When last we published long-term U.S. interest rates had recovered about half of their move higher. The yield of the benchmark 10-year Treasury note was 2.20%, down from a recent high of 2.38% (closing yield) on 3/19/12. When the yield of the 10-year note approached 2.40%, many market commentators predicted a continued run-up of long-term interest rates and for the yield of the 10-year note to approach 3.00%. These same pundits forecasted a raging bull market in stocks as it was only a matter of time before the money which was being parked in Treasuries would pour into equities. So we waited, and waited, and waited and still no pouring of money from Treasuries into equities. Why didn't this scenario play out? Because the bulk of the capital residing in U.S. Treasuries is not exiled equity capital.
The simplistic (simple-minded, in our opinion) view is that capital which has been traditionally invested in equities, now resides in bonds (correct) and that means that much of it is in U.S. Treasuries (incorrect) and that once investors become more confident in the economy and the efficient functioning of the equity markets, a large portion of the money residing in "bonds" will migrate to equities. This view ignores many important facts.
First of all, much of the money in Treasuries needs to be invested in Treasuries for a variety of reasons. Much of the "excess" capital residing in Treasuries did not come from equities, but rather from other areas of the fixed income markets. These other areas include, but are not limited to, GSE bonds, foreign sovereign debt and (on the short end of the curve) money market alternatives. Secondly, the bulk of the money which did move from the equity markets into fixed income, landed in the credit markets, both high grade and high yield corporate bonds. Some of this capital may return to the equity markets, but much of it is likely to remain in the fixed income markets due to changing demographics and potential fiscal headwinds which could impede the economic recovery.
How could all of these commentators and strategists have gotten in wrong? Because they are looking to the past for fool-proof precedents and they are equity market commentators and strategists. As we previously stated, they are not entirely wrong. There is probably a sizable amount of equity money sitting in high yield bonds. This makes sense because high yield bonds are the most equity-like of corporate bonds because they are often traded in terms of total return (including recovery values in case of bankruptcies or debt restructurings). This is why bonds on the lower end of the credit quality spectrum are traded on a dollar price basis rather than on spreads versus treasury benchmarks. Few bond traders and fixed income strategists expect many CCC-rated (and lower) bonds to mature on schedule at par. If they do, great, but that would be gravy.
Other areas which could see a net outflow of capital are the structured debt and exchange traded note markets. These non-traditional debt products were designed to permit investors to speculate while enjoying some kind of principal guarantee (either in full or in part) by a corporate issuer, although many investors did not purchase these alternative investments for these reasons and many do not guarantee the repayment of investors' principal.
Out here in the Fields
The amount of capital which would leave fixed income for the Elysian Fields of the equity market might not be enough to generate the kind of rally that many equity strategists expect. However, capital movement could affect various areas of the fixed income markets.
If the economy begins to improve and/or inflation rates begin to rise, there could be some capital outflow from U.S. Treasuries into GSE debt and high grade corporate bonds. If foreign economies begin to improve, there could be a renewed interest in foreign debt, both corporate and sovereign.
Much of the capital currently invested in the high grade corporate bond market is likely to stay with the high grade corporate bond market (with some conservative investors reallocating a portion of their investments to the GSE market). Changing demographics, specifically the Baby-Boomers reaching retirement age and an aging population, should result in a larger portion of investor capital being tucked away in the credit markets in income-generating instruments.
This presents us with an interesting dynamic for the high yield bond market. We have seen record inflows into high yield corporate bonds and high yield bond funds. Some of this record inflow is due to income-oriented investors looking to increase returns to maintain their lifestyles. Some of the inflow of capital is from equity-oriented investors looking for a place to speculate which is out of the reach of high-frequency traders (along with a better chance of receiving some recovery of principal if a company files for bankruptcy). It is for these factors that we believe that, if there is a significant bubble in the fixed income markets, it exists in the high yield market, especially its lower reaches.
Over and Over and Over Again
Equity strategists are a persistent lot. They have been boldly calling for an end to the 25 year bull market in bonds. With long-term rates not much higher than their all-time lows, it is not such a bold call. That is like on April 15th declaring an end to winter. We would like to thank these strategists for stating the bleeding obvious. Equity strategists at one bank termed the coming bear market for bonds "The Great Rotation." The strategists described it as such because they believe that a substantial portion of the capital invested in the "bond market" (as if it was one market) is destined to be reinvested in equities (we addressed this subject earlier in this edition of "In the Trenches). Sorry guys, demographics are working against you. Fixed income will garner a larger portion of investor capital than it has in the past because a larger portion of the population will desire income-oriented investments. This will be one of several factors limiting the rise of long-term interest rates (slower growth, consumers' aversion to leverage and fiscal policies implemented to shrink the budget deficit are others). This could also keep credit spreads relatively tight. However, since very-low-rated high yield bonds are not usually purchased for income purposes, and do not usually trade on a spread basis; they might not hold their values as well as more-highly-rated corporate bonds.
Very-highly-rated corporate bonds (especially industrials and utilities) may experience spread widening as well. Many investors may feel more comfortable allocating more capital to more cyclical sectors such as banking, finance, insurance and metals and mining. There could be asset bubbles (of sorts) at the extreme ends of the corporate bond market, but a wholesale exodus from bonds of all kinds into equities is a very unlikely scenario.
If the equity market sees an influx of capital from other than the high yield bond market, it is likely to come from cash. According to many equity strategists, there is a substantial amount of cash on the sidelines just waiting to be invested. We cannot speak to the veracity of that hypothesis, but even if it is true that there are large cash positions out there in the market, demographics and logic dictate that some of that cash will remain in cash and some will move into fixed income, when rates are somewhat higher. As the population ages, there will be greater needs for liquidity and income than any time during the past 30 years (if not ever).
We have discussed demographic reasons for not having a continuance of the raging bull market in equities, but there are economic factors too. During the past several months there has been an increase in unit labor costs. If consumer spending plateaus or recedes, profit margins could be squeezed. That would not be good for stocks. Many companies could attempt to maintain profit margins by cutting labor costs. This could be done by laying-off U.S. workers and replacing them with overseas product, greater automation and improved technology, or by operating with thinner staffing.
Shot through the Heart
Then there are fiscal headwinds. In about nine months, business conditions are slated to become less friendly. Taxes are expected to rise, government spending is expected to decline and the Fed has few bullets left in the ammo box. Sluggish economies abroad will also have the growth headwinds blowing hard. Although we do not see a recession on the horizon, we do not see the economy picking up much speed.
All of this leads us to believe that long-term interest rates should rise gradually and modestly. Much of the rise will come from a lack of Fed twisting, but foreign demand on the long end of the curve should remain healthy. The U.S. is both the safe haven for risk-averse capital and the largest economy and among the least dysfunctional economy among the top three. Exporters, such as China, manage their currencies. When China rebalances its currency pegs, other exporters must do the same or be left at a disadvantage. This should keep long-term U.S. rates manageable. If we saw 4.00% on the 30-year bond by the end of 2013, it would be surprising. With the Fed likely to keep short-term rates anchored at or near current lows, the yield curve should steepen during the next two years.
A Bloomberg survey of economists forecast that the yield curve, 2-years to 10-year, will steepen from a current spread of 175 basis points to a spread of 215 basis points with the 10-year yield topping out at around 3.00% in the third quarter of 2013. This sounds like a very logical assumption to us.
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Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.