism – that is investors earn­ing some­thing more than a Trea­sury bill. If and when we can­not, then the sys­tem implodes – espe­cially one with exces­sive lever­age. Paul Vol­cker suc­cess­fully redi­rected the U.S. econ­omy from 1979–1981 dur­ing which investors earned less return than a Trea­sury bill, but that could only go on for sev­eral years and occurred in a much less lev­ered finan­cial sys­tem. Vol­cker had it eas­ier than Bernanke/King/Draghi have it today. Is a sys­temic implo­sion still pos­si­ble in 2012 as opposed to 2008? It is, but we will likely face much more mon­e­tary and credit infla­tion before the bal­loon pops. Until then, you should bud­get for “safe carry” to help pay your bills. The bunker port­fo­lio lies fur­ther ahead.

Two addi­tional con­sid­er­a­tions. In a highly lev­ered world, grad­ual rever­sals are not nec­es­sar­ily the high prob­a­ble out­come that a nor­mal bell-shaped curve would sug­gest. Pol­icy mis­takes – too much money cre­ation, too much fis­cal belt-tightening, geopo­lit­i­cal con­flicts and war, geopo­lit­i­cal dis­agree­ments and dis­in­te­gra­tion of mon­e­tary and fis­cal unions – all of these and more lead to poten­tial bimodal dis­tri­b­u­tions – fat left and right tail out­comes that can inflate or deflate asset mar­kets and real eco­nomic growth. If you are a ratio­nal investor you should con­sider hedg­ing our most prob­a­ble inflationary/low growth out­come – what we call a “C-“ sce­nario – by buy­ing hedges for fat­ter tailed pos­si­bil­i­ties. It will cost you some­thing – and hedg­ing in a low return world is harder to buy than when the cot­ton is high and the liv­ing is easy. But you should do it in amounts that hedge against prin­ci­pal down­sides and allow for prin­ci­pal upsides in bimodal out­comes, the lat­ter per­haps being epit­o­mized by equity mar­kets 10–15% returns in the first 80 days of 2012.

And sec­ondly, be mind­ful of invest­ment man­age­ment expenses. Whoops, I’m not sup­posed to say that, but I will. Be sure you’re get­ting value for your expense dol­lars. We of course – per­haps like many other firms would say, “We’re Num­ber One.” Not always, not for me in the sum­mer of 2011, but over the past 1, 5, 10, 25 years? Yes, we are cer­tainly a #1 seed – with aspi­ra­tions as always to be your #1 Champion.

William H. Gross
Man­ag­ing Director

“Safe Spread” also known as “Safe Carry” is defined as sec­tors that we believe are most likely to with­stand the vicis­si­tudes of a wide range of pos­si­ble eco­nomic sce­nar­ios. All invest­ments con­tain risk and may lose value.
Past per­for­mance is not a guar­an­tee or a reli­able indi­ca­tor of future results. Invest­ing in the bond mar­ket is sub­ject to cer­tain risks includ­ing mar­ket, interest-rate, issuer, credit, and infla­tion risk. Equi­ties may decline in value due to both real and per­ceived gen­eral mar­ket, eco­nomic, and indus­try con­di­tions. Com­modi­ties con­tain height­ened risk includ­ing mar­ket, polit­i­cal, reg­u­la­tory, and nat­ural con­di­tions, and may not be suit­able for all investors. Invest­ing in for­eign denom­i­nated and/or domi­ciled secu­ri­ties may involve height­ened risk due to cur­rency fluc­tu­a­tions, and eco­nomic and polit­i­cal risks, which may be enhanced in emerg­ing mar­kets. Sov­er­eign secu­ri­ties are gen­er­ally backed by the issu­ing gov­ern­ment, oblig­a­tions of U.S. Gov­ern­ment agen­cies and author­i­ties are sup­ported by vary­ing degrees but are gen­er­ally not backed by the full faith of the U.S. Gov­ern­ment; port­fo­lios that invest in such secu­ri­ties are not guar­an­teed and will fluc­tu­ate in value. Inflation-linked bonds (ILBs) issued by a gov­ern­ment are fixed-income secu­ri­ties whose prin­ci­pal value is peri­od­i­cally adjusted accord­ing to the rate of infla­tion; ILBs decline in value when real inter­est rates rise. Tail risk hedg­ing may involve enter­ing into finan­cial deriv­a­tives that are expected to increase in value dur­ing the occur­rence of tail events. Invest­ing in a tail event instru­ment could lose all or a por­tion of its value even in a period of severe mar­ket stress. A tail event is unpre­dictable; there­fore, invest­ments in instru­ments tied to the occur­rence of a tail event are spec­u­la­tive. Deriv­a­tives may involve cer­tain costs and risks such as liq­uid­ity, inter­est rate, mar­ket, credit, man­age­ment and the risk that a posi­tion could not be closed when most advan­ta­geous. Invest­ing in deriv­a­tives could lose more than the amount invested. There is no guar­an­tee that these invest­ment strate­gies will work under all mar­ket con­di­tions or are suit­able for all investors and each investor should eval­u­ate their abil­ity to invest long-term, espe­cially dur­ing peri­ods of down­turn in the mar­ket. An investor should con­sult their finan­cial advi­sor prior to mak­ing an invest­ment decision.

