Credit Market Message: Banking Risk is Rising

One of the lessons learned from the 2008 credit crisis was not to ignore warning signs that emanate from the credit markets. Lately we are watching credit market relationships move in a way that indicates that stress is increasing in the global banking system. One measure that is raising concerns is the rise in interbank lending rates, as measured by the spread between Euribor and Overnight Indexed Swaps (OIS). This measure is higher than it was in 2010, and rising fast.

We have also been following credit default swap pricing on several European and domestic banks. Credit Default Swaps (CDS) are contracts that investors buy to protect against company defaults, and the price of this insurance has been rising quickly, particularly in European banking names like Societe Generale, which was rumored last week to be having short-term funding problems. Some believe that CDS prices are overshooting actual problems, and that the Societe Generale rumor was nonsense.

We can’t be sure that rumors aren’t helping to fuel the fire, but we have learned over a long period of time to respect the message from the credit markets. We’ve already been in de-risking mode at Pinnacle due to our call that a recession is probable, and that we are likely trapped in a bear market rather than a deep correction. The current message from the credit markets just adds another element of risk at an already risky time.

Debt Ceiling Q&A

Due to the fast approaching August 2nd debt ceiling deadline, and increasing media coverage, many of our clients have come to us with questions regarding our views on the issue.  We compiled the most common questions and our answers into a brief Special Report, which is posted on the main Pinnacle website.

Please click here to read the Special Report

No One Believes it Could Happen…

One of things the investment team sometimes talks about is what’s consensus versus what’s non-consensus with respect to investor preferences. The reason we talk about it is that we typically think of the consensus as a herd going one way. There’s nothing necessarily wrong with that, since the consensus can be correct at times. But if you think of the market as a mechanism that seems to take pleasure in making the most people look bad, than being part of the “consensus” is scary. And at the turns in the market when emotions are typically too euphoric or pessimistic, then you want to steer clear of the consensus.

One of the most non-consensus trades I can think of right now is that Treasury bond yields will melt down into the low 2% range, or dare I say below it. Inflation and higher yields continue to be the herd’s mantra despite being in a broken financial system, having a banking system that continues to hide losses (evidenced by the suspension of mark-to-market accounting), and a Federal Reserve that has been forced to turn to quantitative easing as a last resort to avoid an all out debt deflation.

It seems like no one believes, or no one wants to believe, that there is even a chance that yields could actually fall below the levels reached at the apex of the 2008 financial crisis. I’m not saying I would lay great odds on it either, but take a look at the chart attached, which shows Japanese 10 year bonds yields. Those yields have been locked under 2% for more than decade. Isn’t there some chance that we could follow suit?

Yes, I know there are differences between Japan and the U.S. There are differences in demographics, and in the way they handled their own crisis from a monetary, fiscal, and currency perspective, and we have Ben Bernanke as our Fed Chairman who just happened to write a paper called “Deflation: Making Sure ‘it’ Doesn’t Happen Here.” I get those arguments, I just don’t get why folks seem so programmed to not look at the similarities between the Japanese bust and the U.S. Great Recession. Too much debt, a housing problem, a busted equity market, and an attempt to cover up bad debts all seem to be a recipe for a prolonged period of subpar economic activity. Below 2% on the 10-year Treasury, nobody believes it could happen, which is precisely why investors should be open to the idea that it could.

10 Year Under 3%

So, in the short run, bond yields rising have proven to be anything but a sure bet. The chart below is a chart of the 10 year U.S. Treasury yield and the current yield has been pushed below 3%. The 3% level is a big psychological level on the 10 year as indicated by the yellow trend line in the chart. In 2008 and during the summer of 2010, the ten year broke below the 3% line as deflation fears spiked and investors ran to the Treasury market as a safe haven. And that break in the bond yield only marked the beginning of a vicious bond bull that would last for months.

The bond bull took yields down to 2% in 2008 and 2.3% in 2010 as indicated by the rising green trend line at the bottom of the chart. If this current break of 3% is a sign of further bond strength then we could see 2.5% on the ten year bond by the time it ends (the intersection of the yield and the rising green trend line). That would be a 15% drop in the yield and would be a significant gain in the Treasury market over the next few months.

