Low Fed Rates till 2014 Sparks Gold

In today's FOMC announcement, the Fed signaled that they will be keeping rates ultra low thru most of 2014. That even raised my eyebrow...

This news put some giddy-up into gold, which vaulted about $50 this afternoon on the FOMC news.

I used this leap to sell my GLD position. It's up about 10% from its lows, price is now filling the gap, and stochastics are getting twisty in the overbought zone.

Am also concerned about the re-hypothecation issues surrounding these metal ETFs on the back of the MF Global situation last fall.

Selling this position puts me just about 0% net long (long metal and ag commodities against short equity index). Feels about right given the current field position of various asset classes.

position in commodities, SPX

Treasury Yields Not Following Stocks

Usually, when market participants are ready to take on risk, they sell bonds and buy stocks. When bonds get sold, their yields go higher. Thus, higher stock prices and bond yields are often positively correlated.

Not this time--at least so far.

As stocks have lifted over the past few weeks, bond yields have not done the same. Ten yr Treasury yields are approaching mid December lows at ~1.8%.

This suggests that there is still lots of deleveraging behind the scenes--investors are swapping risky assets (perhaps assets grounded in Europe) for the safety in US Treasuries.

Stock bulls will argue that this is a positive. "Imagine what will happen to stocks when this pocket of 'de-risking' is past. Demand for stocks will swamp supply!"

Stock bears will argue that this is a negative. "Imagine what will happen to equities when this pocket of stock buying is past. Supply of stocks will swamp demand!"

And so it goes...

position in SPX

Hussman's Hard Negative

Another weekly letter by John Hussman that contains several nuggets of insight. Right off the bat, he makes it clear that conditions have turned decisively negative, in his view.

The current situation is "characterized by an extremely unfavorable ensemble of conditions across valuations, sentiment, economic factors, and other conditions. Current conditions cluster with periods such as May 1962, October 1973, July 2001, and December 2007, all of which produced 10-20% market losses in extremely short order."

Dr J notes the increasing disparity between the leading indicators that his firm and ECRI tracks, which now signal an extremely high probability of US recession, and the prognostications of mainstream forecasters and pundits.

He notes some exchange between a Bloomber interviewer and ECRI's, Lakshman Achuthan:

Bloomber interviewer: [ECRI recently made] a recession call. What happened?
Achuthan: It's happening.

Suggests significant cognitive dissonance out there regarding recession chances.

He also notes that the EU summit last week did (and can do) little to avert the central condition of credit crisis: solvency. Solvency is a shortfall between money owed and the resources needed to credibly repay it. Emphasis on 'credibly.' Printing money to pay back debts in devalued currency is not a credible strategy--at least in the eyes of creditors...

John suggests that perhaps one credible means for relieving stress in the EU is for countries to issue convertible sovereign bonds as they roll debt. The bonds would be convertible into the currency of the issuer at the option of the issuing government. Those countries with shaky fiscal houses would be required to pay a significant premium in order to compensate bond buyers for the commensurate risk.

Over time, John suggests, convertible debt might relieve the acute pressure that has built in the EU system. EU members would need to achieve sufficient financial credibility to remain in the EU system, lest they be subject to huge premiums on debt issued. The need for questionable bureaucratic enforcement mechanisms would be reduced. John suggests, "If the system can be saved, it will be saved" under such an arrangement.

One problem, of course, is that the significant discount that many EU countries currently enjoy by issuing debt under the implicit backing of the EU umbrella would vanish. Those countries would be forced to pay up and/or get their fiscal houses in order.

Market forces hate moral hazard...

position in SPX

Gold Moving Lower

Never got off a comment last week on the head-and-shoulders (bearish) pattern setting up in gold. This morning gold is down nearly $50, which essentially validates the 'dandruff.'

Why the thrust downward in the yellow metal? Not sure, cookie, as there is no 'obvious' gold-related news on the tape. Over the weekend, however, there were some rumblings that last week's EU summit outcomes 'did not go far enough' in resolving the debt crisis. Swap spreads are generally widening today, with Greek spreads crossing the 10,000 bps mark--implying a 100% chance of default.