This mate­r­ial con­tains the cur­rent opin­ions of the author but not nec­es­sar­ily those of PIMCO and such opin­ions are sub­ject to change with­out notice. This mate­r­ial is dis­trib­uted for infor­ma­tional pur­poses only. Fore­casts, esti­mates, and cer­tain infor­ma­tion con­tained herein are based upon pro­pri­etary research and should not be con­sid­ered as invest­ment advice or a rec­om­men­da­tion of any par­tic­u­lar secu­rity, strat­egy or invest­ment prod­uct. Infor­ma­tion con­tained herein has been obtained from sources believed to be reli­able, but not guar­an­teed. No part of this arti­cle may be repro­duced in any form, or referred to in any other pub­li­ca­tion, with­out express writ­ten per­mis­sion of Pacific Invest­ment Man­age­ment Com­pany LLC. ©2012, PIMCO.

Tags: Bill Gross, Bond Market, Bretton Woods, Central Banking, Commodities, Commodity, Commodity Products, Debasement, Dividend Paying Stocks, Financial Assets, Financial Leverage, Future Returns, Global Economy, Gold Standard, Great Escape, Gross Investment, Inflation Protected Bonds, Investment Outlook, PIMCO, Three Decades, Treasury Bills, William H Gross
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The Economy and Bond Market Radar (March 26, 2012)

Sunday, March 25th, 2012

The Econ­omy and Bond Mar­ket Radar (March 26, 2012)

Trea­sury yields reversed course this week and headed lower as con­cerns sur­round­ing a slow­down in China inten­si­fied. A com­bi­na­tion of weaker fac­tory data out of China and talk of slower steel and iron ore demand from China by global min­ing giant BHP Bil­li­ton was a cat­a­lyst for investors to rethink last week’s move in trea­sury yields.

Strengths

• Ini­tial job­less claims con­tinue to improve, hit­ting the low­est level since March 2008.
• Infla­tion data in China, Brazil and the U.K. all indi­cated a slow­ing trend this week.
• The Con­fer­ence Board’s Lead­ing Indi­ca­tor Index con­tin­ues to grind higher for the fifth month in a row.

Weak­nesses

• The HSBC Flash China Man­u­fac­tur­ing Pur­chas­ing Man­agers’ Index (PMI) fell to 48.1, con­firm­ing other recent weak data and com­ments by gov­ern­ment officials.
• Signs of weak­ness in the auto area are start­ing to build as gaso­line demand fell 7 per­cent and some indi­ca­tors are point­ing to a slow­down in auto sales.
• FedEx announced earn­ings this week and low­ered its global growth forecast.

Oppor­tu­ni­ties

• Should a growth scare resur­face due to the lack of an announce­ment of fur­ther quan­ti­ta­tive eas­ing from the Fed­eral Reserve, bonds may rally again as investors flee to safety, sim­i­lar to what hap­pened in mid-2010 and mid-2011 when the QE1 and QE2 pro­grams ended.

Threats

• Ris­ing oil and gaso­line prices com­bined with liq­uid­ity impli­ca­tions of global eas­ing, led by Europe, may raise the prospect of the reap­pear­ance of higher infla­tion going forward.

Tags: Auto Sales, Bhp Billiton, Bond Market, Brazil, China Manufacturing, Fedex, Gasoline Prices, Giant Bhp, Global Growth, Inflation Data, Initial Jobless Claims, Iron Ore, Leading Indicator, liquidity, Market Radar, Pmi, Purchasing Managers Index, Qe1, Qe2, Slowdown, Treasury Yields
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Falling Treasuries: A Currency Perspective (Merk)

Wednesday, March 21st, 2012

Axel Merk, Merk Funds

March 20, 2012

What are the impli­ca­tions for the U.S. dol­lar and investors’ port­fo­lios if bond prices con­tinue to fall, as they have of late? Within that con­text, should investors care whether the U.S. retains its sta­tus as a “reserve cur­rency”? Should it effect the way investors think about their own cash reserves?

Until the end of last year, China had been a net seller of U.S. Trea­suries for six con­sec­u­tive months, spook­ing some investors that China might start to diver­sify its reserves in earnest. That trend was reversed in Jan­u­ary, when its Trea­sury hold­ings grew by 0.7% in one month to $1.159 tril­lion; year-on-year, China’s hold­ings increased a mere $4.8 bil­lion. China’s year-on-year increase in Trea­sury hold­ings is suf­fi­cient to finance the U.S. cur­rent account deficit for about 3 busi­ness days; that’s a good rea­son why investors should care, as the cur­rent account deficit reflects the amount of U.S. dol­lar denom­i­nated assets for­eign­ers need to buy just to keep the green­back from falling.

Whereas China has taken a breather with regard to pil­ing on U.S. debt, Japan has increased its pur­chases of Trea­suries, pos­si­bly because it is eager to weaken its own cur­rency. Japan’s Trea­sury hold­ings now stand at $1.1 tril­lion. Together, total for­eign hold­ings of U.S. Trea­suries rose 0.9% to a record $5.05 tril­lion in January.

