Investment Postcards from Cape Town

I have been bearish on government bonds since March this year and have repeatedly warned that they were an overpriced asset class, saying at the time: “… one should be cognizant of the fact that an investment in a 10-year Treasury Note will by definition lock in a total return of 3.5% over the next 10 years. This sounds unsustainable and I find it difficult to see the long-term investment merit of such an investment. Long-dated bond prices could be hit hard once yields adjust to more realistic levels.” (See “Long Bonds in Injury Time”, March 28, 2008.)

Although rising bond yields have been given a reprieve as a result of the deteriorating outlook for economic growth and commensurate safe-haven buying, I maintain that the medium-term outlook remains negative owing to valuation levels still being stretched, especially in the light of mounting inflationary pressures.

The chart below shows the long-term pattern of US ten-year Treasury bond yields and specifically the low of 3.14% reached on March 17 and the subsequent turnaround.

Source: StockCharts.com

A very apt and well-reasoned summary of the various factors impacting the outlook for government bonds appeared in The Economist a few weeks ago. This article is greatly complementary to my previous posts on bonds and is therefore republished in full in the paragraphs below.

“The yield of Treasury bonds is arguably the single most important indicator in financial markets. Since the American government is unlikely to default, the bond yield sets the risk-free rate against which other assets are measured. It also serves as a barometer of investors’ feelings about economic variables like inflation and recession.

“But precisely because it does so many things, the Treasury bond can send out conflicting signals. Consumers have been grumbling about the inflationary impact of higher oil and food prices for a while. But bond investors have only recently taken fright, pushing the yield on the 10-year Treasury bond above 4% on May 28, for the first time since the start of the year. Even now, however, the breakeven inflation rate (the difference between yields on conventional and inflation-linked bonds) on five-year Treasury issues is just 2.4%, within the range it has occupied for the past four years; compare that with the 7.7% inflation rate that American consumers expect over the next 12 months.

“One possibility is that the ‘bond-market vigilantes’ have been asleep. ‘We sometimes wonder if Treasury-bond investors enjoy losing money,’ muses Tim Bond, a strategist at Barclays Capital, as he ponders the logic of owning ten-year Treasuries yielding close to 4% when headline inflation is heading (on his view) for more than 5% by August.

“Bill Gross of Pimco, a bond-market investor, argues that inflation is understated in the official American figures because of statistical adjustments made over the past 25 years. The result may be that investors have been fooled into buying Treasury bonds on unrealistic expectations of real (after-inflation) yields.

“Another possibility is that breakeven rates are not an effective measure of investors’ inflation expectations. That is the view of Jack Malvey, a strategist at Lehman Brothers. He argues that yields on inflation-linked bonds have been distorted over the past decade by demand from pension funds, which see the bonds as an ideal way to match their liabilities.

“A third option is that bond investors think today’s inflation rates are a blip. ‘Inflation may be an issue now but it likely won’t be over the next ten years,’ says Pavan Wadhwa, head of European rates strategy at JPMorgan Chase. Optimists argue the anti-inflation credibility of central banks is stronger than in the 1970s. And they note that high oil prices, although they push up inflation in the short term, ultimately tend to act as a tax on growth.

“The credit crunch may also be having lingering effects. Bond yields reached their low in mid-March when the Bear Stearns crisis was in full swing. At that point, the ten-year Treasury bond yielded just 3.31%, the lowest level in five years. Investors were fleeing the riskier debt of bank and other corporate borrowers for the safety of government paper.

“Yields have moved up by more than half a percentage point since then, as investors have started to move money out of government bonds and back into the equity market. But recessionary fears still linger, especially when investors are bombarded with statistics such as the continued fall in American house prices and the decline in consumer confidence. It may still be worth holding Treasury bonds yielding around 4% as a hedge against a sharp economic downturn.

“In short, the bond market is caught in an awkward compromise, with worries about the financial and economic outlook balancing concern about inflation.

“In the medium term, however, it is hard to argue with Lehman’s Mr Malvey when he says that he expects yields in some government-bond markets to rise by two to three percentage points over the next two or three years. Although the world may not be about to return to the excesses of the 1970s, the Goldilocks era is tapering off: the trade-off between growth and inflation has deteriorated.