Am starting to sense that gold may be a leading indicator of another round of 'risk off' in the markets. Added to my short equity position this am, and may do more in the upcoming sessions depending on how things unfold.

position in GLD, SPX

The Influence of Dividends

Borrowed the chart below from this article. The graph suggests the dominant influence of dividends on stock performance over time.

Since 1871, dividends account for more than half the nominal gains in the S&P 500 Index. Today many folks shun dividends in search of capital gains. Over time, however, capital gains have accounted for less than 2% of the 8.8% annual return.

Parenthetically, note that there was no inflation prior to the mid 1910's. The Federal Reserve Act was passed in 1913.

Before running out and loading up on dividend paying stocks right here, keep in mind that average dividend yields rest at the low end of historical benchmarks. Current yield on the SPX is about 2%. Historical buying opportunities in stocks have typically corresponded to aggregate yields in the 5-6% range or higher.

While there may be special situations here or there that are paying outsized dividends, I'm trying to remain patient for much higher dividend yields in aggregate before 'buying the list.'

position in SPX

Long Bond Yields at All Time Lows

Below is monthly chart of the yield on a ten year Treasury note over the past 20 years. Earlier this month 10 yr yields dropped below 2% for the first time ever.

After the Fed announced Operation Twist this past wk, yields broke lower yet again. They now reside at about 1.8%.

The Fed is trying to buoy economic activity thru borrowing--particularly w.r.t. housing. But anyone with a pulse recognizes that interest rates, which have been at generational lows for months, do not constitute a binding constraint on economic activity here. Economies around the world are already choking on debt and have little appetite for more. The Fed is thus pushing on a string.

Two groups are especially hurt by Fed policy here. Retired people and other savers are having trouble making ends meet as it is becoming impossible to make ends meet by making 1-2% off modest principal. Savings are being gutted by Fed policy. Moreover, low returns on savings are nudging more people into risky assets such as dividend-paying stocks.

Keep in mind that, over time, savings are the driver of higher standard of living as resources set aside are invested in productivity-enhancing technologies.

Pension funds are also significantly impacted by long bond rates. Pensions funds are built on bond portfolios, and these portfolios are returning less and less. Lower bond yields increase pension fund assumptions about future liabilities, thereby creating funding gaps. To close these gaps, pension fund managers can take more risk increasing their allocation towards stocks, or, in the case of corporate pension funds, have the corporate parents write checks out of retained earnings to fund the shortfall. Those checks in turn reduce earnings...

By discouraging saving and encouraging risk taking, current Fed policy serves as a major drag on standard of living.

position in SPX

Long Bond Yields and the Fed

The chart below displays yields on the 10 year T-note over the past 200+ years.

If we were to calculate the standard deviation of interest rates for the first half of the series, and then do the same for the second half, which standard deviation would be higher?

Answer: the second half by a mile. Long bond rates have been significantly more volatile during the past 100 years than during the previous 100.

A key difference between the two periods is the presence of the Federal Reserve. The Fed came into being in 1913, and has been getting progressively more intrusive in markets since then.

Ironically, a primary justification for the Fed was that a central bank was needed to stabilize economies and markets that purportedly were too volatile in their free unregulated states.

The interest rate data above suggest just the opposite. The Fed's presence increases, rather than decreases, volatility in credit markets which, because of credit's centrality to economic activity, spills instability into the entire economic and financial system.

Stated differently, credit markets unhampered by central bank regulation are likely to be more stable, rather than less, stable. How can that not be a boon for economic activity?

no positions 

Widening Corporate Spreads

Below shows the current spread between 10 yr B corporates and 10 yr Treasury note. Spread haven't been this wide since early 2009.

Widening spreads imply lower risk appetite (buyers less willing to pay up for lower grade corporate bonds relative to 'risk free' Tresuries).

no positions

Nice General Market Valuation Piece

Fine weekly note by John Hussman. Particularly noteworthy was the 'Valuation Review' section. I continue to view John's work on general market valuation as among the best.

