Background: The Fed has nearly completed its last and most massive round of Large Scale Asset Purchases, aka quantitative easing, or QE. The consensus expects that interest rates will now normalize, increasing both on the short and long end.
This article proposes an alternative view - though as with most predictions, humility/uncertainty is the first order of business in my world.
A core of my argument is that both the history and theory of QE have been incorrectly represented.
When a major topic such as QE is misunderstood, a correct understanding ought to tilt the investment odds in favor of those who have a clear picture of it.
QE really has been stimulatory, and its ending once again really will be de-stimulatory. Thus it is no surprise that a review of the short history of QE shows that when implemented, interest rates have risen, and when it has ceased, they have declined.
The following introduction sets an historical stage for the points that then follow.
Introduction: QE 3 (or 4, depending on how one counts), which began almost two years ago and is now being tapered to zero. Even though bonds have rallied this year, bonds remain in the hated- feared-mistrusted category. This year's bond rally is merely a counter-trend move, it is thought.
There are, of course, good reasons why rates "should" rise; plus, numerous unpredictable events will affect what the future brings. However, since 1981, there has been a powerful trend toward lower rates; I see the forces behind that trend as remaining present.
With Gen X/millenials etc. collectively not owning all that much investable wealth, money is in the U.S. is largely in the hands of: 1) the still-large 'Greatest Generation,' 2) Boomers and 3) pension funds. All of these three classes of investors provide a continual bid for high quality bonds, prizing stability of principal a great deal.
An objective look at the range of U.S. interest rates provides perspective that explains my viewpoint. This is shown via a chart of the 10 year bond starting from the post-Civil War days.
Current 10 Year Treasury Rate: 2.43%At market close Wed Aug 20, 2014
Mean: 4.63% Median: 3.91% Min: 1.53% (Jul 2012) Max: 15.32% (Sep 1981)
For more than three decades beginning in the late 1960s, T-bonds traded continuously at what had been record levels compared to the past 70 or so years.
This fact is the historical anomaly. Only since about 2001 did bond rates (as measured by the 10 year Treasury) become historically normal. Only since late 2008 did they become historically low. If one believes in symmetry, perhaps they will stay low for as long as they stayed unusually high.
We now have the lowest global interest rates in history. Of all the safe haven countries, only the small isolated ones of Australia and New Zealand have higher bond yields than the U.S.
Brazil, with a low investment grade credit rating and a history of hyperinflation as recently as 20 years ago, borrows at an amazing 3.88%.
Whether it is from the standpoint of a Brazilian investor or a U.S. one, if you wanted to own a government bond, which would you prefer to lend $100 to? You could lend to the United States for 10 years and at the end of that period, your $100 would grow to $124 at a 2.4% interest rate. Or the $100 lent to Brazil would grow to $138.80. Is the extra bit of interest worth the currency, default and political risk? Which bond is likely to be more salable in a crisis?
Now let's take the comparison in the reverse direction. France, with a troubled economy, is borrowing at 1.37% for 10 years. Why isn't lending to the U.S. at 2.4% more attractive? Which economy is stronger? Which country is geopolitically stronger? Which is a safer haven?
With this backdrop, let's look at quantitative easing.
A discussion of QE - Part 1 - a chronology: QE began in November 2008 after some major events. The Great Recession was underway in the U.S. and much of the world. And Barack Obama had been elected; it was clear that with his party in complete control of the Federal Government, a large deficit-spending program was going to be enacted and needed to be financed. Dr. Bernanke, a student of the Great Depression and as we know the then-Chairman of the Fed, had found his time in history. It was time, in his view, to undertake LSAPs - quantitative easing - and stimulate the economy, allowing the government to spend money without taking any resources from an already strained economy.
The above point is made well by former Chief Economist of Northern Trust (NASDAQ:NTRS), Paul Kasriel, who blogs in retirement. His latest post is How Quantitative Easing "Works" -- The Mainstream Still Doesn't Get It:
The main way QE has boosted the American economy has been by the Fed creating credit out of thin air, enabling some entities to increase their current spending without requiring any other entities to cut back on their current spending. Contrary to what the editors of The Economist and many mainstream economic analysts assert (but don't verify), QE has not boosted the American economy by lowering corporate bond yields.
