Dr. Bernankenstein Insist the Experiment Will Continue
The Fed re-iterated its commitment to purchasing $85 billion a month of mortgages and treasuries until the job market improves. So far, all that is clear, is that the Fed is pushing investors into risky assets and is at the risk of turning investors into a bunch of zombies, in the search of risk. Here are my biggest concerns
- Mortgage rates have creeped steadily higher since September, which makes the premise that low mortgage rates will help housing which will in turn help the economy, at least somewhat dubious
- Treasury yields have backed up as well, dragging corporate bond yields with them as spread tightening can no longer offset that. So the two things the Fed is actually buying have underperformed. I can understand some of the logic, but at the same time it also looks like a lot of risk taking has been front run
- Jobs created in January were actually weak. The bright spot of the Non Farm Payroll (NFP) report on Friday was that previous months had big upward revisions. The trend is actually negative, which should be an even greater concern since avoiding the Fiscal Cliff on January 1 should have sparked more hiring, not less.
- Financial engineering is a safer and better way for companies to generate share price growth when compared to actual engineering or production. The Fed, without a doubt, has shifted the balance towards taking financial risk rather than economic risk, which I don’t think was their intention and the long lasting impact of which has yet to be felt.
The saying “don’t fight the fed” exists for a reason, but 2008 happened in the midst of what at the time was unprecedented support, and there is something that is troubling about an economy that requires low yields, but can’t keep them low, even with the Fed buying.
A Wile E Coyote Moment for Corporate Debt
There was a brief moment on Thursday morning when there was no real buyer of corporate bonds. Investors weren’t looking to sell them, but if you made a casual call to your market maker about where a bond was, they assumed:
- You weren’t calling to buy bonds, you were calling to potentially sell
- They had no interest in buying the bonds for their own account, and had already scouted around to find buyers for bonds they held in inventory, only to find there was a buyers strike
The situation reversed fairly quickly on Friday as stocks set off to new highs, but now is the time to lighten exposure to corporate bonds. A few things drove this move
- Retail is slowly but surely pulling back from corporate bonds, the shares outstanding of LQD, HYG, and JNK have all been on the decline, in spite of the Fed re-iterating its intention to purchase bonds
- Pension funds and Insurance companies are reasonably full on their allocations to fixed income and are reluctant to add more at the first sign of weakness, they can finally afford to be patient
- New issues started to struggle. THC and DNR were two junk issues from the week before that traded below issue price. That puts pressure on all the “flippers” and also causes investors to hold off on the secondary market and focus on trying to get greater concessions out of the new issue market, where the calendar remains robust
- Hedge funds, in their focus on getting 10% returns in a low yield environment, have started to use leverage. While they have plenty of room to “buy the dip” and to add, they wait for the turns because they get nervous that even a 3% drop in high yield bond prices (hardly a rare event) could damage their ability to perform for the rest of the year.
The market bounced quickly on Friday, but still didn’t finish as strong as equities and that bit of wobbliness may return.
Spain and Italy
I haven’t mentioned these countries in awhile, but both suffered setbacks last week. Italy was hit by a banking scandal with Monte dei Paschi which has links to Mario Draghi at the ECB. It was before his time at the ECB, but certainly cannot help the situation in Europe.
Both the Italian stock markets and 5 year Italian debt suffered losses on the week. It wasn’t horrible, or even particularly scary, but it wasn’t last year either, until it was.
Spain got hit by allegations of corruption in the Rajoy government. Not the same as what occurred in Italy, but not so different.
The concern I have is that investors and politicians in Europe have become very complacent. Victory speeches are the norm, and yet hints that problems are deep rooted and not being resolved are being ignored. It is also important to remember that neither Italy nor Spain have officially entered into a program allowing the ECB to make open market transactions (OMT).
OMT’s announcement in September was the last nail in bear coffin last year, but it is only a theoretical program. Countries have to enter into agreements to get the support. So far the market has been happy to rally without testing that commitment. If selling pressure mounts (and I think it will, as I removed Spain and Italy from our institutional “Best Idea” list on Wednesday) they may need OMT, but will the IMF and the EU be eager to commit funds when little has been done to fix the core problem and the signs of corruption remain? If I was an opponent of Merkel in Germany I would certainly raise the issue of giving money to untrustworthy borrowers.
The Market’s Catch 22 (repeat of last week)
The week ended with stocks rallying and bonds selling off. The problem, at least as I see it, is that can’t last for long. One version of the bull case is:
- Low rates encourage business to borrow to grow
- Low rates helps consumers spend and lets the housing market do better
- Growth and housing doing better is very good for stocks
- Rates go higher as investors move from bonds to stocks
It is that last link that strikes me as contradictory. If low rates are one of the key reasons for the market to get excited, the virtual “certainty” that rates should be going higher seems to be a direct contradiction. Won’t rising rates (if they happen in a meaningful way) not only stop the stock market rally (discounted cash flow and relative value both affected)?
In the past 4 years, credit spreads could contract enough that even if treasuries rose, the yields on most loans (corporate, real estate, or individual) could move lower while treasury yields rose. The “risk” component of the risky bonds could offset that rate move while risk (including equities) did well. That CANNOT happen this time.
High yield, as measured by HYG, is up less than 1% since the January 2nd close. LQD (a proxy for investment grade bonds) is down since then. So while stocks have rallied, the borrowing cost for corporations has not improved much this month. That is different than in prior periods of QE. Municipalities have fared better, but still not getting the big benefit.
The U.S. Government has almost $3 trillion of debt maturing in 2013, all of which will need to be replaced, plus some. Every 1% increase on just the debt that gets rolled would cost us $30 billion (I’m ashamed to admit, but I used a spreadsheet on that calculation because it just seemed too large). So a 2% move higher on the cost of the debt we roll would cost as much as a hurricane Sandy.