At a time when our portfolio duration (price sensitivity to yield) is under benchmark, we have been mulling the bond market over for the past few weeks. We could use our small cash positions to purchase Treasury bonds, increasing our duration to try and protect portfolios during this slow growth patch; we could sit tight with our current allocation; or we could use this bond rally as an opportunity to further reduce duration in anticipation of stronger growth by the end of the year. We will soon be reaching a decision on this issue.

Interest Rates & Group Think

Today I had the chance to attend a CFA luncheon in Baltimore with Carl Noble where Jim Grant was the keynote speaker. For anyone not familiar with Jim Grant, he is a very accomplished writer, historian, and value investor, and he writes an excellent newsletter called Grant’s Interest Rate Observer. Jim is also an excellent speaker, and I would encourage anyone that gets the chance to go hear him pontificate about the markets in his very unique style.

As he has been for some time, Jim is bearish on bonds (he thinks yields will rise) and the U.S. dollar, and very bullish on the price of gold. On the topic of yields, we have shared his view that they will likely drift up if the economy stays supported, but have also acknowledged that the view certainly seems consensus at this point, which is a little bit worrisome from a contrarian investing standpoint. As I sat and watched the reaction to Grant’s view on rates, the feeling I got from being in the room was that most audience members agreed with what he was saying. I mean, who can’t see that rates at these levels can’t go much lower, right?

As it turned out, I got the last question of the day and had a chance to ask Jim what a contracting money multiplier and huge bank reserves meant to his view, because the behavior of these metrics might lead some people to believe that the U.S. is currently dealing with Japanese-like deflationary symptoms that could cause interest rates to stay low for a lot longer than most folks think is possible. Jim was undeterred and essentially believes that Japan’s cultural differences were the biggest reason for their lost decade, and he believes and sincerely hopes that we don’t head down the same economic path as Japan.

At the moment we continue to be positioned to benefit from higher rates, if for no other reason that our cyclical view is for continuing economic expansion, and investors had piled into bonds in the Great Recession and may still be unwinding that trade. But I have to admit that I occasionally get the nagging feeling that current "group think" is all for higher rates at the moment, which leaves the herd vulnerable to rates moving lower and staying there longer than most expect.

Is the U.S. the Next Greece?

Yesterday Standard and Poor’s issued a warning about the health of the U.S. economy when they changed the outlook on U.S. debt from stable to negative. This created some big headlines, and no doubt contributed to some of the volatility on the day. So what does this mean, are we the next Greece?

No one should debate that the U.S. has too much debt, and it may be that Treasury yields need to rise just to normalize with the pickup in the economy. However, investors should not forget that the U.S. is still home to the largest and most liquid capital market structure in the world. There may not be much value left in the Treasury market, but in my opinion we are still a long way from becoming the next Greece. While we don’t treat this announcement as good news, we don’t believe it will be much of a factor for the cyclical time frame we invest, and therefore it is not a game changer to our current forecast that the cyclical bull market is still intact.

One of the interesting aspects to the day was that risk assets lost ground and talking heads blamed the ratings warning as the key catalyst, but market action seemed to imply that other factors may have been at work. We couldn’t help but notice that the U.S. dollar actually went up during the day, and though Treasuries started the day lower, they rallied as money came out of high beta sectors and fled to safety in bonds. If markets were worried that we will go the way of the PIIGS (Portugal, Ireland, Italy, Greece, Spain), then the bond market vigilantes would have likely given us a much bigger wakeup call in the form of higher, not lower, bond yields.

30 Year Treasury Bonds

The 30 year US Treasury bond has had a rough couple of months. The yield on the 30 year US Treasury bond was 3.45% on August 25th and has since risen to a yield of 4.73%, which means that the price has fallen over 18% in roughly 6 months as price and yield move inversely to each other. It is not very surprising as general commodity prices have skyrocketed while trust in paper assets has declined, which in turn has stoked inflation fears around the globe. This has led to frequent discussions between Pinnacle analysts regarding topics including hedging techniques and the overall technical state of the Treasury market.