“Nor have Treasury-bond investors exactly been coining it in recent years. According to Barclays Capital, the annualised real return since the start of 2003 has been a meagre 1%. Will the Chinese, with a domestic inflation rate of 8.5%, really want to hold bonds yielding 4% in a currency they expect to depreciate against the yuan? Is the anti-inflationary credibility of the Federal Reserve really that convincing when it is clear that its rate decisions can be driven by concern for the health of the banking sector? Indeed does it make sense for German ten-year bonds to yield more than Treasuries when the inflationary rhetoric of the European Central Bank looks much more hawkish?

“Veteran investors may recall 1962, when the Treasury-bond yield was less than 4%. Those who bought bonds then earned negative real returns over the succeeding five-, ten- and 20-year periods. They should be very careful about making the same mistake again.”

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I have alerted readers in two recent posts (US Long Bonds in Injury Time and Watch the Stock/Bond Ratio) that I was of the opinion that US long-dated bonds were topping out.

The following chart of the US 10-year Treasury Note yield indicates that we have now arrived at an important point of resolve regarding an upward break of both the trendline and 50-day moving average:

Source: StockCharts.com

Whereas safe-haven buying has driven long bond yields sharply lower ever since the advent of the sub-prime crisis, investors now seem to have started focusing more strongly on the inflation outlook rather than on economic growth considerations. And rightly so, as the latest batch of statistics points to rising inflation around the globe.

It would appear that financial markets currently face three potential price pressures, as succinctly summarized by GaveKal:

“1. Soaring food and energy prices
Whatever the reason may be, elevated food and energy prices are becoming a real concern. The price of rice, for example, has simply gone parabolic this year. In Bangkok, white rice is now up +120% YTD.

Meanwhile, oil reached yet another record high yesterday, closing at US$113.8/barrel. On that topic, we note with some concern that … world expenditure on oil, as a percentage of global GDP, is back to 7% - a level not seen since 1980. Given the severity of the global recession that followed in the early 80s, this data point does not instil confidence.

2. Rising export prices from Asia
According to BLS data from March, import prices from China are now rising +4% YoY, highlighting a rise from negative growth only one year ago. Moreover, US producer prices are now rising faster than expected, up +6.9% in YoY in March. These are all signs that we are indeed witnessing a significant shift in the terms of trade between the East and the West, and all of this does not bode well for the US consumer, whose spending is already waning.

3. Excessive monetary easing by central banks
Two months ago, the Fed was under great pressure to ‘get back on the curve’. With a couple of significant rate cuts and a series of other easing measures in mid-March, some say the concern is now that the Fed is easing too much – and that it could now be creating the next bubble, this time in commodities. However, we are hesitant to criticize the Fed in this respect when M1 growth remains non-existent (as it has been for the last couple of years) and monetary base growth is at a 7-year low.”

Although long bond yields may not yet skyrocket given the poor economic outlook, it seems prudent not to be exposed to an investment that will by definition lock in an unattractive total return of 3.7% over the next 10 years. As a matter of fact, it may not be a bad proposition to buy a few out-of-the-money put options on long-dated bonds.

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Since the advent of the credit crisis, stock markets, real estate and the US dollar have been the subject of investors’ angst. However, two markets – commodities and long bonds – have remained in bullish trends. That, at least, is the way it looked until recently.

The Reuters/Jeffries CRB Index hit a peak on March 13, and I argued in a subsequent post that although a correction was overdue, the long-term trend was still upwards.

But what about the outlook for US bonds, especially as yields have edged up since the recent lows of 3.314% (March 17) and 4.165% (March 20) for the 10-year and 30-year Treasury Note respectively?

The graph below shows the long-term movement of the yield on the US 10-year Treasury Note, indicating that long-dated US bonds have experienced a multi-year bull market and are trading at levels last seen more than 40 years ago as far as nominal yields are concerned and 28 years ago in real terms. Thinking of which, the only investors who first-hand experienced the last major bear market in bonds (from 1971 to 1980) are now all on the wrong side of 50!

Source: I-Net Bridge

Let’s now turn to a shorter-term graph of the 10-year Treasury Note yield in order to see the recent action.

Source: StockCharts.com

The chart illustrates the sharp fall in the yield over the past few months as investors scrambled for safe-haven investments as the subprime fallout intensified. Although the yield has bounced off the bottom Bollinger Band (bottom green line), no sell signal as such has been given. However, the positive divergence of the Stochastic Oscillator is of some significance as it often acts as leading indicator of the yield graph. Although the 50-day moving average (off-blue line) could provide a short-term barrier, the real test will be the February high of 3.917%, which also coincides with the top Bollinger Band (top green line).

It would be remiss not to also show the weekly chart of the 30-year Treasury Note yield, and specifically to point out the triple bottom that has formed over the past five years, providing particularly strong support in the 4.15% to 4.20% area.