Here is what happened to interest rates in the past five years:
QE 1 ended at the end of March 2010, though delayed settlements mean that some list its end as June. Interest rates peaked around March, then plummeted as new money ceased entering the financial system. The bond (10 year Treasury bond/note herein unless otherwise named) plunged in half a year from 3.9% to 2.4%. Forward-looking economic indicators plunged.
The Fed panicked and resumed QE "1.5" in August. Throughout late summer and into the fall, the Fed stated that it might do another round of QE. Its initial, oft-repeated stated goal was to force interest rates to stay down, thus helping housing and achieving other policy goals.
The Fed decided to make its second bond-buying project a recognized policy, called QE 2, later that fall. That renewed money drop reignited both inflation and inflationary expectations. Interest rates and stock prices both rose on confirmation of QE 2.
Then QE 2 ended with no Taper, on schedule, at the end of June 2011. By then-current thinking, given how much inflation there had just been, interest rates had no business dropping. But in fact it was deja vu all over again. They plunged. The bond had already peaked under 3.7% in the winter, despite high monthly inflation. Of course, there were other reasons for interest rates to fall, such as the worsening European economy and various issues in the U.S. So one cannot be certain.
In summer 2011, with gold passing $1900/ounce, the Fed could not go to the QE well so soon. Thus the stimulative but non-money-printing Op Twist came into being, and lo and behold, this time rates that had collapsed when QE ended stayed down. The panic 2008 post-Lehman low in rates was smashed as the bond hit 1.8%, at or near an all-time low.
With Operation Twist in place, long rates dropped below 3% for the 30 year bond. The 10 year hit an all-time low under 1.5%. Op Twist involved the Fed selling short maturity bills and notes and buying the 10-30 bonds. But no new money creation was involved. The recovery faltered.
Thus it was time to stimulate, and - surprise, the bond yield bottomed as QE resumed.
QE 3/4 (I call it all QE 3) began with a mortgage-backed purchase operation in fall 2012, then when Op Twist ended at year-end, full-blown QE of $85 B monthly, both Treasuries and MBS, began.
In 2013, QE 3 put $1 T of new money into the economy. This represented 6% of GDP created out of thin air to buy bonds from bond holders and in turn give them cash. It was so large an amount of money that it far exceeded the Federal deficit. Hundreds of billions of more dollars have been created the past 18 months since QE 3 came into effect than were needed to finance new debt issuance by the government. This has meant that the Federal deficit "crowded out" no private spending, just as Dr. Kasriel stated as quoted above.
And, interest rates rose - until the Taper began this year. As the flood of new money diminished, so did the bond rate. Coincidence again?
Next I propose practical reasons why this pattern has occurred and why it should repeat, at least based on QE considerations (they are not the only factors, of course).
QE - Part 2 - Facts and Theory: When it performs its LSAPs, the Fed comes to institutions with an unlimited checkbook and transfers to the seller a bank credit ("cash") in return for a security such as a Treasury bill/note/bond or a Federally-backed mortgage-backed security. Unless the seller has sold a T-bill yielding almost nothing, the seller is now going to receive, say, 25 basis points (0.25%) annually on that cash. 25 bps is the rate the Fed pays on idle, excess reserves on deposit with it.
Believing that the cash is "trash," the seller may spend the cash on something. If the spending is on a good or service, that spending is spending that would not have occurred if the seller kept the bond. If the seller turns around purchases- say - a newly-issued Treasury security, that funds the government, which promptly spends the money. Government spending is part of GDP; this purchase of a new bond is stimulatory, at least in theory. If the seller purchases a stock or other bond, whomever sells that security then gets the cash. Eventually all the Fed's QE-generated cash gets spent without disrupting any other spending that would have occurred; or it gets put back on deposit with the Fed at 0.25% interest.