The chart below shows the Generic 30 Year US Treasury Yield back to 1985. This bond bull market has been quite impressive although the chart below shows that the bull may be ending. The white line represents the downtrend line in yields from 1996 to 2011. During bond sell-offs, the yield found support at this line 4 times before this latest sell-off pushed the yield above the downtrend line. But is this enough evidence to call the bond bull over?

Viewing the last 999 days gives a slightly different picture. The yield has found support at exactly this level four or five times over the last few years. The green lines drawn on the chart represent the support zone. If we do see yields break higher out of the support zone this could add to the possibility that yields will move significantly higher. If the support zone holds we will likely see lower yields, and 4 out of 5 times that happened equities followed right with them.

Unusual Excitement in the Muni Market

Lately we’ve been watching municipal (muni) bond exchange traded funds (ETFs) fall at a rate that hasn’t happened since the Great Credit Crisis of 2008. Most of the available research is painting a picture of an almost perfect storm hitting the municipal market at the present time. Municipalities currently face: tough budgetary constraints due to revenue shortfalls, severely underfunded public pension funds, the possibility of an extension of the Bush tax cuts, a recent surge in new issuance, doubts about the future of the Build America Bond program, and a large municipal bond insurer filing for chapter 11 bankruptcy protection. In addition, some think this is a reaction to the Fed not buying a larger percentage of long-term bonds in its recently announced QE2 program. Whew, that’s a nasty witch’s brew for munis, which is reflected in the chart below.

With various muni ETFs down a quick 5-7% since the beginning of November, we are currently internally debating whether the decline is just a short-term dislocation that presents a buying opportunity, or a warning signal for the health of the overall market. At the moment, we are furiously digging through the research to make sure we have an informed opinion regarding this situation. My gut feeling is that this is an overshoot that will likely present a short-term window for investors to capitalize on. But many years in this business has taught me that investors ignore credit markets at their own peril, and so it’s worth double and triple checking before acting. Municipal bonds are typically thought of as boring investment vehicles for conservative investors. However, right now things are pretty exciting in the muni markets.

Chart: iShares Municipal Bond ETF (MUB)

Bond Market Not Cooperating With QE2

Since November 2nd, the day before the Federal Reserve officially unveiled QE2 (consisting of $600 billion in new purchases of Treasury securities), the 10-year Treasury yield has climbed by 36 basis points, from 2.59% to 2.95%. Higher yields run counter to the Fed’s intentions, since they’ve specifically cited lower interest rates as one of the main reasons for implementing QE2. They believe that if they can drive rates even lower than they are now, it will help spur economic activity and support the recovery.

Although a 0.36% rise in rates may not seem that large, it’s already started to have an impact in the housing market. According to a weekly report from the Mortgage Bankers Association, 30-year mortgage rates rose from 4.28% to 4.46% last week, causing substantial declines in applications for both new purchases and refinancings (see the table below). Considering that the Fed is specifically trying to drive interest rates lower in order to help the housing market, they can’t be very pleased by the market’s reaction so far. It may just be a short-term phenomenon, or it could be a broader signal that the market doesn’t have much confidence in QE2’s ultimate effectiveness. The Fed is undoubtedly watching this very closely, and hoping that it’s the former, not the latter.

Managing Fixed Income

With the advent of Exchange Traded Funds (ETFs), we have raised the question of how to best manage fixed income on multiple occasions. Since our inception, we have used individual municipal and government bonds when we felt there was value in that asset class. This is very normal in the institutional world, and has served our clients very well. However, I recently informed our Chief Investment Officer (Ken Solow) that the fixed income portfolios for many clients are drifting from our targeted duration due to the use of individual securities. As a reminder, duration is the sensitivity of a bonds price to a change in interest rates. A longer duration bond has greater price moves when interest rates change than shorter duration bonds. When an individual bond gets closer and closer to maturity its duration becomes shorter and drifts away from our intended target.

If we bought bonds to generate income, and just held them to maturity it would be a much simpler world. However, we manage bonds for total return – which is income plus changes in price. And as bonds drift from their duration targets, the total return on the bond also drifts from our expectations, and we are left with a choice. Do we sell the current bonds to purchase longer duration bonds, or do we hold on to them with the realization that our total return expectations would have to change?

