The Bond Herd, 6% and Gold
December 16, 2010
David R. Kotok
Chairman and Chief Investment Officer
Europe is very cold, too. We’re back. Six days of travel, 8000 miles, and seven meetings later, we take away some conclusions about the recent, volatile, and scary spike in bond yields.
First and foremost, let’s be clear. This bond market riot is a global phenomenon. US-centric observers are blaming the rise of the benchmark ten-year Treasury note yield on an inflation-risk scare or on Fed money printing with QE2 (quantitative easing round 2) or on expanded deficits because of the tax-cut extensions. These observers are missing the boat.
This is global. Look at this chart (http://www.cumber.com/content/special/G4.pdf) on Cumberland’s website in the Special Reports section. The title is “Charts for Bond Herd Commentary.” In chart one we have rebased the yields of the four key global currency benchmark ten-year notes. We start at the low yield day of October 12. Since then the upward movement in yields has been correlated worldwide. We pick the four big denominations of debt, the yen, pound, dollar, and euro. Together they define the overwhelming majority of world capital markets.
This correlated movement suggests that the selling is coming from a reallocation of assets in large indexed global funds. They are moving monies out of the highest-grade sovereign debt bonds and into other sectors. We have now confirmed this with several large portfolios. We infer from our anecdotal evidence that there are many others doing the same thing. Their reasons for acting may be different but their actions constitute a herd mentality in this sector of high-grade sovereign debt.
Please note that we are using high-grade here for a reason. We want to examine this reallocation movement without the interference of price changes due to default risk or credit risk. That is why you see the German bund as the reference for the euro and not the Greek or Irish bonds. That is also why you see the Japanese bond. It is showing the same reallocation action. Japan is a country where QE has existed for years and where there is deflation.
We are often asked, “Where is the reallocated money going?” And we are asked, “Isn’t this due to a fear of inflation?” The questions are very fair. Let’s take them one at a time.
We think the first answer is that monies are moving into two asset classes: stocks and commodities. The evidence to support this observation is also clear. Nearly all stock markets of the world have been rising during the same time period that bond prices were falling. Rising markets mean inflows of cash, and that cash has to come from somewhere. In Japan, it includes outright purchases of ETFs by the central bank as they continue to expand their version of QE.
Commodity prices and precious metals have also been on an upward trajectory. Following a technique we learned from Dennis Gartman, we have indexed the four currencies of the four benchmark bonds we used in the first chart. Our index choice is to rebase the currency to a current gold price. That second chart (http://www.cumber.com/content/special/gold.pdf) is also in the Special Reports section on our website. Note the correlation. Some of the money coming from bonds is going into gold and other precious metals. Using that for a proxy, we infer those flows are also going into industrial commodities and into oil as well.
Now let’s add a dimension to this discussion. Chart three (http://www.cumber.com/content/special/Gold2.pdf) on our website smoothes the volatility during the period and combines the yield change and the gold price change into a single linear trend for each of the benchmark currency-denominated bonds. Note how Japan and the US are identical when you rebase the yield change and the currency change to the gold price. JP and US are the two biggest users of QE. Also note how close the UK and the Eurozone are. They live in the same neighborhood and are interrelated in their problems..
What we are trying to depict is the adjustments in interest rates and currency values. They normally are viewed in a relative way. We want to introduce a constant so we can compare them against each other. We choose gold.
Think of it this way. Each of these bonds is a promise to pay in a single currency. We rebase that promise to the gold price at the start of the period. We have already rebased the bond yield changes. So we need to convert the changes in the yields to the unit of gold that the bond represented at the start of the period. Chart three is the result. The correlation improves; hence, we conclude that a herd is at work and that the reallocation theme is supported by this evidence.
There is other evidence of a herd as well. Barclays Capital surveyed 2000 institutional investors in preparation for its 2011 outlook series. Respondents included “hedge funds, money managers, proprietary trading and corporate trading desks” among others. They were asked, “Which asset class will perform best in 2011?” 40% said equities, 34% said commodities. Only 9% selected “high-grade government bonds.” Credit (10%) and peripheral Europe (7%) were the other choices.
So what about the question of inflation risk? It may be in the expectations component; that one is very hard to measure or even estimate. But it doesn’t seem to be supported by what we can see.
The evidence is that the rise in yields has been in “real” rates and not in the inflation component of interest rates. Measures of real rates that are market-derived support this conclusion. Other measures that are inferred do so as well. And the inflation evidence itself remains very subdued. In the US there are measures of inflation that are near zero. In Japan there is deflation. In Europe there is very low inflation, and in the UK there is some inflation but its sustainability is questioned.
Sure we have rising prices in gasoline and food. That is worldwide. It is also the warning sign of the worst-case “nightmare scenario.” I borrow the words from Neal Soss and his team at Credit Suisse. They describe it as an “eruption of headline inflation (food and gasoline) with no accompanying pick-up in wages or real growth.” We think they have properly characterized the key risk for 2011. If they are correct, we get an economic slowing in 2011 and these rising sovereign debt bond yields will reverse and plummet.
That is not our forecast but it is a big risk. We see modest growth, stagnant wages and very little inflation for the US in 2011.
In the bond space, we have avoided the sovereign debt subsector and emphasized spread product. That has been a correct relative choice. Of course, all bonds have sold off in this recent rout. In an absolute sense all bonds fell in price. No bond performed well in the last six weeks.
What is our expectation? We continue to believe that high-grade tax-free bonds in well-selected credits are very cheap. The US state and local government debt sector is $3 trillion out of the total worldwide $90 trillion in tradable debt. In a global selloff it will fall in price just like everything else.
Does that mean it should be abandoned? No. Consider that a very safe, very good-credit (AAA), tax-free yield of 6% is available to a buyer who is willing to do the research. Think about that return and how much it is worth to the high-tax-bracket American investor (35% top federal rate plus 3.8% federal addition coming soon, plus your state tax if you pay it). Compare this to today’s environment where the inflation rate is near zero and the outlook for cash equivalents is also near zero.
At Cumberland we are raising our allocation to this sector for our balanced-account clients. I have also done so for myself.
Lastly, through the December 10 data, foreigners have not been buyers of US Treasury and agency debt. The home mortgage rate in the US has backed up to nearly 5%. US bond markets exhibit signs of panic selling. The Fed’s policy of US Treasury purchases appears to be defeated by the markets. That suggests a possible economic weakening is coming in the spring and another downturn leg in housing is possible. Spain is now paying a real interest rate of 5% to borrow, according to its latest auction. The Eurozone issues are not resolved.
In sum, this crisis and the disinflationary or deflationary consequences of deleveraging that originate with it are not over. 6%, AAA, tax-free looks pretty good to me.
Special thanks to my colleagues, Michael Comes and Sam Santiago for help with the graphics and the research. Any errors are mine.
All the best for the holidays and the New Year.
David R. Kotok, Chairman and Chief Investment Officer