All of the above have happened. Over $2.5 T of the Fed's LSAP/QE cash has gone right back on deposit with it as excess reserves. Is this inflationary and should it raise interest rates? On the face of it, no. The money there is only growing by a non-inflationary 0.25% per year. If the economy were really ready to zoom, the Fed and the banking system, plus the shadow banking system, could and would provide those funds. The tsunami of excess reserves merely mirrors the Japanese deflationary experience.
Perhaps $1 T of spending since QE began can be attributable to the Fed's cash injections into the bank accounts of securities holders since late 2008; that's the amount that the Fed printed through QE that did not go back on deposit with it. Assume that's $160 B per year on average, or about 1% or so of GDP. After factoring in population growth of almost 1% per year and inflation (pick your number), if you subtract out the artificial spending attributable to QE, you come out with, roughly, little or no GDP gain per capita.
This is what is strikes me as important: The starting point of that calculation is the end of November 2008, one year into the Great Recession. From that low level, there's basically been no growth not due to newly-printed money.
Let us look beyond QE for other validations or refutations of this analysis.
Bank credit analysis: Dr. Kasriel demonstrates the importance of the concept of the combined creation of new money by the Fed and bank credit in a June blog post. Note he assumed QE 3 would end in December, not October, and also assumed steady private credit growth. Here's his chart:
This is broader than the preceding analysis that focuses only on the Fed; it leads us to the same correlation. Peaks in total new money/credit creation marked or were close to peaks in the interest rate cycle at the end of 2009 and in spring 2011. They were not perfect but each time delineated excellent short-to-intermediate-term buy points for long-term bonds. His analysis suggests a peak in total Fed money + bank credit creation right around now.
Further correlations; setting interest rate targets: Focusing only on the Fed's assets, GaveKal demonstrates the recent relationship between yoy changes in the Fed's balance sheet and interest rates (inverted) in a recent blog:
The 10-year looks more undervalued by this metric than the 30-year bond, which is fairly valued per the GaveKal correlation.
Is QE inflationary?: Injection of new money into the economy either is inflation by definition (Austrian theory) or is inflationary (Keynesian theory). The problem is, what do you do for an encore? All the new money has gone where it is today. What used to be a zero amount, namely the amount of excess reserves on deposit with the Fed, is now in the $2.6 T range. The rest of the QE funds have been spent on leveraged loans/homes purchases, many for cash/stocks/bonds/consumer goods/etc. What is the result? A sluggish economy, falling interest rates, and inflation under 2%.
With the economy not having deleveraged, debt deflation could potentially lie ahead.
There actually is some evidence of deflation right now.
The PriceStats inflation series is a daily measure of inflation derived from prices posted to public websites by hundreds of online retailers.
US Monthly Inflation Rate on August 19, 2014*-0.104%
Weakness in the online economy is supported by the findings of Consumer Metrics, which provides the following graph of the trends it measures:
Monthly Absolute Demand Index(3):
(Click here for best resolution)
The prolonged downtrend shown above began when QE 2 ended.
Counterpoints: Unfortunately, one of the major problems with the bull thesis on bonds is how much actual price inflation exists today, and how committed Chair Yellen may be to an inflationary outcome. She was a student of James Tobin, a cheerleader for the inflationary policies of the 1960s. Her husband, Nobelist George Akerlof, co-authored Animal Spirits with Robert Shiller. This book praises the use of the "money illusion," designed to fool wage earners by granting raises that do not keep up with the inflation. (I reviewed this book for Naked Capitalism when it came out in 2009.)
So I am looking at my ownership of the 10 year and other bonds as a trade, not a really sound investment.
Technical picture: The bond crashed last year with the Taper tantrum but it has recovered perhaps half its loss. This is neutral technically, but the long term trend and current moving averages favor the bulls.