Unfor­tu­nately, for­eign­ers might be attracted to the U.S. dol­lar more for liq­uid­ity and less so for qual­ity con­sid­er­a­tions. Cen­tral banks with bil­lions to deploy are able to do so in U.S. Trea­sury mar­kets with­out influ­enc­ing mar­ket prices too much. Think of it as the upside of issu­ing a huge amount of debt: there’s lots of it one can buy and sell. Liq­uid­ity, how­ever, doesn’t guar­an­tee suc­cess, as the Ital­ian bond mar­ket has clearly shown; when weaker Euro­zone coun­tries are engulfed in a cri­sis of con­fi­dence, Ital­ian bonds have often been sold as a proxy due to the size and depth of the mar­ket. Japan rep­re­sents another large bond mar­ket. Still, the U.S. bond mar­ket dwarfs all of these. When it comes to per­ceived safe havens, Swiss gov­ern­ment bonds may be hard to come by at times; given the erratic actions of the Swiss National Bank in recent months and years, we have to cau­tion that even Switzer­land may not be the safe haven some per­ceive it to be. Mov­ing to Ger­many – con­sid­ered to be a large, mature mar­ket by many – note that even Ger­man Trea­sury bills have been extremely dif­fi­cult to obtain dur­ing stretches of the finan­cial cri­sis, even at neg­a­tive yields.

Indeed, one of the most pos­i­tive global devel­op­ments would be if emerg­ing mar­ket coun­tries develop their domes­tic fixed income mar­kets. If gov­ern­ments, par­tic­u­larly in Asia, were to issue more debt in their domes­tic cur­ren­cies, they would be less depen­dent on U.S. dol­lar fund­ing, reduc­ing the so-called con­ta­gion risk in a finan­cial cri­sis. Ide­ally, emerg­ing mar­kets would fur­ther develop both long-term bond mar­kets, as well as short-term Trea­sury mar­kets. The fol­low­ing exam­ple illus­trates how global mar­kets are so inter­re­lated, and why such a devel­op­ment is so impor­tant: cur­rently, a great deal of emerg­ing mar­ket financ­ing is U.S. dol­lar denom­i­nated, but orig­i­nates from Euro­pean banks. Those Euro­pean banks, with trou­ble at home, are cut­ting their credit lines, to both shrink their loan port­fo­lios, but also as their cost of bor­row­ing U.S. dol­lars soared. That’s because Euro­pean banks his­tor­i­cally obtain much of their U.S. dol­lar financ­ing through U.S. money mar­ket funds. On aver­age, U.S. prime money mar­ket funds held about 50% of their assets in U.S. dol­lar denom­i­nated com­mer­cial paper issued by Euro­pean banks. After lots of pub­lic scrutiny, includ­ing from us (see: Mak­ing the U.S. Dol­lar Safer: Return OF Your Money), those hold­ings fell to about 1/3rd of money mar­ket fund assets in late 2011. As U.S. money mar­ket funds reduced their appetite for debt issued by Euro­pean banks, the Fed­eral Reserve (Fed), in con­junc­tion with other major cen­tral banks, put in place “cen­tral bank liq­uid­ity swaps”, a fancy way of describ­ing U.S. dol­lar loans extended by the Fed to the Euro­pean bank­ing sys­tem via the Euro­pean Cen­tral Bank (ECB) to alle­vi­ate U.S. dol­lar financ­ing con­cerns and ulti­mately, con­ta­gion risks to the global economy.

A key attribute of liq­uid­ity is the abil­ity to take money out of a coun­try. An investor will be more will­ing to invest in a coun­try when there are no cap­i­tal con­trols, when there’s con­fi­dence in the rule of law, con­fi­dence that investors’ rights are pro­tected. And while emerg­ing mar­kets are gen­er­ally on the right path, it’s a path that takes a long time to build, as investors’ trust must be earned over many years.

As such, odds are the reserve cur­rency sta­tus of the U.S. is likely to erode over time rather than overnight, if for no other rea­son than the lack of suit­able alter­na­tives. In our view, how­ever, U.S. pol­icy mak­ers would be well served if they attempted to make the U.S. dol­lar as attrac­tive as pos­si­ble, rather than rely­ing on the fact that for­eign­ers have lim­ited alter­na­tives. As recent years have shown, the Chi­nese, for exam­ple, have gained oper­a­tional expe­ri­ence in deploy­ing their reserves into assets out­side of U.S. Trea­suries, in real assets, through­out the world: notably by invest­ing in nat­ural resources in Aus­tralia, Africa, Latin Amer­ica and Canada.

For many years, until a month ago, the ECB, in its monthly com­mu­niqué, warned of a “poten­tial for a dis­or­derly cor­rec­tion of global imbal­ances.” That was cen­tral bank par­lance for a dol­lar crash. For what it’s worth, the warn­ing was miss­ing for the first time in years in this month’s state­ment.¹ Like the boy who cried wolf, when some­one warns about some­thing repeat­edly, few may take that risk seri­ously any­more. Is it com­pla­cency when one drops the warning?

