February 2008

The Last Asset Bubble?

The Last Asset Bubble?…It's clear that in addition to reacting to equities, the credit markets themselves have been leading the Fed by the nose directionally in recent months.  The drop in short term yields on the Treasury curve just begging the Fed to fall in line has been nothing short of astounding, but we need to remember that a good portion of this drop in short term yields has been related directly to credit market distress of the last half year or so.  Distrust of asset backed commercial paper, as an example, has resulted in a flooding of funds into short Treasuries as an alternative.  General global financial market unease has again seen the US Treasury market play its self appointed role as safe haven.  As you are well aware, there are more than a fair amount of institutional investors out there mandated to hold AAA rated paper.  Now that supposedly AAA rated CDO's and SIV's are hitting the credit rating skids almost daily, we've got a lot of capital looking for anything retaining (at least for now) AAA status.  So we certainly need to realize that a lot of what is happening along the Treasury curve these days is not completely reflective of and driven by forward US domestic economic prospects solely, but rather reflects the theme/unintended consequence of systemic credit market deleveraging, along with the heightened attraction of capital preservation for many of those either in or formerly in a good bit of distress.  We've long argued that in an environment of low nominal yields to start with, it's longer term consumer, corporate and mortgage rates that deserve attention when it comes to potential real world economic impact, not necessarily the Funds rate singularly.  The Fed Funds rate is a nice symbol, but it does not make the world go around for consumers and businesses in their daily lives.  Although this may sound like blasphemy to many in the investment community steeped in the tradition of historical interest rate and yield curve relationship rhythm, in a period of very low nominal yields, the job of the Fed Funds rate in terms of actually sparking true fundamental economic (and really credit cycle) reacceleration is much more difficult than would be the case when initiating a monetary easing cycle from the simplicity of higher nominal interest rate levels.

Moreover, and we believe this is very important and perhaps little appreciated, the fact is that credit market distress over the last half year at least has already distorted yield levels along the Treasury curve to the downside, and meaningfully so.  This very circumstance has already put a bit of a boat anchor around the potential forward effectiveness of monetary policy to come. Yes, the Fed can continue dropping the Funds rate, but yield levels along the curve are already low and have meaningfully accelerated to the downside over the last seven to eight months.  If you'll indulge us, let us show you what we mean with a few pictures that we believe tell a rather elegant story.  First, the following is a look at the yield curve at the close on "rate cut Tuesday" (to co-opt a CNBC-ism characterization, it's the day of the "surprise" 75 basis point cut) as well as post the 50 basis point official FOMC meeting gift to the markets (or rather acquiescing to market demands).  Wonderful, the Funds rate magically dropped 75 basis points overnight to 3.5% and then was followed up with an icing on the cake 50 basis point drop a week later.  Yippee.  But as is clear as day, the Treasury yield curve remains meaningfully inverted short term, flat out to five years, a modest 60 basis points of steepness out to ten, and less than 140 basis points of steepness all the way out to thirty years as a result of these actions.
          

The last time we checked, it's yield curve steepness that the Fed would really like to see, especially in the current environment where we have to believe a major end game goal of the Fed is to rebuild weakening banking system and broader financial sector balance sheets that are currently being torn apart by mortgage paper related write downs and write offs.  What you see above is not going to do the trick.  In fact, when it comes to the financial sector, and the banking crowd specifically, lowering nominal short term rates set against current yield curve dynamics does nothing but increase interest rate margin pressure in an already wildly competitive and overpopulated lending environment.  You've already seen the cat calls by the Bill Gross' of the world and other similar prognosticators calling for a  below 3% Funds rate.  Let's face it, unless the Funds rate is dropped to 2% or lower, all else being equal at the moment, just how is the Fed to engineer anything even approaching meaningful curve steepness?  We don't know.  If the curve remains inverted to flat, or even mildly positive at best out a good ways in terms of maturities, Fed Funds rate cuts are largely symbolic as opposed to substantive from the perspective of financial sector P&L and balance sheet reality.

Again, as we mentioned, longer dated yields have already dropped dramatically since last summer due to their supposedly safe haven status in a credit market distressed environment.  To put this into a bit of longer term cycle perspective, the chart below chronicles the history of the 30, 10, 5 year and short term Treasury yields from the inception of the current decade to the present.  Again, for perspective, we've shaded in red the period where legendary Fed chairman Greenspan and FOMC buddies at the time kept the Fed Funds rate at 1%.  The very rate level Anna Schwartz (yes, the Anna Schwartz who is a member of the NBER and wife to now deceased Milton Friedman) recently charged was quite the inappropriate monetary action in the clarity of hindsight.  Notice anything in this combo chart?  Of course you do.
        