I’ve been reading some reports that attempt to explain why stocks can do well with rising yields, but so far I haven’t found them convincing. Not when so much of the move seems predicated on low yields.
Sentiment versus Reality, or What is Priced In
Our assessment of what the real outlook is for various asset classes versus our sense of how people are positioned. Red indicates overvalued, Green is undervalued, and Yellow, is neutral. It isn’t exact. In our view, positioning and sentiment is more important, at least from a contrarian view. While it is possible to have strong support for an asset class with strong fundamentals still be a “buy” it is far more common to see sentiment diverge from reality and that is the opportunity.
Treasuries, Selling From 9 to 5
Last Friday was ugly for treasuries, and this Friday was even worse. At one point on Friday morning, TLT was up on the week. By the end of the day, it was down almost 2%.
That was a painful move for anyone recommending long treasuries (which we continue to do). So for a full week treasuries held in well. In fact they responded positively to the FOMC minutes on Wednesday. They were up as the market felt weak on Thursday and even on Friday morning. Then the bottom falls out and there is no liquidity.
I had been tempted to take some off on Friday morning, I failed to do so. I’m looking at them now wondering if I need to reduce exposure, but for now will leave them alone. The day was strange and I think many of the reasons treasuries had stabilized throughout the week remain in play.
Credit – Not as Good as it “Should” Be
We wrote about the Wile E Coyote moment earlier in the report. There was that brief moment where it felt like the market had gotten ahead of itself and there was no support. It clawed back, but it felt very dangerous.
LQD finished down on the week, another reminder, that in spite of all the talk about credit “spreads” most retail investors are invested in credit “yields” and they got hit with treasuries. That is an ongoing concern in this environment.
IG19, the US Investment Grade CDS index, started the week at 85 (near the tights of the year) and went as wide as 91.5 (the wides of the year). It finished back at 86, but that is in spite of stocks setting new highs. Could this be a crowded short now and a great contra indicator? Possibly, especially as some synthetic CDO’s are getting done, but first I think we need to see some real fear out of bond investors, who are still clinging to the belief that bonds will outperform CDS. IG19 is still trading rich to intrinsic value, which remains a sign that complacency is with the bulls, not the bears.
The relationship between leveraged loans and high yield played out nicely. High yield was down more, which makes perfect sense, as the high yield bonds were hit by duration risk and a tiny bit of credit fear. I am looking for signs that relationship is truly abating before liking high yield. Friday was too easy and too equity driven to provide an “all clear” signal.
Floating rate bonds are attracting some attention. Personally I think the issuers are too heavily skewed towards financials to get too excited, and think the Fed will leave short term rates at zero long after they are done with bond purchases, but an interesting asset class to watch.
For all the fixed income ETF’s, but particularly for LQD, HYG, and JNK, I think at these levels trading at a discount is a warning to sell rather than a buying opportunity. At lower prices, or bigger discounts, I will change that view, but here, it indicates to me that we are in early stages of weakness, but denial remains high.
I was neutral coming into this week and remain neutral. The sector performed well (not losing much was good this week in fixed income). The pressure on treasury yields will start to impact munis, I think they benefitted more from a lack of institutional focus this week, but will start to look expensive soon.
This is the first appearance of mortgages as a separate section, but given how much hope is being placed on a housing recovery, and at least some of that is based on low mortgage rates, it is worthwhile treating separately here. We will increase the focus over time, but we have seen Fannie Mae mortgage rates increase across the board, particularly at the long end. This is primarily a function of treasuries, but unlike other periods of QE, when credit spreads were wide and could offset the treasury related yield rise, they are too tight right now and mortgage yields move closely with treasury yields.
EM Bonds – A Timely Warning
Last week we mentioned that EM bonds were not EM stocks and that they had attracted to much attention too early. This week they got hit reasonably hard, largely due to treasuries.
I’d also mentioned, but sadly did nothing about, getting up to speed on local currency bonds. If the EM revival story is true, local currency bonds should outperform and they certainly did last week.
Dividend Stocks as an “Other”
Nice and steady. Under the “could have, would have, should have” column goes my failure to add some utility stocks as I had intended last week. By the time I was ready, I thought they would get dragged down with investment grade credit. I was wrong and still want to add, but will be patient.
Fixed Income Allocations
The “Core” strategy is meant to have limited number of trades. It would only be readjusted as longer term views change, or short term views become very large or very strong.
This strategy would have lost 0.73% for the week bringing the YTD return to minus 0.34%.
Horrible week. Treausries were the bulk of the problem, but high yield didn’t help and even leveraged loans hurt. I am questioning the allocation to treasuries, though, having said that, they were fine until after the open on Friday. I will actually be looking to add risk on weakness, particularly high yield, but may cut back on muni’s and leveraged loans.
The core strategy has moderate duration risk and medium high on the credit exposure.
The “Traded Strategy” is meant to have more frequent rebalancing and to capture smaller moves in the market.
The traded strategy lost 0.57% last week bringing the YTD return to -0.67%.
Friday morning was the first time I had been tempted to cut some treasuries and add some high yield. I didn’t, that was a costly mistake. For now I remain comfortable, I will be looking to add some risk, but won’t be taking treasuries down yet, as I think Fed purchases, and the Catch 22 nature of the market will provide yet another bounce.
The “Aggressive Trading Strategy” is meant to be traded frequently and will expect to generate more from positioning than from yield.
The strategy lost 0.38% last week dropping the YTD return to -0.60%.
Treasuries were to blame, but high yield short finally kicked in. This short will get covered soon, but I do want to see some semi recent new issues do better rather than just a stock market induced bounce.
The portfolio is defensively positioned.
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