What many don’t real­ize is that we don’t need a low prob­a­bil­ity / high-risk event – a “black swan” event – to be con­cerned. Take the recent tur­moil in the Trea­sury mar­ket: from the high on Feb­ru­ary 28, 2012 until the close on March 15, 2012, the U.S. 30 year bond had fallen about 8.5% in value (with declines con­tin­u­ing as of this writ­ing). Many have pre­vi­ously been chas­ing yields: a lot of money had moved into longer dated secu­ri­ties, the so-called long end of the yield curve. In that process, volatil­ity in that mar­ket had come down, pro­vid­ing the illu­sion of safety. We don’t need a crash, we need a return to a more nor­mal envi­ron­ment to have what may be a rude awak­en­ing for investors. The plunge in the 30-year bond in just over 2 weeks should serve as a wake-up call. It turns out that for­eign­ers appear to have piled into longer-dated Trea­suries just before the recent cor­rec­tion (net long-term TIC flows of $101 bil­lion in Jan­u­ary vs. $38.5 bil­lion expected), pos­si­bly mak­ing for a few very unhappy, but very impor­tant investors.

What is the rel­e­vance for the dol­lar? For­eign investors tend to own a large amount of Trea­suries. When Trea­suries fall in value, their invest­ments may go down, unless the dol­lar increases by the same amount. While some pun­dits – in an effort to com­ment on short-term cur­rency moves on any one day — point out that falling bond prices make the dol­lar more attrac­tive as yields are higher, that’s lit­tle con­sol­i­da­tion to those already hold­ing Trea­suries. Indeed, his­tor­i­cally speak­ing, our analy­sis indi­cates that the U.S. dol­lar tends to weaken dur­ing early and mid phases of an increas­ing inter­est rate cycle. That’s pre­cisely because the bond mar­ket turns into a bear mar­ket in such an envi­ron­ment. It’s in the late phases of a tight­en­ing cycle that for­eign­ers come back to the bond mar­ket, in antic­i­pa­tion that the next bull mar­ket for bonds is around the cor­ner; in that phase, the dol­lar may get a reprieve.

How­ever, when rates are ris­ing, investors may want to con­sider reduc­ing their inter­est risk, mov­ing from longer dated bond funds to shorter dated ones. Look­ing at it from an inter­na­tional per­spec­tive, the same rela­tion­ship applies; it should not be a sur­prise that the volatil­ity in shorter dated fixed income secu­ri­ties is less than that of longer dated ones:

Per­for­mance data in the chart above rep­re­sents past per­for­mance and is no guar­an­tee of future results.

For investors con­cerned about plung­ing bond prices, the obvi­ous move may be to trim inter­est risk. Some may appre­ci­ate the per­ceived safety of U.S. dol­lar cash, although, as our dis­cus­sion of U.S. money mar­ket funds above has shown, not all cash is equal. Investors con­cerned about the pur­chas­ing power of the U.S. dol­lar may want to con­sider mit­i­gat­ing the poten­tial risk of a declin­ing dol­lar by diver­si­fy­ing to other cur­ren­cies. Be warned, though, that cur­rency risk is then intro­duced. A money mar­ket fund will thrive to hold a sta­ble net asset value in U.S. dol­lar terms; a cur­rency fund will not. Indeed, much of invest­ing is about try­ing to pre­serve pur­chas­ing power. By mov­ing to cash in other cur­ren­cies, one does avoid equity risk, and pos­si­bly mit­i­gates inter­est and credit risk. But risk-free it is not. Indeed, we have argued for a long time that cen­tral banks may be erod­ing the pur­chas­ing power of cur­ren­cies around the world – risk free assets can no longer be thought of as such. It was in 2006 when I first said “there is no such thing any­more as a safe asset: investors may want to con­sider a diver­si­fied approach to some­thing as mun­dane as cash.”

Notes:

Please sign up for our newslet­ter to be informed as we dis­cuss global dynam­ics and their impact on currencies.We man­age the Merk Funds, includ­ing the Merk Hard Cur­rency Fund. To learn more about the Funds, please visit www.merkfunds.com.

¹For­mer ECB Pres­i­dent Willem Duisen­berg men­tioned "risks per­tain­ing to exter­nal imbal­ances" in the first time in March 1999. But he didn't ref­er­ence it again until 2002. (Instead, he men­tioned "there are no major imbal­ances in the euro area which would require a longer-term adjust­ment process" in 2001.) In May 2002, Duisen­berg brought up this topic again at the press con­fer­ence, say­ing "there are still a num­ber of uncer­tain­ties such as those related to ... and to the impact of exist­ing imbal­ances else­where on the world econ­omy". He used the sim­i­lar phras­ing in June, Octo­ber and Decem­ber 2002 but not every meeting.

It was Jan­u­ary 2003 that for the first time Duisen­berg ref­er­enced "a dis­or­derly adjust­ment of global imbal­ances" by say­ing "there are still risks relat­ing to a dis­or­derly adjust­ment of the past accu­mu­la­tion of macro­eco­nomic imbal­ances, espe­cially out­side the euro area." Then he reit­er­ated it a cou­ple of times dur­ing his remain­ing term as ECB pres­i­dent ended in Octo­ber 2003. A note here, cur­rent Greek PM and then ECB vice-president Lucas Papademos hosted the Sep­tem­ber con­fer­ence in 2003, where he also ref­er­enced "macro­eco­nomic imbal­ances in some regions of the world persist."