Note the graph that plots projected 10 year projected annual return of the SPX versus current SPX price level. Today's level of about 1200 projects to about 5 1/2% annualized.

To achieve projected returns corresponding to the oft cited 10% historical returns of stocks would require the SPX to be at about 800.

As Dr J observes, those rare secular buying opportunities (e.g., circa 1982), those that correspond to single digit P/Es and 6-8% dividend yields correspond to an SPX of 400.

John notes that while this may seem 'utterly ridiculous,' historical evidence suggests otherwise.

position in SPX

Strong Treasuries

Largely lost in the drama this week was the rally in long bonds. On Friday, 10 yr Treasury yields hit a new low for the move.

Technically, it appears that a two month head and shoulders pattern has resolved lower.

Bonds could be strong for a number of reasons. One is that bond market investors are not very concerned about a default or about a US credit rating downgrade (otherwise bonds would be selling off). Another is that investors are seeking safety in the midst of domestic and EU fiscal turmoil.

Of course, an alternative view is that domestic bond markets have been so manipulated that no interpretation is possible...

no positions

US Money Market Exposure in Europe

Learned via Bill Fleckenstein today that Jim Grant, in his most recent newsletter, has observed that US money market funds have substantial fractions of their assets invested in European bank debt. Many money fund managers have been extending themselves abroad in search of yield, given the Fed's suppression of short rates to essentially zero.

The five largest domestic money market funds (three at Fidelity, one at Vanguard, one at Blackrock) with about $400 billion under management have about 45% of their assets in Euro bank paper.

If a credit crisis commences in Europe on the back of sovereign debt probs, then the spectre is raised that collapsing Euro bank paper could pressure net asset values of US money market funds to the point where they could 'break the buck' (fall below the $1 unit value). This occured to a small degree two years ago here in the US.

The implication is that US investors should make sure that they understand the nature of their cash holdings. Some funds may be FDIC insured. Current insurance amount, which was raised during the recent credit crisis, is $250,000 per depositor per insured bank.

For cash holdings that exceed the insurance limit or that are not covered, then the strategy should be locating the safest principal preserving vehicle possible. For those who are capable, this might mean parking cash in 1 to 3 month T-bills. They yield next to nothing but likely reflect the surest bet on preservation of principal.

Some believe that the US government would intervene should US money market funds begin to feel stress. Based on history, that may be a good bet. It is also one of the reasons why moral hazard is so high among bank depositors. As a class, depositors are largely clueless of the issues discussed here since they figure that the government has their back.

Follow-up Charts

Last week, durring a summer session of MGT 305, an impromptu extra credit assignment on the definition and causes of market bubbles morphed into an interesting class discussion of our current economic and fiscal situation.

The following charts serve as follow-up to a couple of discussion threads. Notes that all charts show about 20 years of monthly data.

 

position in oil, gold

Cash and Opportunity Cost

Jim Grant sees some value in large cap stocks like Cisco (CSCO) and Johnson & Johnson (JNJ). Generally, however, he sees most asset classes as richly priced.

He suggests that one investment strategy in the current environment is to simply hold cash, because the opportunity cost associated with not being in T-bills and other short term instruments is 'not much.' Although you make next to nothing on the cash, it is available when other asset classes become more attractively valued. Overvaluation, he observes, often 'passes in a thunderclap' and those who are liquid can 'get fully invested in a comfortable way.'

This strategy has made sense to me for some time. I find it interesting coming out of Jim Grant's mouth because of his inclination toward inflationary macro scenarios. What he is describing his more consistent with what happens in a deflationary situation. After all, why hold cash if you think its value will be inflated away.

Currently my cash level is just over 50%. I wouldn't mind bumping this to the 60-70% range, and will be looking to sell strength to do so.

positions in CSCO, JNJ

Low Bond Yields in an Inflationary World?