Source: StockCharts.com

Why would long bond yields be breaking upwards (i.e. why would long bond prices be topping out) from a fundamental perspective? Bonds could be discounting better business prospects a few quarters down the line, or they could be discounting rising inflation ahead, or perhaps both. Quite a likely scenario is that we could see a continued base formation for a while longer as the forces of inflation versus deteriorating/improving economic prospects play themselves out.

Time will tell when bond yields will hit a secular low, but in the meantime one should be cognizant of the fact that an investment in a 10-Year Treasury Note will by definition lock in a total return of 3.5% over the next 10 years. This sounds unsustainable and I find it difficult to see the long-term investment merit of such an investment. Long-dated bond prices could be hit hard once yields adjust to more realistic levels.

Be careful – we’re in injury time.

PS: South Korea pension fund shuns US debt

I have just been alerted to a very topical article that recently appeared in the Financial Times. The relevant paragraphs are republished below:

“The world’s fifth-largest pension fund will no longer buy US Treasuries because yields are too low. The move signals what could be a big shift by financial institutions away from US government debt into higher-yielding assets.

“South Korea’s National Pension Service, which has $220 billion in assets, said on Wednesday it wanted to broaden its range of overseas investments.

“’It is difficult to buy more US Treasuries because the portion of our Treasury investment is already too big and Treasury yields have fallen a lot,’ said Kwag Dae-hwan, head of global investments at the NPS. ‘We need to diversify our portfolio away from US Treasuries and we find asset-backed securities and corporate debt more attractive because of wider credit spreads.’

“A manager at the NPS’s overseas investment team said: ‘The Fed continues to cut interest rates. We are still making profits from the Treasuries that we bought in the past but we think we’d better dispose of them and had better buy higher-yielding European-government debt.’

“Central banks from 16 Asian countries said last weekend at a meeting in Jakarta that they might invest more of their $1,000 billion of official reserves in one another’s sovereign bonds instead of US Treasuries, given the dollar’s volatility.”

Source: Financial Times, March 26, 2008.

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While Western investors are preoccupied with ongoing discussions about escalating financial woes, a recessionary US economy and rising inflation, the consequences of surging Asian inflation have received relatively little coverage.

The upshot of rapidly rising inflation in Asia could not only result in stronger Asian currencies, but also in reduced Asian investment in Western bond markets and, over the longer term, the need for higher real rates in the West with commensurate implications for lower economic activity.

This scenario was very succinctly argued in a recent research report by Pierre Gave of investment house GaveKal. His views are repeated below.

For the past year, we have warned that rising inflationary pressures in Asia could trigger a change in Asian monetary policy. The idea was fairly simple: If Asian inflation continued to creep up, then Asian policymakers would have little choice but to let their currencies appreciate. And in so doing, they would no longer be forced buyers of US and EMU bonds. This would be especially likely if food inflation took off, since the tolerance for rising food prices is very low in the emerging markets of Asia.

We first saw this unfold in India: Frustrated by the inability of conventional tightening measures to combat inflation, Indian policymakers decided to let the currency appreciate. In the second and third quarters of 2007, the Indian rupee was one of the best-performing currencies in the world, gaining 11% against the US$. As a result, Indian inflation fell from 6.7% to 3.0% in just eight months. At the time, the question was whether inflation would spread to the rest of Asia – and, if so, how other Asian policy makers would react.

Recent months have provided a clear answer to that question: Asian inflation is undoubtedly on the rise. China recorded a 7.1% year-on-year gain in consumer prices in January, the highest inflation rate since September 1996. In Singapore, CPI growth accelerated to 6.6% year on year in January, the fastest pace since 1982 … In fact, wherever you care to look, prices in Asia are clearly moving higher, mostly because of a massive rally in soft commodities.

With the above in mind, we should not be surprised to see Asian currencies rise more aggressively in the near future. For example, the market has now massively adjusted its expectations of future Chinese renminbi appreciation.

Given the rising inflationary pressures, we fully expect Asian currencies to appreciate at a faster rate. And as this happens, Asian central banks (followed by Asia’s private savers) will export less capital into the bond markets of the West. This will mean higher real rates in the West, as well as a collapse in monetary aggregates. In turn, this will most likely trigger a big drop in economic activity.

Of immediate consequence: be very careful of overvalued US and EMU government bonds.

Source: Pierre Gave, GaveKal – Ad Hoc Comment, February 29, 2008.

