Introduction: In the current Foreign Affairs, Alan Greenspan pens an article titled Never Saw It Coming: Why the Financial Crisis Took Economists By Surprise. While he does mention undercapitalized financial institutions, he also appears to channel Nassim Taleb and concludes that risk models did not include "fat" enough "tails." He explains that:
In fact, as became clear in the wake of the Lehman collapse, the tail was morbidly obese. As a consequence of an underestimation of that risk, financial firms failed to anticipate the amount of additional capital that would be required to serve as an adequate buffer when the financial system was jolted.
But here's what he gets wrong. It wasn't merely that firms were undercapitalized for shocks. It was that they were insolvent. Fannie Mae and Freddie Mac collapsed into the reluctant hands of the Federal government because they were insolvent. Their collapse preceded that of Lehman by weeks. In fact, around the time the GSEs were revealed as insolvent, Alan Greenspan was stating that there was some risk of recession coming on. This was about nine months into the recession. In addition, numerous other banks were being revealed as insolvent. It was not Lehman per se that caused the crisis, but the realization that the entire capital structure of the United States, and therefore most of the relevant world, had been grossly misrepresented.
There is also no mention in Sir Alan's article of why these firms were insolvent: widespread poor to abysmal lending practices, and massive mortgage fraud.
The Greenspan analysis is of course the mainstream one.
Because it is mainstream, the U.S. government and leading financial institutions have been going the Japanese route: continuing the familiar and comfortable policy with the same familiar names that led us to the recent catastrophe. Extending and pretending, as it were.
Background: In Japan's post-bubble burst, the neglect of the underlying problems led to a crisis and also led to sudden stock market crashes at unpredictable intervals and the "need" for yet lower interest rates to "recharge" the economy. This may occur here, due to similar governmental and Big Finance behavior post-crisis.
The Japan scenario for the U.S. economy that I predicted nearly five years ago therefore continues to be in play, yet few in the media recognize even its possibility. Thus we see, confidently stated, the WSJ say this weekend: Bond Investors Should Brace for Higher Rates.
Unfortunately, as is shown below, a robust recovery in nominal GDP is exactly the opposite of what various indicators are suggesting.
Contrarian and Technical Analysis: Every poll of Big Money that Barron's has reported on for at least the past five quarters shows bonds hated and stocks loved, especially U.S. stocks. That trend is so long in the tooth that it may be "due" to reverse.
Futures traders have been acting on the belief in higher interest rates soon in an increasingly aggressive manner. For the past several years, that has been the contrarian sign that a major bond bull move toward lower interest rates is soon to begin, or is already underway. From FINVIZ, here's the positioning of commercial hedgers in the 10-year bond. These hedgers offset the sum of the large and small traders. Different time spans are shown:
The first chart shows what might be a head and shoulders bottom in bond prices in association with extreme bearish sentiment amongst speculators. As the lower chart shows, this degree of bearishness has rarely been seen in the past several years. (The extremely high long position by the commercial hedgers as shown by the green line is equal to the combined short positions of the small and large speculators).
The head and shoulders pattern mentioned begins with the horizontal price action of the long bond in mid-June into late August, followed by the spike down and then the recent price recovery to a somewhat higher high than was seen in the summer.
From an interest rate perspective, on the one hand, moving average analysis points to higher rates. However, given my macro thematic view that goes back almost five years (linked article above), I am more interested in this chart of the 30-year bond (linear scale):
Treasury Yield 30 Years (^TYX)
The long-term pattern of lower lows and lower highs has remained intact
In other words, just as stock bulls ride out bear markets but stay long-term bullish, I think the interest rate trend also is your friend until it ends. Technically speaking, the bond bull lives and could buck some more.
Fundamentals: The bond technicals are consistent with the action in commodities. The Greenhaven Continuous Commodity Index (GCC) shows a bearish pattern since the early 2011 peak:
Gold has been in a pronounced downtrend more than two years after its August 2011 peak.
Then there's West Texas Intermediate oil (also FINVIZ), which looks becalmed with both lower highs and higher lows the past few years:
The gold bear market and oil downtrends are mirrored by deceleration in inflation rates in both the U.S. and the eurozone, per ECRI:
Another fundamental reason for bond prices to rally is the seesaw pattern of stock dividend yields and the long bond interest rate. Per Multpl.com, the S&P 500 dividend yield is again nearing record lows below 2%:
Current Yield: 1.92% +0.71 bps4:32 pm EST, Mon Nov 18
Mean: 4.43% Median: 4.37% Min: 1.11% (Aug 2000) Max: 13.84% (Jun 1932
With the 10-year Treasury about 70-80 basis points higher-yielding than stocks, there is lots of room for Mr. Market to salvage the stock bull market and also bring the yields again into alignment by increasing bond prices, thus lowering bond interest rates. This would be a goal of the Fed, which does not want to see a major bear market in stocks.
