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The Pain Trade: Bull Bonds!

Jan. 12, 2011 4:39 AM ETTLT, BEP
Erwan Mahe profile picture
Erwan Mahe's Blog
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The term, pain trade, refers to those moments when financial markets catch the consensus going the wrong way, thus, wrecking havoc on positions accumulated over the preceding weeks.
Despite my desire to avoid issuing a prognosis for 2011, many clients have asked me about my view of the current overwhelming consensus on the three major asset classes:
·         Negative on government bonds: interest rates rising due to supply of paper, inflation fears and debasement of paper money.
·         Positive on equities: global economy in better shape, poor yield on cash
·         Bearish on euro vs dollar: only escape hatch for eurozone on the verge of implosion
I will limit myself today to American interest rates, which besides being the most complex, are poised to play again this year a pivotal role for the other asset classes.
As it is, the latest comments made by Fed members in recent days as we approach the next FOMC meeting on 26-27 January far from conform to the above-mentioned consensus.
I will provide the links to their talks, below, but, as you will see, their tone is the same and their conclusions similar, with only the resident hawks, Fisher and Plosser, expressing discordant views, but they are clearly isolated within the FOMC.
·         The current quantitative easing (QE2) has been useful and will extend to its completion.
·         Projections of inflation remain low and could even lead to a QE3, if need be.
·         Unemployment will not contract for quite some time, meaning the slack will ensure no inflation surge.
·         Cross winds are still possible (US real estate market, European debt crisis, etc.).
Vice Chairman Janet L.Yellen: The Federal Reserve's Asset Purchase Program
Governor Elizabeth A. Duke: The Economic Outlook
Federal Reserve Bank President Dennis Lockhart: Sees `Headwinds' for Economy as Growth Accelerates in 2011
Chicago Federal Reserve Bank President Charles Evans: open-minded about more easing
Federal Reserve Bank of Minneapolis President Narayana Kocherlakota: Bar for a dissenting vote “pretty high
These comments are meant to hold dampen upward pressures on interest rates, but they also perfectly reflect the current state of the US economy, as you can see in the graphs below.
First, one of the necessary (although insufficient) conditions for inflationist pressures (due to rising commodity prices) spread to the entire economy is for aggregate demand follows said price growth.
For that to happen, this inflation must pass through higher salaries to bolster the nominal purchasing power of households, thus, creating the celebrated price-salary loop and second round effects.
However, the United States is very far from any such scenario.
There are abundant examples of significant salary declines (up to 20%) for those lucky enough to have a job. I found the following article on this topic ver edifying: ‘Downturn’s ugly trademark : steep, lasting drop in wages’.
The graph below compares changes in aggregate private-sector salaries since 1982 with Core CPI.
The growth of "Average Hourly Earnings" has not yet fallen to the lows of 1986 or 2003, but it is getting their fast.
If we also consider the austerity budgets being implemented by state governments facing budget disaster along with the freeze or cuts in the salaries of government workers, it must be obvious that salaries are not going to propel any future price inflation!
Core CPI, which is now growing at less than 1% for the first time since the conversion to fiat currencies (0.80% YoY in November, after scraping bottom in October at +0.60%), is clearly maintaining its downward trend, and if it fall a little closer to 0%, we can count on a new QE.
Salary growth and Core CPI.
Who can guarantee us that Core CPI has finally bottomed?
Salaries under such pressure due to the deplorable state of the US jobs market: The NFP and official U3 (9.4%) reflect imperfectly the reality on the employment market.
You can see the change in the average length of unemployment (number of weeks) and the Bureau of Labor Statistics' definition of U6 unemployment:
·         U3: Official unemployment rate per the ILO definition occurs when people are without jobs and they have actively looked for work within the past four weeks.[2]
·         U4: U3 + "discouraged workers", or those who have stopped looking for work because current economic conditions make them believe that no work is available for them.
·         U5: U4 + other "marginally attached workers", or "loosely attached workers", or those who "would like" and are able to work, but have not looked for work recently.
·         U6: U5 + Part time workers who want to work full time, but cannot due to economic reasons (underemployment).
The average length of unemployment, at 34 weeks, is clearly a depression level.  
Compared with the worst of previous recessions (21 weeks in 1983, 19 in 1994, 20.5 in 2004), this figure illustrates just how far the US to go before it returns to a healthy level of employment.
We see the same thing with U6; at 16.70%, it far exceeds the 10.40% of 2003-04 or 11.80% of 1994.
Moreover, the labour participation rate has shrunk to 64.30, which is the lowest level since 1984.
If we consider that the average rate since women joined en masse the work force has been around 66.50%, that means that there will remain an abundance of reserve labour ready to join the work force, even if the economic recovery is stronger than expected. 
All that means that salaries and thus prices are not heading up for quite some time.
Average time of unemployment and US unemployment rate
Now that we have peeled away the veneer from the economic situation, what conclusions can we draw on US interest rate markets?
As you can see in the graph below, the 10-year rate, at 3.33%, is groso modo in the middle of a large range of 2.50% - 4.00%, excluding the exception 2% rate of December 2008, which reflects more total panic than true relative value asset allocation.  
10-year rates have climbed nearly 100 bps since the beginning of October, depending on the category, either due to the meagre QE2 (it would have taken another $600bn to have a real influence on such a big market) or to the very existence of the QE2 (debasement of the money, guaranteeing inflation, etc.).
Remember that the QE2's opponents predicted an inevitable decline in the dollar, which is hardly the case today, given that the US money is driven much more by the economic outlook than by the fears of money supply ideologues, who never grasped the restrictions of "0% lower bound'…
2-year rates have increased much less during this period, at +25 bps, reflecting belief that the Fed should not hike key rates before mid-2012 at the earliest (fed fund rates driven by the OER). As such, recent fears, which pushed January 2012 fed fund futures toward 0.50%, should soon recede.
To take a contrarian stance (OK, not the first time for me!), I would be inclined to bet today in the direction of pain trading and look for a hike in US bonds, heightened by a squeeze effect, with a target rate of 3% on 10-year bonds, i.e. towards 123 on 10-year futures, as compared with 120.28/32 today.
(Out of sympathy, the Bund could return toward the 127.50/128 range, but German debt also depends on others factors relating to peripheral nation debt).
US 10- and 2-year rates, and Core PCE
If you don't believe in a significant hike in Core PCE, why sell bonds?
Have a good day.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds, Thaler's Corner.

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