Since Trichet took office in Novem­ber 2003, it became almost a rou­tine to ref­er­ence "external/global imbal­ances" at the press con­fer­ences, though his word­ing changed over time. Dur­ing Novem­ber 2003 and June 2006, Trichet often used the word "per­sis­tent global imbal­ances" when talk­ing about con­cerns and risks to growth. Then he ref­er­enced "a dis­or­derly unwind­ing of global imbal­ances" for the first time in August 2006. He fre­quently used "pos­si­ble dis­or­derly devel­op­ments owing to global imbal­ances" dur­ing 2007–2008 and "adverse devel­op­ments in the world econ­omy stem­ming from a dis­or­derly cor­rec­tion of global imbal­ances" in 2009, and started to reg­u­larly ref­er­ence "con­cerns remain relat­ing to … and the pos­si­bil­ity of a dis­or­derly cor­rec­tion of global imbal­ances" since Sep­tem­ber 2009, through his last press con­fer­ence in Octo­ber 2011. Dur­ing his eight years in office, the only times he didn't men­tion "global imbal­ance" at all were August 2007, April 2005, and from Octo­ber 2004 to Jan­u­ary 2005.

Draghi con­tin­ued the tra­di­tion of ref­er­enc­ing "the pos­si­bil­ity of a dis­or­derly cor­rec­tion of global imbal­ances" in all of his press con­fer­ences from Novem­ber 2011 to Feb­ru­ary this year. The past meet­ing in March was the first time he didn't ref­er­ence it.

Axel Merk

Man­ager of the Merk Hard Cur­rency Fund, Asian Cur­rency Fund, Absolute Return Cur­rency Fund, and Cur­rency Enhanced U.S. Equity Fund, www.merkfunds.com

Axel Merk, Pres­i­dent & CIO of Merk Invest­ments, LLC, is an expert on hard money, macro trends and inter­na­tional invest­ing. He is con­sid­ered an author­ity on currencies.

The Merk Hard Cur­rency Fund (MERKX) seeks to profit from a rise in hard cur­ren­cies ver­sus the U.S. dol­lar. Hard cur­ren­cies are cur­ren­cies backed by sound mon­e­tary pol­icy; sound mon­e­tary pol­icy focuses on price stability.

The Merk Asian Cur­rency Fund (MEAFX) seeks to profit from a rise in Asian cur­ren­cies ver­sus the U.S. dol­lar. The Fund typ­i­cally invests in a bas­ket of Asian cur­ren­cies that may include, but are not lim­ited to, the cur­ren­cies of China, Hong Kong, Japan, India, Indone­sia, Malaysia, the Philip­pines, Sin­ga­pore, South Korea, Tai­wan and Thailand.

The Merk Absolute Return Cur­rency Fund (MABFX) seeks to gen­er­ate pos­i­tive absolute returns by invest­ing in cur­ren­cies. The Fund is a pure-play on cur­ren­cies, aim­ing to profit regard­less of the direc­tion of the U.S. dol­lar or tra­di­tional asset classes.

The Merk Cur­rency Enhanced U.S. Equity Fund (MUSFX) seeks to gen­er­ate total returns that exceed that of the S&P 500 Index. By employ­ing a cur­rency over­lay, the Merk Cur­rency Enhanced U.S. Equity Fund actively man­ages U.S. dol­lar and other cur­rency risk while con­cur­rently pro­vid­ing invest­ment expo­sure to the S&P 500.

The Funds may be appro­pri­ate for you if you are pur­su­ing a long-term goal with a cur­rency com­po­nent to your port­fo­lio; are will­ing to tol­er­ate the risks asso­ci­ated with invest­ments in for­eign cur­ren­cies; or are look­ing for a way to poten­tially mit­i­gate down­side risk in or profit from a sec­u­lar bear mar­ket. For more infor­ma­tion on the Funds and to down­load a prospec­tus, please visit www.merkfunds.com.

Investors should con­sider the invest­ment objec­tives, risks and charges and expenses of the Merk Funds care­fully before invest­ing. This and other infor­ma­tion is in the prospec­tus, a copy of which may be obtained by vis­it­ing the Funds' web­site at www.merkfunds.com or call­ing 866-MERK FUND. Please read the prospec­tus care­fully before you invest.

Since the Funds pri­mar­ily invest in for­eign cur­ren­cies, changes in cur­rency exchange rates affect the value of what the Funds own and the price of the Funds' shares. Invest­ing in for­eign instru­ments bears a greater risk than invest­ing in domes­tic instru­ments for rea­sons such as volatil­ity of cur­rency exchange rates and, in some cases, lim­ited geo­graphic focus, polit­i­cal and eco­nomic insta­bil­ity, emerg­ing mar­ket risk, and rel­a­tively illiq­uid mar­kets. The Funds are sub­ject to inter­est rate risk, which is the risk that debt secu­ri­ties in the Funds' port­fo­lio will decline in value because of increases in mar­ket inter­est rates. The Funds may also invest in deriv­a­tive secu­ri­ties, such as for– ward con­tracts, which can be volatile and involve var­i­ous types and degrees of risk. If the U.S. dol­lar fluc­tu­ates in value against cur­ren­cies the Funds are exposed to, your invest­ment may also fluc­tu­ate in value. The Merk Cur­rency Enhanced U.S. Equity Fund may invest in exchange traded funds ("ETFs"). Like stocks, ETFs are sub­ject to fluc­tu­a­tions in mar­ket value, may trade at prices above or below net asset value and are sub­ject to direct, as well as indi­rect fees and expenses. As a non-diversified fund, the Merk Hard Cur­rency Fund will be sub­ject to more invest­ment risk and poten­tial for volatil­ity than a diver­si­fied fund because its port­fo­lio may, at times, focus on a lim­ited num­ber of issuers. For a more com­plete dis­cus­sion of these and other Fund risks please refer to the Funds' prospectuses.

