June 27, 2014
By Steve Blumenthal
I listened to a Lacy Hunt presentation this week. In his view, debt is choking growth in the U.S. and the balance of the developed world and will continue to do so. In short, he shared research detailing that when total debt gets above 275% GDP, growth slows at a faster and faster pace. It was a convincing presentation.
To his point, final first quarter GDP was again revised lower to -2.9% (not a typo). Blamed was bad weather but what should be blamed is big bad debt. Lacy further believes interest rates have further to move to the downside. He is on the deflation side of the inflation/deflation argument and is positioned long bonds with 20-year duration exposure. His firm, Hoisington Investment Management, is a bond manager. He shared that QE and Fed manipulation is causing more harm than good. I agree. Debt at excessive levels is a drag on growth – the Fed is pushing on a string. Lacy has conviction in his bet.
Most of Wall Street (analysts) is on the other side of this view. Not one analyst sees the 10-year Treasury yield ending 2014 below 3% (average expectation at the beginning of 2014 was 3.25%). The Fed, too, thinks rates will rise over the next several years with the first Fed rate hike expected in 2015. They are on a mission to create inflation.
I’ve shown the following chart several times. It shows both the risk and the reward of an investment in 10-year and 30-year Treasury bond exposure. This is the bet. Your outcome depends on which side of the bet you are on.
It is important to note that interest rates are tied to inflation. Over many economic cycles, the long Treasury bond has steadily yielded 2% more than inflation. For example, inflation at 2% means that the 30-year Treasury bond will yield 4%. Inflation at 3% gives us a 5% yield. Inflation at 6% gives us an 8% Treasury bond yield. In Lacy’s view, debt is too big of a drag and will continue to push inflation towards 0% giving us a 2% Treasury bond yield and a home run for investors. Love his conviction – he may be right – he may not be right.
The orange highlight in the chart shows where yields were about a month ago. Today rates are a bit higher. For the 30-year Treasury bond yield to drop from 3.4% to 2.4%, inflation will have to drop to 0.4%. The Fed is desperately trying to prevent such a move.
With rates so low today, Lacy’s bet is an even bigger risk. If the starting place were yields of 6% and yields rose to 9%, the loss on your bond investments is not as much as it would be if yields increase from 2.51% to 5.51% (both mathematically and psychologically). I like Lacy and trust him. I can point to many other equally brilliant economists sitting on the other side of Lacy’s bet. With current rates low, the risk reward is not lined up very well. We are all in a bigger bet today than we may know.
Use the above interest rate movement chart to help show your clients just what will happen depending on the direction interest rates move. Because rates are so low and risk proportionately elevated, now is the time for a tactical risk managed approach towards your fixed income exposure.
There are some things you can do. I favor a combination of trend following and tactical relative strength based on identifying the price momentum of short and longer term bonds. It is about staying in-line with price leadership. See Understanding Tactical Investment Strategies.
Each week I share the research we customized with NDR on the Zweig Bond Model in Trade Signals (link below). It was originally developed in the mid 1980s and has done a good job at keeping one on the right side of the trade. This is something you can include in your portfolios with relative ease (tactically move to short-term bond ETFs on sell signals and move to longer-term bond ETFs on buy signals).
Along with the above thoughts on interest rates, excessive bullish investor sentiment is once again evident today; however, over the last 18 months such high levels of extreme optimism has done an unusually poor job at identifying short-term stock market price peaks. I include a great piece on the subject courtesy of Ned Davis Research.
Included in this week’s On My Radar:
- Why Excessive Optimism Has Been Less Effective the Past 18 Months
- Trade Signals: Sentiment Remains Extreme – 06-25-2014
Why Excessive Optimism Has Been Less Effective the Past 18 Months
Here is the link to the full piece.
Trade Signals: Sentiment Remains Extreme – 06-25-2014
The cyclical trend remains bullish for both the equity and fixed income markets. However, Investor Sentiment is convincingly in the extreme optimism zone.
Click here for a link to Wednesday’s Trade Signals.
Conclusion
Lacy may be much smarter than me and much smarter than the teams at Goldman and Merrill Lynch and the many hedge fund managers on the other side of his trade, but he may be wrong. Quite honestly, I may be wrong. I spend so much time trying to figure out which direction rates will move. This is because all risks everywhere are tied to funding rates. The Fed is manipulatively in the mix like never before. To me it is more about making money than being right. I can count many times when I was certain one of my High Yield trend following buy or sell signals was sure to be wrong. Far too many times it was my view that turned out to be wrong. The trend signal was correct. It proved best for me to follow the weight of technical evidence.
Years of experience has taught me to stay humble. I think about that as it relates to making money. I can’t say I hope Lacy is right. If he is, then we are in for some pretty tough economic times (depression comes to mind). I also think inflation is coming and that, while the lesser of the two evils, comes with its own set of issues. I also think about the many economists who reevaluate, revise and change course. A tough game.
Deflation or Inflation? Maybe we get both. I conclude that I really don’t know which way rates will go and when. I have a view but it, too, is subject to revision. Then what do I do with the bond bet I may have placed? It is for this reason that I favor a weight of evidence approach and adhere to my disciplined trend and relative strength based price momentum models pointing the way. I hold conviction in the long-term probabilities of those processes. Right now they are saying to be invested long in bonds.
Speaking of bad debt, Susan and I stayed at the Revel Hotel in Atlantic City last night. It is a beautiful hotel facing bankruptcy. Probably Atlantic City at its best (hold the emails – I know…). We had dinner at Azure by Allegretti. I highly recommend it – a completely fantastic meal. We spoke with some of the staff – their concerns are big yet hopes are high. We were told that the Revel doors may close in two months unless a buyout / debt restructuring takes place. When we take big bets (no pun intended) we can lose. The equity investors will be wiped out and the bond investors will take a big hit. New money will buy in at decidedly lower levels with debt restructured and a new leadership team in place. Not a bad thing. It is actually a very healthy and important part of the business cycle. Hope the FOMC is listening.
I’m writing this morning from another NJ beach town. We are in beautiful Stone Harbor to pick up our boys. The beach is calling and the weather is outstanding so I’m going to check out and wish you an outstanding weekend. Hope you have beach plans in your near future.
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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