Christopher Butler is a principal of Butler, Lanz & Wagler, L.C., an Overland Park, Kan.-based RIA founded in 1998. The firm manages the investments of individuals and institutions throughout the Midwest, specializing in macroeconomic investing using the business cycle as the primary tool for analysis.
Chris, who's earned an M.B.A. and M.A. in economics, has over 20 years experience as an economist and portfolio manager. Seeking Alpha recently got the chance to ask about his current highest-conviction position.
What is your Highest Conviction position in your portfolio - long or short?
We're short long-term Treasurys. Specifically, we own ProFunds Rising Rates Opportunity Fund (RRPIX, RRPSX). The fund's objective is to return 125% of the inverse of the daily move in the most recently issued 30-year Treasury bond.
While there are plenty of ways to capitalize on rising interest rates or a bearish outlook on bonds, the easiest for most investors is to use exchange-traded funds. Examples would include ProShares UltraShort 20+ Year Treasury (TBT), Direxion Daily 30-Year Treasury Bear 3X Shares (TMV), Direxion Daily 10-Year Treasury Bear 3X Shares (TYO) and ProShares UltraShort 7-10 Year Treasurys (PST). These ETFs employ varying degrees of leverage in shorting different maturities of Treasury issues. I would advise anyone interested in these ETFs to make sure they understand all the risks involved in whatever product they're considering.
You can also look into rising-rate trusts to take advantage of an expectation of inflation. We currently own the ING Prime Rate Trust (PPR) for precisely that reason. Finally, if you're bearish on Treasurys, you could always short the futures contract.
Over the past several months, the economic situation in the U.S. has improved. Last September, the Economic Cycle Research Institute's Index of Leading Economic Indicators turned positive on a year-over-year basis. The Index of Coincident Economic Indicators will likely follow suit in the next month or two. The lagging index clearly bottomed and has since turned up.
Interest rates are a lagging indicator and we are therefore bullish on interest rates. It's no secret that as aggregate demand drives prices up, the same uptick in demand is taking place in the loanable funds market. The price of loanable funds is the market rate of interest. So, if we're bullish on interest rates, we're ex vi termini bearish on bonds.
We are also bullish on other mid- to late-cycle sectors like gold, commodities and real estate.
Can you tell us a bit about the underlying securities in your highest conviction pick?
Most of your readers know that the duration on low-coupon, longer-term Treasury securities will be higher than high-coupon, shorter-term securities. If you believe interest rates are going up, you'll want to short the highest duration securities possible. The most recent 30-year T-bond has a relatively low coupon of 4.625% and a long 30-year maturity. You can't get much more bang for the buck if you're bullish on rates. That's what RRPIX and RRPSX are benchmarking - the inverse move of the 30-year.
Can you talk a bit about bonds as an asset class? How much of your position reflects your view on Treasurys specifically as opposed to bonds as a broad asset class?
In this phase of the business cycle, inflation will hurt all fixed income securities to a greater or lesser extent. We do think that interest rates on corporate bonds will rise as they react to inflationary concerns, but unlike the federal government, the credit situation of corporate America is likely to strengthen as a growing economy helps improve balance sheets. This will give corporate bonds at least a little upward pressure to offset the downward price pressure created by inflation expectations.
Junk bonds are not all that sensitive to interest rates and tend to behave like equities. We would expect lower-quality bonds to continue to track stocks until the lagging indicators have been heating up for a while. We're likely months away from that, and have been long junk for the past several months.
Other than corporates and junk, the most risky capital might find a home in munis, but budget concerns in those municipalities skew the risk-reward payoff. In other words, there's probably not enough reward to outweigh the risks. That said, we're steering clear of the muni sector until we're confident these fiscal situations can be worked out. But even if states were to get their fiscal houses in order, inflation expectations are likely to hurt these bonds at some point. There may be a few municipals out there that can be cherry-picked as a turnaround play, but the sector as a whole has too much risk.
What about the competitive environment for U.S. Treasurys? How is U.S. debt positioned vis-à-vis its competitors - i.e., other government debt?
Inflation will be a concern of every industrialized nation dependent upon, among other things, how much currency was printed out of thin air. There has never been a more concerted, global, and synchronized pumping of currency in history. Further, economies are more intertwined than at any previous point in history. Central banks around the world will either have to allow inflation or risk sinking the economic ship by taking the punch bowl away.
In fact, central bankers will be doing everything within their power to spark "manageable" price inflation because of all the debt they've issued. We've all heard the old Wall Street saw "Don't fight the Fed." This makes it particularly important to realize that the Fed wants inflation. Some would argue that they need inflation. This certainly applies to all central banks and sovereign debt around the globe.
For example, over the past two-plus years, the eurozone has borrowed at a rate two-thirds above the rate seen from 2005-2007. The U.S. has increased its total debt 32% in two years. That's a lot of debt that must be inflated into submission.