This report was pre­pared by Merk Invest­ments LLC, and reflects the cur­rent opin­ion of the authors. It is based upon sources and data believed to be accu­rate and reli­able. Opin­ions and forward-looking state­ments expressed are sub­ject to change with­out notice. This infor­ma­tion does not con­sti­tute invest­ment advice. Fore­side Fund Ser­vices, LLC, distributor.

Tags: Axel, Billions, Bond Market, Bond Prices, Business Days, Canadian Market, Cash Reserves, Central Banks, Current Account Deficit, ETF, ETFs, Eurozone Countries, Foreigners, Good Reason, Greenback, Guarantee Success, liquidity, Portfolios, Quality Considerations, Reserve Currency, Treasuries, Treasury Markets, Trillion, U S Treasury
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Do High Yield Bonds Know Something Stocks Don't?

Monday, March 19th, 2012

 
As the S&P 500 reaches new multi-year highs and VIX touches multi-year lows, there is one rather large and risk-appetite-proxying mar­ket out there that is not as excited. The high-yield bond mar­ket has seen record in-flows drop­ping off recently and for the last four-to-six weeks high-yield spreads, yields, and bond prices have been very flat as stocks have surged ahead. Despite US earn­ings yields at near-record highs rel­a­tive to high-yield bond yields, we see lit­tle pick-up in LBO chat­ter sug­gest­ing a notable pref­er­ence for higher-quality junk credit (and/or lack of belief in sus­tain­abil­ity of earn­ings yields) and the recent 'dra­matic' out­per­for­mance in invest­ment grade credit is a notable up-in-quality rota­tion (as well as early spread-compression reac­tion to Trea­sury weak­ness recently) that strongly sug­gests less risk appetite among real money man­agers (given how 'cheap' high-yield appears across asset classes). Lastly, the ratio of HY bond prices to VIX is near its extreme once again, some­thing we saw occur before the risk flares of 2010 and 2011 sur­round­ing the end of the Fed's QE ses­sions.

The S&P 500 (Blue line) has stormed higher from its Octo­ber lows and extended gains recently despite sig­nals that QE3 may not be so immi­nent. Invest­ment grade credit (dark red) has pushed higher with it as size and qual­ity was pre­ferred (and the last week or so of out­per­for­mance likely reflects the ini­tial spread com­pres­sion impact as Trea­suries blew higher in yield but cor­po­rates remained bid from safety up-in-quality rota­tions). What is most clear is the HYG (green line) and HY (red line) have flat-lined in the last 4–6 weeks while stocks have accel­er­ated. We have seen this pat­tern before and the old saw that 'credit antic­i­pates and equity con­firms' has been extremely use­ful a num­ber of times over the past few years.

Here is the mar­ket moves head­ing into the end of QE2...obvi­ously HY became anx­ious first and proved cor­rect once again...

There are plenty of tech­ni­cal rea­sons for why HY may be strug­gling includ­ing neg­a­tive con­vex­ity at such low yields but the slow­ing flows and rel­a­tive decom­pres­sion far out­weighs the stick­i­ness of bond prices and their calla­bil­ity here.

Fur­ther­more, the ratio of HY bond prices to VIX has soared to record 'risky' highs strongly sug­gest­ing that either VIX is set to rise notably, high-yield bond prices are set to fall notably or both and these extremes have tended to occur in the lead ups to notable risk flares (around Fed implicit eas­ing periods).

While not per­fectly fun­gi­ble, VIX and HY rep­re­sent risk pre­mia for extreme down­side pro­tec­tion and there is clearly a major dis­con­nect. Using longer-dated Volatil­ity we get a bet­ter more real­is­tic per­spec­tive between the two mar­kets — once again con­firm­ing that short-dated enthu­si­asm is at extreme lev­els as even with mod­est rises in VIX we see the term struc­ture steep­en­ing today.

Charts: Bloomberg

Tags: Asset Classes, Bond Market, Bond Prices, Bond Yields, Earnings Yields, Flares, High Yield Bond, High Yield Bonds, Investment Grade, Junk Credit, Lbo, Lows, Money Managers, Outperformance, Qe, Qe2, Record Highs, Red Line, Risk Appetite, Treasuries
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PIMCO's Bill Gross Opines on the Bond Market Moves, QE, Inflation, Et Al

Monday, March 19th, 2012

PIMCO's Bill Gross joined Dan Gross on Yahoo Tech Ticker to dis­cuss a host of bond related and eco­nomic views.  Much like myself, he sees another round of QE (ster­l­ized or oth­er­wise) – in fact he takes it another step fur­ther and says there is a good chance of QE4 as well.

Another round (or two) of quan­ti­ta­tive eas­ing from the Fed­eral  Reserve, muted growth and an end to the 30-year bull run in gov­ern­ment  bonds. That's what Bill Gross,  one of the largest bond investors in the world, sees for the U.S.  econ­omy in the com­ing year.