One phenomenon that is perplexing many who believe in the Big Inflation thesis is the behavior of bond markets--particularly government bond markets. Theory says that yields should go up with inflationary expectations. People should be selling bonds today out of worries that the real value of their bonds will go down as their coupons get paid back in dollars that are lower in value.

That theory has not been working out well in practice. Despite the $trillions created by the Federal Reserve over the past couple of years, and commodity prices screaming higher, long bond yields have not gone to the moon as many inflationistas have forecast.

Perhaps the theory doesn not account well for the dynamics of transitionary periods.

For more than two decades, central  banks have been suppressing interest rates and offering credit on the cheap. This credit has gone into all kinds of risky assets--stocks, commodities, real estate, plants and equipment. Bonds are also a risky asset class although they are often perceived as less risky than other categories. This is particularly true of bonds issued by the US government.

The easy credit spawned a secular boom in leveraged risk taking. Individuals, organizations, and governments have all borrowed at low interest rates and invested in assets deemed to return something more than the cost of carrying the loan. This behavior is also known as the carry trade.

Leverage magnifies returns when prices are going in your direction. A few years back people could buy a $500,000 house with little money down and low interest rate, and flip that house a year or two later for $750,000, generating an enormous return over the cost of carry.

As many have discovered over the past couple of years, leverage magnifies losses as well. When firms like Bears Stearns and Fannie Mae (FNMA) were levered 30:1 or higher in mortgage related derivatives, it did not take much decline in home prices before their assets were less than liabilities, creating conditions of insolvency.

In leveraged systems, falling prices motivate many to close out their carry trades. Risky assets are sold, dollars are bought back, and loans are paid off. We saw, and continue to see, a lot of this since 2007-2008.

But not all carry trades are taken off. Some leveraged investors, rather than totally getting out of risk, merely substitute less risky assets. Thus, rather than using credit to buy stocks, carry traders buy bonds instead. Leverage is still in the system, but it is located in assets classes deemes 'less risky.'

One explanation as to why bond yields have not yet backed up is that much leverage remains in the system. Carry traders are content to earn the spread between nearly 0% borrowing cost from the Fed and ten year T-notes paying 3.1%.

But this is a transitory situation. Huge amounts of leverage cannot last forever. Central banks can seek to force spreads open but over time they must collapse as resources borrowed from the future are paid back (or defaulted upon). Short rates will rise and/or returns on risky assets will fall and the carry trade spread will be crushed--regardless of government intervention to the contrary.

At some point, then, we may witness another counterintuitive situation as markets rebalance. It does not seem out of the realm of possibility that bonds could sell off big-time as more and more leverage leaves the system.

position in SH

Falling Treasury Yields

Perhaps a key tell that the commodity-driven inflation trade was on borrowed time was Treasury yields. After threatening to break higher a couple months back, ten year yields flipped over and have been heading lower.

Yields have now fallen to the 3.1ish level--an area that has frequently found support since 2009. If yields can't get traction around here, then there is not much support till down around 2.5%.

Since lower bond yields often correspond to increased risk aversion among market participants, one has to be conscious about what bond yield trends might be forecasting about the direction of stock and other risky assets prices.

position in SPX

The Case for Extreme Overvaluation

This analysis provides insight into the general relationship between aggregate stock valuations and long term returns. The study indicates a strong relationship between real returns and the level of valuation at which an investment is made.

The chart below captures one presentation of the results.

Essentially, the proposition goes like this:

The higher the market P/E ratio when an investment is made, the lower the return over the next decade.

The same thing holds true when dividend yields are low:

The lower the market dividend yield when an investment is made, the lower the return over the next decade.

This analysis suggests that, presently, markets offer little value in aggregate. Currently the S&P 500 sports a ten year normalized P/E of about 27 and dividend yield of 1.8%. Subsequent ten year returns associated with made at these levels have historically averaged about 1% annually or less.