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The past week witnessed mounting uncertainty as investors digested news regarding the ongoing credit market problems and deepening gloom about the global economy. In the words of Richard Russell, author of the 50-year old Dow Theory Letters: “If you’re standing on the railroad track and the train is bearing down on you at 90 miles per hour, don’t stand there trying to decide whether the oncoming train is the ‘Midnight Special’ or the ‘Wabash Cannon Ball’. Just get the hell off the tracks. Which train was coming at you can be determined later – right now that’s not the problem.”

In a speech on Thursday (January 10), Fed Chairman Ben Bernanke acknowledged a weaker economy and the need for further relaxation of monetary policy. He assured the American public at large, that the Fed would “take substantive additional action as needed to support growth and to provide adequate insurance against downside risks”.

However, this was cold comfort for The Street as Stock Trader’s Almanac pointed out that 11 of the last twelve easing periods have proved to be tumultuous times for the markets. It certainly does not inspire confidence when considering that the S&P 500 Index registered its worst performance on record (i.e. since 1950) for the first five trading days of 2008. Also, the fact that the Dow Jones Industrial Index closed below its December closing low (on January 2) and continues to trade below it, points to further weakness. Since 1950, 27 of 29 such occurrences saw continued declines with and average loss of 10.1%, according to Stock Trader’s Almanac.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.

Economy
Philadelphia Fed President Charles Plosser said on Friday (January 11) that the Fed’s biggest worry was potential weakness in consumer spending. Many investors fear that consumer weakness could push the US economy into a recession, a concern exacerbated by overall disappointing retail sales. Rising energy prices, weakening housing markets and slower job growth are all weighing heavily on consumer moods.

The annualized growth rate of the ECRI Weekly Leading Indicator continued on its way down, with Moody’s Economy.com remarking that the trajectory was increasingly looking similar to past periods preceding a recession.

With a barrage of economic data coming from all corners of the world, perhaps the more insightful information was the ECB and BOE decisions to leave their benchmark interest rates unchanged at respectively 4.0% and 5.5%. Although growth in the Eurozone is slowing, inflation remains of greater concern to central bankers than a slowdown in economic activity.

On the other hand, the US seems to be heading towards a half-percentage rate cut at the FOMC’s next meeting on January 30. Fed funds futures indicated an 88% chance of a 50 basis point rate cut, up from the pre-Bernanke speech level of 74%. Goldman Sachs sees three further rate cuts after January of 25 basis points each, bringing the Fed funds rate to 3.0% by mid-year.

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, January 11, 2007.

The next week’s economic highlights, courtesy of Northern Trust, include the following:

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.

Source: Wall Street Journal Online, January 13, 2007.

Equities rallied on the back of Bernanke’s assurances, but it did not take long for subprime fears to resurface and most stock markets closed sharply lower on Friday. The MSCI World Index declined by 1.9% during the week, with Japanese stocks (-4.0%) falling to a 26-month low and European stocks (-2.4%) to a 13-month low.

Friday’s sell-off marked the third straight weekly decline for the US stock markets, with the Dow Jones Industrial Index suffering its steepest first-eight-sessions-of-the-year slide in 17 years.

The S&P 600 Small Cap Index (-2.8%) underperformed the larger caps of the S&P 500 Index (-0.8%). Defensive areas that are more resistant to an economic downturn, such as Pharmaceuticals (+3.3%) and Utilities (+1.5%), were among the few sectors registering positive returns for the week.

The depth of the problems faced as a result of the subprime fallout was underscored by Bank of America’s rescue of troubled mortgage lender Countrywide Financial, Merrill’s expected additional $15 billion write-down, and Citigroup’s second capital-raising effort ($14 billion) in as many months.

Government bond yields fell further around the world as the global economic outlook worsened and investors switched stocks to what is perceived to be a safe-haven asset class. However, fears that inflation could become a problem slowed the decline in long-dated maturities.

On the currency front, the US dollar fell somewhat against the euro as expectations of aggressive cuts in US rates increased. Worries about the deteriorating prospects for the UK economy resulted in the British pound hitting a record low against the euro.

The precious metals complex, however, was propelled higher by inflation jitters, with both gold ($898) and platinum ($1 564) recording all-time highs. Silver played catch-up and rose by 7.1% for the week compared with gold’s 3.8% and platinum’s 2.5%.

Base metals and agricultural commodities also performed strongly. A report by the US Department of Agriculture warned of extremely low inventories and pushed wheat prices to an all-time high, corn prices to an 11-year high and soyabean prices to a 34-year high.