Despite  the Fed's com­mu­niqué ear­lier this week, Gross doesn't believe the  cen­tral bank's inter­ven­tions in the bond mar­kets are over. In two rounds  of quan­ti­ta­tive eas­ing (QE), the Fed­eral Reserve printed money to buy  hun­dreds of bil­lions of dol­lars of Trea­sury bonds and mortgage-backed  secu­ri­ties. "I believe there will be a QE3, and per­haps a QE4," he said.  Why? In the past few years, when­ever cen­tral banks have stopped or  paused their quan­ti­ta­tive eas­ing efforts, "stock prices have fallen and  economies have slowed." The globe's pri­vate economies sim­ply aren't  suf­fi­ciently strong enough to sup­port robust growth, and the world's  cen­tral banks aren't will­ing to stand by and watch. "That's not a pol­icy  rec­om­men­da­tion, it's sim­ply a real­iza­tion that the sub­sti­tu­tion of  cen­tral bank mon­e­tary pur­chases will con­tinue for a long time, as long  as they [cen­tral banks] try to sup­port pri­vate economies on a global  basis," Gross said.

Still, Gross  believes the 30-year long bull run for bonds may be com­ing to an end.  "We're cer­tainly close and have been close for a num­ber of months," he  said. It's very dif­fi­cult to imag­ine inter­est rates going lower. "The  bond mar­ket, whether it's Trea­suries, mort­gages, or investment-grade  bonds in com­bi­na­tion, basi­cally yield a lit­tle higher than 2%," Gross  said. "And unless the U.S. econ­omy repli­cates Japan, where yields are  down to 1% on aver­age, then you'd have to say that we're close to the  bot­tom in terms of yield." He adds: "It doesn't mean the begin­ning of a  bear mar­ket, but it does sug­gest at least that the great bond bull  mar­ket since 1981 is prob­a­bly over."

Recent mar­ket activ­ity in  some bonds cer­tainly rat­i­fies that view. In recent weeks, the yield on  the 10-year Trea­sury has risen from about 1.8% in late Jan­u­ary to about  2.28% on Thurs­day. But "those yields aren't attrac­tive," Gross says.  Gross rec­om­mends that investors avoid longer-term bonds —  i.e. 10-year and 30-year bonds — whose prices may fall if long-term  growth and infla­tion expec­ta­tions rise. How­ever, they should also avoid  short-term bonds. "The Fed has con­di­tion­ally guar­an­teed that they won't  be rais­ing inter­est rates until late 2014, and that's almost three years  from now." Gross believes that bonds that mature in five, six, or seven  years occupy the sweet spot in today's market.

Bond hold­ers tend  to fear strong growth because it has the poten­tial to ignite infla­tion  and boost inter­est rates, thus reduc­ing their returns. Gross says that  while the econ­omy has improved, it shows no signs of over­heat­ing. He  believes the U.S. econ­omy is grow­ing at about a 2% annual rate in the  first quar­ter "and prob­a­bly beyond." That's about as good as can be  hoped for. While the Fed­eral Reserve has injected close to $1 tril­lion  into the U.S. econ­omy in the past year, growth is in large mea­sure tied  to what hap­pens in the global econ­omy. And the omens from abroad aren't  par­tic­u­larly good. "China is slow­ing and the euro land is in reces­sion,"  Gross said. The U.S. is grow­ing at a decent clip, "what we call a new  nor­mal, but it prob­a­bly won't get back to the 3 or 4% real growth  num­bers that we wit­nessed over the past decades."

Tags: Bill Gross, Bond Investors, Bond Market, Bond Markets, Central Banks, Consumer Price Index, Economic Views, Federal Reserve, Good Chance, Oil Prices, Opines, PIMCO, Principal Reasons, Qe, Qe3, Stock Prices, Term Bonds, Term Debt, Term Interest, Treasury Bonds
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James Grant Says Bond Market Is "Bubble of Modern Banking"

Monday, March 19th, 2012

James Grant, pub­lisher of Grant's Inter­est Rate Observer, talks about Fed­eral Reserve mon­e­tary pol­icy, the bond mar­ket and invest­ment strat­egy. Grant, speak­ing with Deirdre Bolton on Bloomberg Television's "Money Moves," also dis­cusses the Chi­nese economy.

Link if video does not play: Bond Mar­ket 'Desert of Value'

Select Inter­view Quotes

Grant: The Fed seem bent on sup­press­ing this most ele­gant thing we have called a price mech­a­nism, the move­ment of price that deter­mines all man­ner of things in a mar­ket econ­omy. Yet the Fed seems bound and deter­mined to super­im­pose its will in place of the price mech­a­nism. Take the bond mar­ket for exam­ple, the Fed has ham­mered down yields directly and indi­rectly and in response peo­ple are throw­ing money at things like high-yield or junk bonds. These are the prices the Fed wants, but are they the right prices? No not necessarily.

Deirdre Bolton: How is a bond investor to deal with this cur­rent envi­ron­ment? You are call­ing actu­ally for a bear mar­ket in bonds, am I correct?.

Grant: I have for­ever. So I am no help there. But it seems to me a bond investor is almost bet­ter off in cash. If you were to go out 10 years in a US trea­sury secu­rity you earn yield of approx­i­mate 2%. To remain in cash and be flex­i­ble you sac­ri­fice those 2%. The bond mar­ket is a desert of value.