A 2.7% yield on the 10-year bond is closer to its long-term average than is a 1.9% yield on stocks. Also from Multpl.com:
Current 10-Year Treasury Rate: 2.67%
At market close Mon Nov 18, 2013
Mean: 4.64% Median: 3.92% Min: 1.53% (Jul 2012) Max: 15.32% (Sep 1981)
Investment strategies: One of the problems that most investors have with "playing" for a drop in interest rates is the "who cares" phenomenon. Absent leverage, most people perceive more risk than reward in this game. No argument ensues from me for most people, but some thoughts are that if one believes that the prolonged stock market rally and "not bad" economic statistics mean anything at all, then sound bonds may be purchased with very low default risk. One can find 10-30 year non-callable high-quality tax-exempt bonds yielding the same as or more than Treasuries.
Another approach is to expect a weaker dollar to accompany falling rates, and therefore invest in foreign securities.
Another strategy is not to play long ball and take the position that if trends are bullish for Treasuries, simply buy them and get a positive return on the price appreciation plus a little interest, say thank you, and move on after (one hopes) a profitable trade.
Probably the best-known vehicle for such a trade is the iShares 20+ Year Treasury Bond ETF (TLT). (The intermediate duration, 10-20 year similar ETF has the symbol TLH.) Without personally using leverage, one can obtain the equivalent of it by purchasing funds that invest not in coupon-paying bonds but rather in the more-volatile zero-coupon long-term Treasuries. I am aware of two such ETFs. The PIMCO product has the symbol ZROZ and the Vanguard product has the symbol EDV.
Alternative views: There is no passion in my thesis here. Nominal GDP is above the long Treasury interest rate, so rates "should" be higher. However, we are dealing with insolvency issues, which have not been fully been resolved and which in my opinion explain the persistence of near-zero very short-term interest rates and the continuation of quantitative easing. Overall, I look at U.S. financial markets as uniquely unattractive both for stocks and bonds (and of course cash). I can however find modest investment merit in certain longer-term tax-exempt bonds. Also, there is something truly special about a U.S. government bond that may make it worth accepting possible small negative real returns on a buy-and-hold basis.
Conclusion: It is difficult to get treatment right if the diagnosis is wrong. As the Greenspan article shows, the establishment simply will not admit that the financial crisis was a normal outcome of mortgage fraud, poor lending practices, and the like. All that happened was that market participants and the general public became aware, more or less simultaneously, that they had been lied to. There was no "fat tail" panic response that better "modeling" should have predicted. Rather, there was a rational response to the discovery that many or most of the largest financial institutions in the world were insolvent or nearly so.
Ignoring this, the mainstream is reduced to cheerleading not a resurgence of the real economy (that was so 1950s) but rather a resurgence in something as potentially ephemeral as trading prices, which I documented in an InstaBlog today.
In turn, this over-reliance on the market to the point of ignoring the pace of real incomes and economic activity paves the way for a stock market setback and a "flight to quality." The declines in gold and general commodity prices suggest that the mainstream measurement of a very low inflation rate may actually be valid, in which case a 2% 10-year Treasury rate (or lower) could be fundamentally reasonable for some time to come. All this would go back to the crisis and the holes in the capital structure of the United States, which Federal Reserve policy, deficit spending and tincture of time are attempting to heal. As occurred after the Great 1929-33 crash, these efforts take time that can be measured in decades, not merely years (this is the Japanese experience as well).
The last period of Internet mania in the late1990s was a great time to buck the consensus and accumulate bonds, as the mania masked growing economic weakness. Modified for such factors as lower interest rates, older demographics and lower inflation, on trend a similar investment opportunity may exist today. It's difficult to have strong views on this prospect, but when in doubt, I don't fight the Fed, and there is no doubt that the Fed wants lower rates.
Therefore, all things considered, I am a tactical bond bull here and hold tight to the secular bond bull case because the Japan analogy of zero short rates pulling the longer rates inexorably down has not been disproved in the U.S. yet.
Additional disclosure: Not investment advice. I am not an investment adviser.