The cardinal question for many investors is when interest rates will start to rise. Rising interest rates will change everything. At the moment, long-term interest rates are low; artificially low. Central banks have been slacking their monetary reins and buying bonds for a while; hence, the continued pressure on the yield curves and rising bond prices. Bonds are now arguably expensive.
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Over the past 13+ years U.S. equities have become cheaper as the earnings yield (the reverse of the PE ratio) rose from 3.4% in January 2000 to 6.5% in March 2013. Government bonds on the other hand have become more expensive over the past 30+ years. The yield on the 10-year Treasury has fallen from 10.3% in January 1980 to 1.9% in March 2013. The same is true for cash. The mix of central bank easing like there is no tomorrow and investors seeking yield as if there is no tomorrow resulted in bonds and cash being expensive relative to other investments.
Five related facts regarding bonds:
- Bonds are widely perceived as less risky than equities, mainly due to academia saying so. The argument is that bonds have, generalizing a bit, lower volatility than equities. Since volatility is the metric for risk chosen by modern portfolio theory and its disciples, bonds are perceived to be less risky.
- Regulators like bonds, as do national and supra-national accounting committees. They need to go with the scholarly consensus; what else?
- Liability-benchmark-hugging institutional investors hold long duration bonds as they believe long-term bond are a close to perfect match to their long-term liabilities.
- Retiring-and equity market crash doubly-shell-shocked-baby boomers have been switching from equities into bonds for some time now.
- Last of all, and most importantly, allocations by institutional investors are high, not low. Many bond markets in developed economies had a really good 30-year run, hence the high allocation.
Herbert Stein was the formulator of "Herbert Stein's Law," which he expressed as "If something cannot go on forever, it will stop," by which he meant that if a trend (balance of payments deficits in his example) cannot go on forever, there is no need for action or a program to make it stop, much less to make it stop immediately; it will stop of its own accord. Today, Herbert Stein's Law is often used as an argument that the various forms of easing and repressive action by the authorities (central banks, parliament, Troika, etc.) are winning time in the short term but will eventually fail in the long term. The easing and repression are addressing the symptoms but are not tackling the structural issues. This means kicking the proverbial can down the road to win time works until it does not. The answer to the cardinal question as to when interest rates will rise is: when trust is lost.
The U.S. yield curve, as well as the yield curve by other industrialized economies, has traded in a narrow range over the past couple of years. The U.S. curve is already half under water, i.e., short-term nominal interest rates lower than inflation resulting in large parts of the population being expropriated via negative real interest rates (and, as a result, negative compounding of capital). They can fall further, of course; at least on the long end.
When trust is lost, yields should rise. The European authorities made a major step towards investors losing trust over the past two weeks as the expropriation of parts of the domestic as well as foreign (Russian) population reached a new climax in Cyprus. Even normally calm, ex-KGB, Mr Putin went on record calling the decision "unfair, unprofessional and dangerous." Lawfully robbing its citizens is nothing new, of course.
Mr. Juncker, Europhile and the prime minister from Luxembourg recently compared 2013 with 1913, i.e., the current tensions with the tensions in Europe prior to the First World War. The slide above relates the current time scale with a time scale of the Great Depression and the Second World War with the crashes from 1929 and 2008 being the starting points. The motivation of comparing these time scales is to show that the political errors can take a while to unfold into doing great harm. Financial repression and slowly but steadily eroding property rights is like the first step. The current tension arises from Germany expropriating Russians. Whether this tension develops into something bigger, we do not know; it could.
The vertical grey lines in the slide above show trigger points of a simple four-point rule. This rule, essentially based on moving averages and a recent fall in interest rates, suggests that interest rates are indeed rising. However, this "rule" misfired before, mainly due to monetary intervention. We do not know if yields are on the rise for good. But it is not entirely unthinkable that they are or will in the future. Given the recent institutional popularity of bonds via asset-liability matching, risk parity, and regulation and accounting rules favoring bonds, rising interest rates could result in the "Great Unwind."
TLT, the liquid ETF on long-term Treasuries, as well as LQD (corporate bonds), MUB (municipal bonds), JNK and HYG (high yield bonds) had a very good run over the past couple of years, mainly due to Fed trouble shooting and "helicoptorial" monetary intervention. Currently, the "don't fight the Fed" maxim is probably the most profitable. However, if trust erodes on a larger scale, rates could rise. Investors should keep a close eye on these developments to be ready to short U.S. Treasuries (or other government bond markets), take profits from bond ETFs or sell these bond proxies short.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.