Deirdre Bolton: What does this mean for gold?

Grant: The price of gold is the rec­i­p­ro­cal of the world's faith in the deeds and words of the likes of Ben Bernanke. The world over, cen­tral banks are print­ing money as it has never been printed before. The Euro­pean Cen­tral Bank has increased the size of its bal­ance sheet  at the annual rate of 89%. It's amaz­ing. The Fed is far behind at only 15%. The Bank of Eng­land 67% over the past few months. These are rates of increases in the pro­duc­tion of paper cur­ren­cies we have never seen in the mod­ern  age. It takes no effort at all. They sim­ply tap the com­puter screen.

Time for an "Office of Unin­tended Consequences?"

Grant pro­poses the Fed start an "Office of Unin­tended Con­se­quences" to study all the things that go wrong with Fed policy.

I believe Grant is speak­ing tongue-in-cheek. We cer­tainly do not need such an office. Instead, we need to abol­ish the Fed.

Mike "Mish" Shed­lock
http://globaleconomicanalysis.blogspot.com

Tags: Bank Of England, Ben Bernanke, Bloomberg Television, Bond Market, Central Banks, Chinese Economy, Deirdre Bolton, Economy Link, Federal Reserve Monetary Policy, Interest Rate Observer, Investment Strategy, James Grant, Junk Bonds, Market Economy, Paper Currencies, Price Mechanism, Price Of Gold, Printing Money, Treasury Security, Us Treasury
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The Economy and Bond Market Radar (March 19, 2012)

Saturday, March 17th, 2012

The Econ­omy and Bond Mar­ket Radar (March 19, 2012)

The yield on the 10-Year U.S. Trea­sury note reg­is­tered the biggest weekly advance since July 1, in response to buoy­ant Feb­ru­ary employ­ment data cou­pled with an absence of a strong sig­nal of fur­ther quan­ti­ta­tive eas­ing from the Fed meet­ing on Tues­day. The chart below shows the 10-Year yield broke out of its trad­ing range, oscil­lat­ing around 2 per­cent since Novem­ber. The “risk on” trade was rein­forced this week.

The Fed raised its eco­nomic growth out­look to “mod­er­ate” from “mod­est,” in view of the con­tin­u­a­tion of pos­i­tive eco­nomic data, espe­cially on the employ­ment front. The Fed described recent increases in oil and gaso­line prices as “tem­po­rary,” and kept its ver­biage unchanged for an “excep­tion­ally low” fed funds rate “at least through late 2014.”

Strengths

• Three years of ris­ing employ­ment finally led to the first increase, albeit small, in con­sumer debt in the U.S. since the sec­ond quar­ter of 2008. U.S. house­hold debt rose 0.3 per­cent in the fourth quar­ter of 2011, fol­low­ing 13 con­sec­u­tive quar­ters of decline.
• Despite a 6 per­cent increase in gaso­line prices in Feb­ru­ary, head­line Con­sumer Price Index (CPI) in the U.S. rose only 0.4 per­cent month-over-month and 2.9 per­cent year-over-year, in line with expec­ta­tions, thanks to tame pric­ing changes in non-energy items.
• India’s indus­trial pro­duc­tion expanded by a higher than expected 6.8 per­cent in Jan­u­ary from a year ear­lier, led by a surge in the food prod­ucts and bev­er­ages category.

Weak­nesses

• U.S. indus­trial pro­duc­tion was lit­tle changed month-over-month in Feb­ru­ary, lower than expected and decel­er­at­ing from Decem­ber and Jan­u­ary, due to a decline in min­ing activ­ity and flat out­put from util­i­ties related to warm weather.
• In Jan­u­ary, U.S. new orders of non-defense cap­i­tal goods exclud­ing air­craft posted the first annu­al­ized decline since the sec­ond quar­ter of 2009.
• Chi­nese exports in Jan­u­ary and Feb­ru­ary com­bined grew 7 per­cent year-over-year, decel­er­at­ing from 13.4 per­cent in Decem­ber and 20.3 per­cent in the entire 2011, dri­ven pri­mar­ily by slow­ing ship­ments to Europe.

Oppor­tu­ni­ties

• Should a growth scare resur­face due to a lack of announce­ment of fur­ther quan­ti­ta­tive eas­ing from the Fed, bonds may rally again as investors flee to safety. This sce­nario hap­pened in mid-2010 and mid-2011 when QE1 and QE2 pro­grams ended.

Threats

• Ris­ing oil and gaso­line prices com­bined with liq­uid­ity impli­ca­tions of global eas­ing led by Europe, may raise the prospect of the reap­pear­ance of higher infla­tion going for­ward. An increas­ing num­ber of Asian cen­tral banks decided to leave rates on hold after recent cuts.

Tags: Bond Market, Capital Goods, Chinese Exports, Consecutive Quarters, Consumer Debt, Consumer Price Index, Employment Data, Fed Funds Rate, Fed Meeting, Gasoline Prices, Growth Outlook, Household Debt, Index Cpi, Market Radar, Strong Signal, Treasury Note, U S Treasury, Verbiage, Warm Weather, Weather In January
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