For these reasons, emerging market debt will probably be one of the few attractive government debt opportunities left.
Can you talk about valuation? How does current valuation of Treasurys compare to other sovereign debt and competing asset classes, like stocks?
As mentioned earlier, from a cyclical standpoint, bonds are overvalued relative to where we are in the business cycle. And, although it's not a very fair comparison, yields on the 10-year Treasury are clearly in the lower 5% of a 50-year history.
You can look at relative valuations in competing asset classes using a comparison of 10-year Treasury yields vs. the dividend yield on the S&P 500. P/E on the S&P 500 is fairly to slightly overvalued. Relative to the yield on the 10-year T-note, stocks are very fairly priced. We think a long stock index position has less risk than Treasurys.
What is the current sentiment on Treasurys? How does your view differ from the consensus?
We employ two measures of sentiment in the Treasury market. First, we can monitor the commercial interest in bonds using the Commitments of Traders report. It's interesting to note that the commercial interest in Treasurys from the COT report is pointing to extremely bearish sentiment on bonds. In fact, save for one month in 2005, it's at the most bearish level since 1993.
We can also look at inflation expectations vs. the ECRI's Future Inflation Gauge. First, it looks like there is decreasing conviction that inflation will be a problem over the mid- to long-term. The most recent Fed Open Market Committee minutes reflect that. Also, inflation does not appear to be a concern in the TIPS market either.
You can interpret this in one of two ways. You can hold the opinion that markets are a clearinghouse of all that is known about inflation and participants are not at all factoring in price inflation to the extent that we are at Butler, Lanz & Wagler. You would, therefore, be either bullish or agnostic on bonds. The contrarian view would hold that this is a good time to short bonds amid noninflationary market sentiment, as there appears to be little room on the downside for yields. The latter is in line with our view.
Does monetary and/or fiscal policy play a role in your position?
Absolutely, they play a role in the analysis. Specifically, these are the fundamentals that will ultimately drive the lagging indicators, including interest rates, higher. If you look at Treasury bond issuance, money supply and federal spending, there's not one trend that bodes well for bond prices. We think that it's very important to understand that a good deal of our bearish stance on bonds is related to issuance. This is a supply story as much as it is about inflation.
Deficit spending can lead to a market-saturating level of bond supply issued to cover those deficits. Given a constant demand for U.S. Treasurys, increasing supply will lower the price of those issues. And, as we've mentioned already, total government debt in the U.S. is up over 30% in two years. That must increase Treasury issue supply.
Regarding monetary policy, we look at the Fed statistic MZM (Money Zero Maturity: M2 supply, less time deposits, plus money market funds). Year-over-year growth reached a peak of 16% by the summer of 2008. And while this metric has actually reached a negative annual growth rate recently, the U.S. created so much money that there is still a very real possibility that the Fed moves too slowly to reduce MZM in time to eradicate inflationary price pressure. Remember, the Fed actually desires inflation in order to ease the burden of paying interest on the federal debt. Just to put this in perspective, the U.S. has already paid $202 billion in interest year-to-date. The Department of Education has spent $50 billion.
Fiscally, the U.S. has not shown the restraint necessary to reduce deficits. On a "percentage of GDP" basis, the U.S. budget deficit is at a level last achieved during World War II. Recent healthcare legislation, we believe, will actually add to that deficit, despite what the Congressional Budget Office forecasts.
What catalysts do you see that could move government bonds?
Obviously, economic indicators important to bonds heating up would do it. Primary among these indicators is employment. This is a good place to mention that until the labor market really starts improving, we don't expect to see too many inflation metrics flashing warning signs. But we do expect the labor market to start heating up within the next several months. So the labor market is key. If we do not follow through on job creation, bonds will stay right where they're at, or even appreciate.
A rating agency downgrade, or (less likely) an upgrade, would move bonds too. We recently saw what a credit downgrade did to Greece's sovereign debt.
Finally, as the economy recovers, risk-taking will likely lift emerging-market debt at the expense of safe U.S. debt. In other words, a flight out of quality will move the Treasury market lower. On the other hand, a fresh financial crisis will drive investors to seek the perceived safety of Treasurys.
What could go wrong with this approach?
Like I mentioned, labor market weakness, upgrades by rating agencies and financial crises would all help bonds and hurt the short seller. But we should also mention that any pressure on the euro as a result of deteriorating credit conditions in the PIGS will put upward pressure on the dollar and this would decrease inflationary pressures and subdue interest rates. So we need to watch the eurozone credit situation very closely.
Thanks, Chris, for sharing your thesis with us.
Disclosure: Butler, Lanz & Wagler, L.C., is short U.S. Treasurys through long positions in ProFunds Rising Rates Opportunity Fund and PPR.
If you are a fund manager and interested in doing an interview with us on your highest conviction stock holding, please email Rebecca Barnett.