Getting back to ETFs, many companies have created products that provide exposure to municipal or government bonds while managing duration. For instance, the iShares 20+ Year Treasury (TLT) invests in U.S. government bonds over 20 years in maturity, while maintaining a fairly constant duration in the vicinity of 15.5. We can purchase this product for every client and have two reassurances: the product will generate the same return for each client and iShares will manage the duration for us. So even though the use of individual securities has many merits, I feel like these two factors allow us to more effectively manage our bond allocations and therefore we may see more ETFs used in Pinnacle portfolios in the future.

Are Bonds and Stocks Telling Us We Are in a Sweet Spot?

The dollar continues to fall, reflation trades rage on for the moment, and risk assets are currently in vogue. But has anyone noticed that Treasury bonds have been rallying, too? How could it be that government bonds, which usually thrive off poor economic news and financial misery, could rally at the same time as the high-flying equity markets that benefit from economic and profit growth? Some of the technical (non-fundamental) reasons for the rally we’ve seen recently include ultra-low returns on cash causing nervous investors to seek something safe with a better yield, central banks that continue to park large reserve balances in bonds because of a lack of better alternatives, and banks that would rather buy Treasuries because they’re still reluctant to lend. Some will look at the divergence between bonds yields and stocks and conclude that one market has to be wrong - either bonds are correct and the economy is softening, which is good for bonds and bad for stocks, or stocks are correct and the economy is improving, which is good for earnings and stocks but bad for bonds.

I have a different view, which is that lower yields may be just be signaling that inflation is currently not a problem. One only has to look at the very low levels of capacity utilization, the large negative output gap (the difference between potential GDP and actual GDP), and slack in the labor markets to realize that the economy has plenty of room to grow before inflation pressures build. That has created a sweet spot for equities, allowing them to rally in unison with a cyclical rebound in economic activity without having to worry that the Federal Reserve will be pressured into prematurely tightening monetary policy. We won’t always be in this sweet spot, and at some point much higher or lower yields will probably portend either a tightening environment or very poor future economic growth, neither of which would be good news for the equity markets. But for the limited window that this goldilocks sweet spot exists, I suppose we should all try to enjoy it!

Fixed Income Watch – All Bonds Are Not Created Equal

Mention the word bond to a friend and watch their eyes roll into the back of their head. I don’t think it’s a stretch to say that most of the world pictures a bond to be that safe investment that delivers a coupon, eventually matures, and should yield a little better than a money market, end of story. Most don’t realize just how volatile bonds can be. At Pinnacle Advisory Group we believe bonds can have many purposes in a portfolio, and we believe it is prudent to invest in bonds for total return, not just a yield. Once you get beyond yield clipping and embrace fixed income, it is surprising just how big a world opens up to investors. Investors must assess not only interest rate sensitivity that can cause fluctuations in bond prices (called duration), but also be aware of credit risk, valuation between different bond asset classes, currency risk (for foreign bond holders), etc.

Those who don’t pay attention to the bond market might say that paying attention to what bonds you own just can’t make that big a difference in accounts that are mixed between fixed income and equities. But one look at the returns of different bond classes over a couple of time periods reveals this thinking to be a fallacy.

The chart below shows a number of fixed income sectors and their corresponding returns from the start of the equity bear market to the current market bottom in March. It then lines up the total returns for the same asset classes from the market bottom to August 5th. A few things are notable. US dollar denominated high quality bonds with a high interest rate sensitivity did the best during the recession as the markets gravitated towards quality and shunned the entire risk spectrum. On the run-up we have seen just the opposite, with low quality and non dollar denominated bonds providing the highest return, while traditional “risk free” government bonds have posted returns that have been anything but risk free.

At Pinnacle we take the time to evaluate the bond market for both its message about the economic environment, as well as to look for what we think represents the best risk/reward in any given environment. Many may continue to think that bonds are just a boring asset class that isn’t worth the time or effort to explore, but we don’t agree with that thinking. All bonds are not created equal!