In fact, the case could be made that current markets are extremely overvalued in aggregate.

btw, these findings very closely parallel the work of John Hussman.

position in SPX

The Fed's Problem

Not sure anyone has analyzed the technical problem that the Fed faces here more than John Hussman. Dr J has examined the historical relationship between T-bill rates and monetary base per nominal dollar of GDP (a.k.a. 'liquidity preference').

The results show an asymptotic relationship. When rates are high, people have less desire to carry money around because of opportunity cost. When rates approach zero, however, people are increasingly prone to hold cash because there are few competing uses for it.

I like to think about this in terms of cash that I am holding in investment accounts. I would like to put this cash to work in short term vehicles, but alternatives such as 3 month T-bills or 3 month CDs are yielding next to nothing. Thus, I'm comfortable just staying in cash because at least I am in a flexible position to deploy it should opportunities arise. To me, that is worth more than the pathetic yields I would be getting by tying up cash in short term fixed income vehicles. Just as John's analysis shows, ultra low interest rates have me holding more cash than I otherwise would.

The problem for the Fed is that in order to press interest rates closer and closer to zero, the amount of base money that the Fed has to pump into the system via its asset purchase programs such as QE2 must grow exponentially. Any exogenous forces putting upward pressure on rates (e.g., perceptions about inflation, slow down in offshore Treasury buying) must be met with ever more money printing by the Fed, otherwise all of this money that has been created would quickly seek other uses, and prices of many things would explode higher.

Since the Fed is approaching the zero bound for interest rates, it stands to reason that at some point, perhaps soon, the Fed will be physically unable to suppress rates further in an environment where exogenous forces are pressuring people to reduce their liquidity preference.

Should we reach this point, the Fed faces one of two alternatives: a) it could sit back and watch prices rip higher as people swap out of cash perceived as a rapidly depreciating asset, or b) it could rapidly withdraw the funny money that it has been pumping into the system.

Remember the nonlinear relationship between money printing and interest rates, however. The Fed would have to remove a disproportionate chunk of stimulus in an attempt to normalize rates just a fraction higher than where they currently stand. Dr J estimates that, in order to normalize short rates at 0.25 - 0.50%, the Fed would have to reverse its entire $600 billion QE2 program.

The point is that, if the Fed tries to tame inflation at this point, it will have to suck gigantic amounts of liquidity from the system. If the Fed decides not to do this, then prices of most things are certainly headed much higher.

This is the box that the Fed is in.

This situation also goes a long way toward explaining the action in precious metals. Investors have sniffed the Fed's bind out, and are bidding gold and silver up on a bet that the Fed will choose option a) above.

Before us is a game of chicken of historical proportion.

position in gold, silver

TIPS

Many people presume that Treasury Inflation Protected Securities (TIPS) are fixed income securities with protection against inflation. This article suggests that buyers of TIPS get less insurance than they might suppose.

When it sells TIPS, the US Treasury is selling a bond plus and insurance policy (or put option). One question to ask is why would an insurer want to be short a put option unless it believes that the option was priced in its favor?

no positions

Yield Curve ETNs

The 'yield curve' expresses the difference in yields between short and long dated Treasuries. Stockcharts.com has some excellent graphical representations of the yield curve.

Common wisdom says that steep yield curves are bullish for economic activity. Thinking is that increases in economic activity raise demand for longer dated borrowing (plus the spectre for inflation). At the very least, big spreads between T-bills and the 10 yr present a fertile carry trade environment.

When economic activity is forecast to decline, then the spread between short and long rates narrows as as folks swap risk for short term liquidity, thus flattening the yield curve.

Currently (as suggested by the stockchart graphs) the yield curve is pretty steep, and has been steepening since early 2009.

I suppose it was inevitable, but there are now ETNs to play either steepening or flattening of the yield curve. Caveat emptor for sure...but probably products that some folks are considering for their 'alternative assets' category.

no positions

FDIC Rate Page

Need to know current rates on CDs? The Federal Deposit Insurance Corporation (FDIC) reports weekly national averages for rates on money markets, CDs, and other deposit products.

As you can see, yields on deposit products remain low.

position in CDs