At least for now, the 30 year Treasury yield already rests at the yield level seen as a 1% Fed Funds rate environment dawned in 2003.  But no, we're nowhere near that level on the Funds rate quite yet, despite the so far best efforts of the Bernanke Fed.  There's always next week, right?  The yield on the 10 year UST is less than 60 basis points from its generation lows, likewise seen immediately prior to the invocation of 1% at the Fed.  Five year UST yield?  Ditto, just not that far away from generation lows.  So again, we sit here today and ask ourselves just how much yield decline juice is left in the old Treasury curve ahead when longer dated yield levels are now currently pushing levels last seen when the Funds rate was near the unbelievable 1% level?  We can't believe there is much further meaningful downside for yields unless the world is literally coming to an end and massive recession, if not depression, is imminent.  We see very little value in Treasuries right here outside of being a panic driven safe haven status vehicle.  Are Treasury bonds the last financial asset bubble standing?  Potentially accelerating into some meaningful perhaps secular low in yields and top in prices?  Without trying to sound melodramatic, we believe it's a question that deserves some reflection and needs some consistent revisiting as we move ahead.

So the Fed has dropped the Funds rate to 3%.  How about 2%.  Will 30 year yields maintain their current 130 basis point yield spread differential and plumb new low levels never seen before?  Will the ten year yield move in lockstep down to 3% or 2%, which would be completely uncharted territory?  And all of this potential yield decline will occur when the US economy and financial system is much more levered (read risky) than was the case when Fed Funds were last at 1% in 2003 through mid-2004?  Sounds hard to justify except on a panic basis, at least that's how we see it.  So as we move forward in time and surely in continued Fed response to our current circumstances, we have a really hard time believing the entirety of the curve is about to drop meaningfully further in yield level.  THAT'S the big issue here.  And if indeed we're even close in terms of correct interpretation of the current structure of the curve and how that curve might act ahead, then low yields are already heavily discounted in total broader financial market values as we speak.  It may very well be the Fed is truly pushing on the proverbial string if further Fed actions cannot stimulate meaningful alternative yield level response to the downside.  We'll just have to see how it all works out from here.  And God forbid the equity markets were ever to come to the pushing on a string conclusion.  You think we've seen an equity correction so far?  Trust us, you have not if perceptual trust in the Fed is ever lost.  As we move ahead and the Fed continues to drop the Funds rate, which they surely will, we suggest the key is to watch the response of the entirety of the Treasury curve.  In other words, how low can they go?  And we mean yields other than the Funds rate.

A few quick final thoughts.  We need to remember that the US remains dangerously dependent on a steady and growing diet of foreign capital.  Of course up to this point the foreign community has been more than happy to oblige, given their recycling of trade related dollars.  But as we look ahead, US consumption is slowing, hence less trade related dollars and potentially slowing import activity on a rate of change basis exclusive of energy.  So as we witness these incredibly low nominal Treasury yields of the moment, yet another question comes to mind.  For how long will yields in the 2% and low 3% range be attractive to foreign buyers?  Has the foreign community looked at the numbers and started to ask the same questions we have in terms of just how much upside is left in Treasury bonds as investment vehicles from here?  We’ll be the first to admit that the foreign community has not placed top priority on real or nominal rate of return when purchasing UST’s.  But at current levels, in light of growing inflationary pressures both domestically and globally, as well as taking into consideration the continued weakness in the US dollar, the foreign community now has to look at Treasury investments ahead as being almost a guaranteed loser, at least on a real return basis.  That means foreign buying of Treasuries from here on out is being driven by one thing and one thing only – mercantilist economics.  From an investment standpoint, there’s nothing else there.  Will this continue to be a meaningful rationale for purchase (mercantilist economics) during a period of rate of change slowing in US consumption?  Of course, we're going to find out.  Quick update below of a chart we have shown you in prior discussions.  It’s the longer-term history of foreign buying of UST’s.  For a few years now the rate of change trend has been down.
         

We need to remember that the foreign community is really buying UST’s in the five year and less maturity range, most centered on shorter maturities than not.  Welcome to sub-3% nominal yields, nearing 2% at the shorter end.  Of course, offering negative real returns at current levels.  That’s inspiring, right?

Maybe the most important chart we can think of right now relating to our concerns over Treasuries lies below.  And yes, it’s as much a symbol as it is about substance.  Hopefully it helps put a bit of an exclamation point behind this discussion.  We’re looking at the 30-year US Treasury bond from 1980 to present.  As you can see, we’ve tried our best to draw in what we consider to be a critical multi-decade trend line.  What is absolutely clear is that the multi-decade series of rising lows and rising price highs has been broken in recent years.  For now, we’re testing an approximate triple top price area.  Triple tops can be quite the powerful formations, either when broken to the upside or having failed.  We’ll see what happens.  But as we look a good bit further down the road, when this trend ultimately breaks (and we believe it will due to the ever growing awareness of the true nature of inflation) it’s going to be party over for monetary policy effectiveness for perhaps a good while to come.  Are we looking at the last asset bubble of substance when we look at the current Treasury curve?  Although we wish we had the answer, we do know one thing.  We better all keep watching as this may ultimately turn out to be one of the most important investment guideposts of the next few years.
            

