Crowding In – Bond Interest Rates
David R. Kotok
Cumberland Advisors, December 14, 2013
We are watching bond market volatility as Treasury bonds struggle with questions about what the Fed (Federal Reserve) is going to do. Only the passage of time and improvement of communication from the new Fed leadership will resolve this issue of inadequate clarity and resulting volatility.
At the same time, we are aware that the federal deficit is shrinking. The pressure of new Treasury bond issuance is falling all the time. Markets tend to ignore this trend in the short run. In the longer run and in the past, with the federal government “crowding out” other borrowers, having to sell more bonds put more pressure on markets. The fewer bonds there are to be sold, the less pressure there is on markets. This is called “crowding in” and is a characteristic that market agents have forgotten after the recent and long period of high deficits in the United States.
In 2014, governmental crowding in has arrived in force. Its influence will be felt in markets. Coupled with restrained state and local budgets, we now have a shrinking federal deficit that is now headed under 3% of GDP and trending lower. This is a very powerful force against rising bond yields.
Greg Valliere, an expert observer of Washington, DC, politics and the dynamics of our political system, described the shrinkage of the deficit as follows: “The first two months of the fiscal year look spectacular. Data released yesterday by the Treasury Department show the deficit down by 22% compared to the first two months of last year, with receipts up by 10% to $362 billion. Cynics respond that about $30 billion of that total comes from Fannie and Freddie, which are pumping profits back to the government.” When I asked Greg for more detail about the GSE share, Greg offered this addition about “the enormous one-time tax break of about 20 billion that grossly affected the GSE contribution”: “Both Fannie and Freddie will continue to contribute to the Treasury, but not at the Oct.-Nov. pace.” Many thanks to Greg Valliere for giving us permission to share this insight.
We think Greg is right in his assessment that the falling deficit will persist. We believe it will be a force throughout the rest of the Obama term. It is quite possible that the deficit could decisively dip under 3% of GDP and even approach 2% or 2.5% of GDP. That will be a remarkable event. It will happen at the same time that the pressures on the housing agencies and mortgage finance entities are diminishing. All this coincides with rising house prices and the gradual recovery of our economy. As a nation we find ourselves on the benign recovery side of the pain that convulsed the economy during the financial crisis.
In sum, the new-issuance pressure of bonded indebtedness at all government levels is not intense and not of the nature to drive up interest rates. Instead we have crowding in, not crowding out.
Meanwhile, the issue of inflation is being ignored by bond investors. The headline personal consumption expenditure deflator is falling. Market-based priced Core PCE is falling even more. It is trending under 1%. Core CPI is also falling. Producer Price inflation is trending at about 1%. In fact, the case can be made that the collective indicators of price level changes could all trend under at or near 1% sometime in 2014.
The real interest rate in the bond market (after inflation is removed from the calculation) rises when the anticipated or measured rate of inflation falls. As we know, over time, it is the real interest rate that counts.
Rising real interest rates have a slowing effect on economic activity. Falling or lower real interest rates spur economic activity. Presently, with inflation rates not widely accepted as accurate by market players but trending lower and bond interest rates not widely accepted as bargains by market players but trending higher, a possible collision course or tension between the two indicators results. That tension could slow the pace of economic growth, and any such slowing could and would lead to a subsequent robust rally in bonds.
What bonds to buy, what bonds to hold, and what bonds to sell? When should they be swapped? These are the conundrums investors face.
Fortunately, there are good answers to be found. We have long said that the tax-free, high-grade bond sector is cheap relative to other bonds. It still is. Sectors of the bond markets that are yielding real tax-free returns of 3% and even 4% are very attractive. One can get those returns without taking a lot of credit risk. We are not talking about Detroit, Puerto Rico, or other credits in the municipal bond space that are questionable, facing bankruptcy, in bankruptcy, or otherwise under pressure. We are talking about the highest-quality credits that are available at bargain real yields and bargain relative nominal yields. Build America Bonds, the taxable cousins in Muniland, also remain cheap.
Lastly, the disposition of investors to run from the bond market continues to intensify. We see evidence week after week of liquidation of mutual fund shares. This has been going on for six months. Credit Suisse recently created an analysis of various fund flows (December 10, 2013). They ask the question, “What’s all the fuss about fund flows about?” They then dissect the various measures of fund flows. The conclusion is fairly clear. The flight from bonds has forced mutual funds to sell. They are selling as a class. That means when Fidelity sells, it has to sell its bonds, and Vanguard is not able to buy because they have to sell bonds as well.
As in an earlier period of intense liquidation, the liquidation of bonds now underway works to create bargains in the bond space as sequential investors capitulate due to fear. They extract money from the bond side and place it elsewhere. Then they wonder and second guess their actions.
Has anyone thought that the bond sell-off might be overdone? The economy and its recovery are not so robust and not so impacted by rising inflation pressures as to cause bond interest rates to spike higher.
Maybe, just maybe, we will have low inflation, lower interest rates, and gradual economic recovery that will persist for quite some time. Maybe, just maybe, the backup in home mortgage interest rates will slow the housing recovery so that it will not be robust. The recovery in the labor market may also persist slowly, as the evidence seems to show.
We are approaching the end of the year in managed bond accounts. That is a big piece of Cumberland’s activity. We resist this notion that the bond market is headed for an absolute debacle in 2014. We particularly favor the tax-free municipal bond. Where appropriate, we recommend tactical hedging as a method of dampening overall bond portfolio volatility.
At Cumberland, we do not view the world as coming to an end in bond land. When a high-grade, long-term tax-free yield of 5% is obtainable in a very low-inflation environment, we think that bond investors who run from bonds and liquidate them will look back, regret the opportunities they missed, and wonder why they did it.
David R. Kotok, Chairman and Chief Investment Officer