One of the reliable contrary indicators ever since the advent of formal QE early in 2009 has been the positioning of speculators (red plus blue lines) versus commercial hedgers (green line) as shown by FINVIZ for futures traders in the 10 year bond:
Every time since 2009 that the commercial hedgers have had a sustained 200,000 contract net long positioning, bonds have rallied. The current rally is very interesting, in that a large number of gaps have occurred just where the bond is trading now. This is much better seen on the one-year chart:
This could be an important hurdle to definitely clear for the bond.
My guess is that after some backing and filling, the end of QE and the deflationary/disinflationary conditions present in parts of the U.S. and global economies will probably allow bonds to catch down toward the sub-1.0% yield of the safest of the other major safe havens, the German government bond (the "bund").
The yield curve is not compressed: The spread between short and long rates is the lowest since 2009, now around 200 basis points. Is it too low? No. Look at where that metric was in the pre-Great Recession period:
This graph shows that a 200 basis point spread between 2 year T-notes and the 10 year bond has lots of room to decline. Might they meet each other halfway at 1.45%?
The stock market: Frothy action has been seen in low-quality, highly-leveraged stocks such as Hertz Global (NYSE:HTZ).
General measures of overvaluation such as a version of Tobin's q and Shiller's CAPE are clearly present.
In the past, the presence of these patterns has been correlated with bond rallies, sometimes to new cycle low yields. In the past, such as in the 1990s, resets lower in interest rates have sustained a richly-valued stock market. Might the same phenomenon occur again?
Strategies for the Taper: For people who want to invest, hedge or speculate in Treasury bonds, one choice is the Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV), which is commission-free for Vanguard clients. Another very similar ETF is run by PIMCO (NYSEARCA:ZROZ). EDV and ZROZ own very long duration, zero coupon T-bonds. Zeroes are more volatile than the much more common par bonds, and therefore riskier. Neither EDV nor ZROZ is a very good day-trading vehicle.
Alternatives on the shorter end include the iShares 7-10 Treasury ETF (NYSEARCA:IEF). Other liquid choices give exposure to two other iShares ETFs, the well-known 20-30 year ETF (NYSEARCA:TLT) and lesser-known 10-20 year ETF (NYSEARCA:TLH).
Conclusion: Every bond rally since 1982 has been greeted with skepticism; the positioning of speculators on the futures market in the 10 year bond reflects the same losing bet that the common wisdom has been propounding since the bond peaked in yield in 1981.
With our economy already releveraged, with covenant-lite (or covenant-absent) lending booming, the current downtrend in 10-30 year Treasuries may well be set to continue. Comparative interest rate analysis suggests that in an ultra-low interest rate world, U.S. Treasuries may be the least overvalued of any major government bonds.
Regarding QE, the consensus view that rates are now set to rise could be correct, but it goes against the historical correlations of QE on/off with interest rate trends. It also goes against the simple fact that when the Fed creates cash ex nihilo, some of it gets spent and stimulates prices and economic activity - and interest rates tend rise in response to the increased demand for credit that follows greater economic activity. The cessation of this ends that response.
While the following point is beyond the scope of my expertise, a possible conclusion that can be drawn from my argument here is that long-term rates may be too high to allow healthy economic growth. This is argued cogently by long-time bond bulls Van Hoisington and Lacy Hunt in their most recent public commentary. They argue that the 30-year Treasury may, over the next few years, trade to and perhaps below 2.0%. The point I would emphasize that ties to their research is that Treasuries are special debt instruments. They are not "normal" investments for yield-seeking individuals, and should not be valued by standard criteria that are applied to corporate bonds.
All things considered, I think that there are several reasons for investors to consider being long U.S. Treasury bonds for the weeks, months, and perhaps years ahead. All the usual uncertainties about what will actually occur are readily acknowledged.
No matter what happens to rates, bonds cannot achieve much if any alpha, at least not without substantial exogenous leverage. Thus a number of other investments may well be superior to bonds in a flat-to-declining interest rate environment. (This is one reason I am bullish on biotech.)
I may discuss this topic in one or more future articles.
Disclosure: The author is long TLT, TLH, EDV, IEF.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.