Before we leave you, one last view of live in the institutional world we believe is important.  Certainly we're all aware of the crowded theater example when asset classes go bad.  Only one door out and everybody wanting to go through it at the same time.  Absolutely classic as an analogy for financial market action resulting from nothing more than the repetition of human behavior.  Well, we see the current Treasury market as being this analogy in reverse.  Everyone has been trying to get into the theater through a very small door, and of course they all want in at the same time.  Let's face it, how else would we see two year Treasury yields last week kiss the 1.8% range, virtually guaranteeing a big time negative real rate of return?  C'mon, buying Treasuries two years out at recent levels has nothing to do with fundamental investing or acknowledgement of basic economics.  But it does have everything to do with the most basic of all human behavior and emotions - fear.  Fear coupled with relative lack of AAA credit supply, or even the perception of lack of supply, can do very strange things to prices over very short spaces of time.

Anyway,  in the chart below we're looking at the behavior of bond mutual fund managers in the aggregate, and what we personally see at the moment is quite the anomaly.  The top portion of the chart is cash as a percentage of total assets in the bond mutual fund complex over time.  The bottom portion is self explanatory - the price of the 30 year UST over the same period.  
              

With the lines and all of the shaded red bars we've drawn in, there are more than a number of messages here.  First, and very simplistically, the longer term trend decline in cash as a percentage of total assets in the mutual bond fund complex mirrors the upward trajectory of thirty year US Treasury price from the early 1980's through to the early part of this decade.  Easy to understand as the initial part of the period was characterized by meaningful pessimism regarding bonds, as was expressed in the very high level of cash holdings at that time, in aggregate post the horrendous performance of bonds in the inflation laden 1970's.  But as bond prices rose during the decade of the '80's, pessimism regarding bonds as investments faded and mutual fund cash was put to work.  Typical behavioral pattern of the institutional investment community that has been repeated time and again.  Over this two decade period (1980's and 1990's) we notice yet another phenomenon as we look at the red bars we've drawn in.  Every time Treasuries rose meaningfully in price over shorter periods of time (cyclical upturns within a longer term secular upward price move), cash as a percentage of total assets in the bond fund complex fell materially.  Every time.  As is the case with almost any longer term asset class movement, mutual fund managers chase price performance.  You've seen it a million times.

But as we enter the current decade, mutual bond fund manger behavior starts to change relative to character exhibited during the prior two decades.  Look at the red bars we've drawn in for the current decade.  As the price of Treasury bonds rose on a cyclical basis in this decade, cash as a percentage of bond mutual fund assets actually rose in spike fashion.  Just the opposite of what transpired in the '80's and '90's.  Bond fund managers reversed prior behavior and began to sell bond market rallies.  This occurred from mid '02 through early 2003, at the exact time the Fed was getting toward 1% on the Fed Funds rate.  It also occurred from mid '04 through mid '05, as the Fed reversed course off of generation lows in the Funds rate and began to tighten nominal yields in literally baby step fashion.  Why the change in bond fund manager behavior?  At least from our standpoint, we believe it was the recognition of two things.  First, nominal yields during these periods were very low, which means bond price performance relative to interest rate movements could easily overshadow coupon yield in terms of total bond fund performance.  At low nominal yields and recognizing that interest rates run in cycles over time, bond fund managers were responding to higher price risk academically inherent in bond investments during a period of low nominal coupon yields.  The second reason we believe risk became a heightened concern within the bond fund complex early this decade was the recognition of the length of the in place secular bond bull market environment up to this point.  The bull is indeed quite the senior citizen from an asset class standpoint.  And we all know that asset class bull markets do not grow to the sky indefinitely.  

Let's fast forward to very recent experience.  Since mid-2005, cash as a percentage of total assets in the bond fund complex has dropped from just under 10% to just under 4%.  Quite the contraction in cash assets.  Moreover, and really over the last six to twelve months, we've seen more than a fair amount of money flow into the bond fund complex as equity returns have become more volatile.  Now we see that with the recent spike upward in Treasury prices, bond fund managers did not increase cash holdings as they have done consistently in other like occurrences this decade to date.  Importantly, as we stand back and again look at the character of current investment environment in the Treasury market, we see anomalistic recent buying within the context of: 1) lack of alternative AAA rated fixed income vehicles, 2) negative real rates of return along virtually the entirety of the Treasury curve, 3) buying based on safe haven status as opposed to economic return potential, and 4) cash in the mutual bond fund complex remains quite low relative to historical experience.

So as we look ahead, we believe now is the time to at least start thinking about the possibilities for financial market and real economic outcomes if and when this panic behavioral trade in the US Treasury market reverses.  We already know that at that point it does become the crowded theater with one small exit door.  For at least as far as the message and data of history is concerned, it may very well be that at some point the US bond mutual fund complex is trying its best to squeeze out of the same door with so many institutions who first panicked to get in.  Aren't the actions and thinking of crowds amazing...to watch from a distance, of course?  Indeed they are.