Now for a few news items and some words (and graphs) from the investment wise that will hopefully assist to make sense of financial markets’ shenanigans during the week ahead.

Source: Steve Sack, Slate, January 8, 2008.

Moody’s Economy.com: Survey of business confidence for world
“US business confidence fell to a new record low at the start of 2008 and is consistent with recession. Sentiment is stronger elsewhere across the globe, particularly in Asia, although it is down everywhere since the subprime financial shock began this past summer. Expectations regarding the first half of 2008 are especially bleak, plunging to another new low last week. Businesses have also become notably cautious with respect to their inventories and office space needs. Hiring and fixed investment are soft, but holding up better. Pricing pressures have risen with oil prices near $100 per barrel, but remain very subdued compared to the pressures that prevailed during previous oil price spurts.”

Source: Moody’s Economy.com, January 7, 2008.

BCA Research: Global economy – the oil tax
“The surge in oil prices toward the US$100 threshold adds to growth risks for many of the world’s economies. At US$100 per barrel of WTI, the world’s oil bill will approach US$3 trillion, equivalent to roughly 5% of GDP. That would mark a 1% increase compared with last year and comes at a time when growth in the advanced economies is already moderating in response to the US housing collapse and tightening credit conditions. US consumers in particular will feel the pinch, increasing downside risks for the American economy.

“While strong oil demand – especially in China and the Middle East – is contributing to the surge in crude prices, the rising world oil bill is bearish for global growth. This ‘tax’ on growth adds to pressure for major central banks to ease monetary policy. While rising oil prices have temporarily push up headline inflation, the impact of crude on price pressures may already be peaking. Bottom line: High oil prices will require more aggressive stimulus from policymakers in order to support economic growth.”

Source: BCA Research, January 7, 2008.

James Quinn (Telegraph): US recession is already here, warns Merrill
“The US has entered its first full-blown economic recession in 16 years, according to investment bank Merrill Lynch. Merrill, itself one of Wall Street’s biggest casualties of the sub-prime crisis, is the first major bank to declare that a recession in the world’s biggest economy is now underway.

“David Rosenberg, the bank’s chief North American economist, argues that a weakening employment picture and declining retail sales signal the economy has tipped into its first month of recession. Mr Rosenberg, who is well-respected on Wall Street, argues: ‘According to our analysis, this [recession] isn’t even a forecast any more but is a present day reality.’

“His comments are the strongest sign yet that the gloom on Wall Street over the US economy is deepening as the sub-prime mortgage crisis and the credit rout show little sign of easing.

“Mr Rosenberg points to a whole batch of negative data to support his analysis, including the four key barometers used by the National Bureau of Economic Research (NEBR) - employment, real personal income, industrial production, and real sales activity in retail and manufacturing. … he believes that all four of these barometers ‘seem to have peaked around the November-December period, strongly suggesting that we are actually into the first month of a recession.’”

Source: James Quinn, Telegraph, January 8, 2008.

Ambrose Evans-Pritchard (Telegraph): Bush convenes Plunge Protection Team
“Bears beware. The New Deal of 2008 is in the works. The US Treasury is about to shower households with rebate cheques to head off a full-blown slump, and save the Bush presidency. On Friday, Mr Bush convened the so-called Plunge Protection Team for its first known meeting in the Oval Office. The black arts unit – officially the President’s Working Group on Financial Markets – was created after the 1987 crash.

“It appears to have powers to support the markets in a crisis with a host of instruments, mostly by through buying futures contracts on the stock indexes and key credit levers. And it has the means to fry ‘short’ traders in the hottest of oils.

“The team is led by Treasury chief Hank Paulson, ex-Goldman Sachs, a man with a nose for market psychology, and includes Fed chairman Ben Bernanke and the key exchange regulators.

“Judging by a well-briefed report in the Washington Post, a mood of deep alarm has taken hold in the upper echelons of the administration. ‘What everyone’s looking at is what is the fastest way to get money out there,’ said a Bush aide. Emergency measures are now clearly on the agenda, apparently consisting of a mix of tax cuts for businesses and bungs for consumers.

“‘In terms of any stimulus package, we’re considering all options,’ said Mr Bush. This should be interesting to watch. The president is not one for half measures. He has already shown in Iraq and on biofuels that he will pursue policies a l’outrance once he gets the bit between his teeth.”

Source: Ambrose Evans-Pritchard, Telegraph, January 8, 2008.

(more…)

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