“The Bible says…”
David R. Kotok
Cumberland Advisors, September 16, 2012
“The Lord giveth and the Lord taketh away, blessed be the name of the Lord.” Job 1:21
The Federal Reserve (Chairman Bernanke) sent the message of giving at the Jackson Hole conference on Labor Day weekend. Many, including us, read it as a statement that Operation Twist would continue and may be extended. Many, including us, concluded that the forecast period of low rates would be lengthened to 2015. At the FOMC, Bernanke gave us both.
After Jackson Hole, we did not expect the additional and open-ended, long duration, new asset purchase program to run at $40 billion a month. Some call this QE3. Others call it QE infinity. My colleague, Bob Eisenbeis, is writing about our reasons and our assessment in detail.
Needless to say, we were wrong about QE infinity. The Fed has now monumentally changed the game. The eventual (very long term) outcomes are unpredictable. We can assert, guess, estimate, calculate, infer but we cannot be certain of the final outcomes or their timing.
We do know that the Fed is committed to expand its balance sheet to an unprecedented size. We will track that weekly at www.cumber.com. And we do know that the acquisition of securities in the mortgage area will expand coincident with the Fed also rolling over its existing portfolio. Simultaneously, the Fed will continue twisting its portfolio to longer duration holdings.
So here is what we think this implies for markets.
The Fed is now extracting more and more duration from the market. It may be more than the federal government creates. That means the market price of duration will rise from this additional demand if all things are held equal. But in a global world where the world’s reserve currency is in rapid new money creation, all things are not equal. There are sellers of duration who want to disgorge their US dollar holdings into the Fed’s bid.
Ok, that is the technical definition. Let’s translate this into English.
A quick definition of duration is needed. Duration is a technical term. It measures the sensitivity of the price of an asset to changes in interest rates. It is commonly thought of in terms of years. For example: a single US treasury bill that matures in one year, with no intervening interest payments is considered to have a duration of 1. A zero coupon, 30 year, US Treasury strip has a duration of 30. A 30-year treasury bond with semi-annual coupon payments and a final 30-year maturity has a duration which is calculated as a weighted and discounted series of values of all the payments over the entire 30-year period. The approximate duration of that instrument is about 13. I hope that was understandable. I tried.
The Fed is enlarging the duration of its balance sheet and thereby altering the market’s clearing mechanism. Thus, long duration asset prices are expected to rise. That means US treasury bond yields are expected to fall. But global sellers may have other things in mind. They now suspect the US dollar will weaken and therefore they want to exit their holdings. When they do that, the yields on those instruments will rise and the prices fall if the global sellers sell more in a given period than the Fed is buying. This is the tradeoff we cannot estimate. Only time will tell.
So the volatility in the bond market is rising and will continue to do so. That is what happens when you mess around with duration.
Stocks are a very long duration, variable rate, asset class. They also have the ability to adjust to the inflationary outcomes that this extraordinary Fed policy can deliver. American stocks can state their foreign earnings in US dollar terms. Therefore a weakening US dollar means they will report higher earnings. Thus stocks get a double kick from this policy. They benefit from the weak dollar earnings translation and they benefit from the Fed duration switch.
That explains the market’s reaction to the Fed’s announcement. US long treasury yields rose, not fell. Stocks rose.
We can affirm this reaction by digging into the market.
The cap-weighted S&P 500 average was up 4.49% from Labor Day weekend until the September 14 close. The top 100 are found in an ETF; its symbol is OEF. It was up 4.30%. Remember, it is the larger companies that get the biggest kick from the weaker dollar. So we would expect OEF to trade closely with SPY (the symbol for the S&P 500). It did.
Contrast that with RWL. It is the symbol for the revenue-weighted S&P 500. These are same stocks but with a different weighting method. If the Fed’s policy is expected to result in more inflation, there will be a greater impact on the revenue side, with top-line growth. We should see that expectation show up in the market, where we track revenue weightings vs. cap weightings. It did. RWL was up 5.13% vs. SPY up 4.49%. Note also that risk-taking is broadening in the stock market. We see that by examining RSP. It is the equal-weighted version of the 500 Index. It was up 5.61%.
Let me be very clear. I disagree with this Fed policy move. It was not my first choice. I think the Fed is now playing with fire. But our job is to manage portfolios and not to make policy. If the Fed is now in QE infinity and if the Fed is now buying duration from the market at a rate faster than the market is creating it, then we want to be on the bullish side of that trade. Our US stock accounts are nearly fully invested. Our bond accounts are avoiding the longer-term treasuries and are using them as hedging vehicles. Our international accounts have been realigned accordingly.
The Bible says that Job was tested to his limits. In the next few years the financial and investing world will be tested, too.
The central bank giveth and the central bank can taketh away.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors