Tuesday, August 30, 2011

Did Bonds Just Peak?

One of my favorite strategists, Jim Bianco of Bianco Research, was on Yahoo Breakout on Tuesday urging caution as he expects more losses to come:

A week ago the market was gripped with fear and talk of a "retest" of the August lows of 1100 filled the airwaves. Today, markets are surging and the bulls are giddily predicting a run to S&P 1250, 1300 and beyond.

Building on last week's 4.7% gain, the S&P was recently up 2.83% to 1210 while the Dow was higher by 2.26%.

Bucking the rising trend, Jim Bianco of Bianco Research says investors should take a "risk-off attitude."

While most observers (and investors) focus on the equity market, Bianco is focused on the credit markets, which he notes "continue to worsen" and are "not confirming a bottom in stocks."

Clearly, there's not nearly as much stress in credit markets today as in 2008, but Bianco sees similarities between the current environment and the summer of 2008, when the stock market was "attempting rallies" even while the credit market worsened. "Eventually, the stock market gave it up and corrected back to the credit markets," he recalls.

While Bianco is not predicting the kind of "calamity" that befell stocks in 2008 and early 2009, he expects the stock market will soon revisit its August lows, and possibly break below them with risk to S&P 1070. This negative view is buttressed by a forecast the economy will soon slide into another recession, meaning "the $100 per share earnings consensus estimate for the S&P 500 might be 30% to 40% too high."

In sum, Bianco believes investors are better off selling this rally and positioning themselves for another downdraft by sticking with defensive stocks like utilities. "There isn't a safe place [to hide]," he says. "I expect more losses to come. Returns between now and year-end will have a minus sign."

Given that fairly dire outlook, Bianco continues to recommend short-term Treasuries, even at today's miniscule yields. "You're not getting any return but there's no downside risk," he says.

Jim is a great guy and I absolutely love his research. He might be right, credit markets have led the stock markets so this rally could fizzle or remain range-bound (perfect for traders). Having said this, don't be surprised if stocks keep grinding higher, especially large cap tech stocks which just clobbered in the first two weeks of August. I also wouldn't be surprised to see credit spreads come in the next few months as investors dive into corporate bonds and the US economy slowly improves.

Another thing that caught my attention was Bill Gross's mea culpa, prompting Brett Arends of MarketWatch to ask, Did bonds just peak?:

They say the time to sell is when the last bear turns bullish.

When it comes to U.S. Treasury bonds, did that just happen?

Bill Gross, the world’s most famous bond manager, has now fessed up that he made a blunder when he turned bearish on the bonds last winter. Gross says his bet against Treasurys was a “mistake” and that he had been “losing sleep” over it this summer. Read the story about Gross losing sleep on the Wall Street Journal web site.

Treasury bonds have been booming to higher and higher prices for months, as fears have grown of a new recession and a deepening financial crisis.

Bonds work like a seesaw, so when the prices go up, the yield, or interest rate, goes down. Today the interest rate on 10-year Treasury notes (ICAPSD:10_YEAR) has plummeted to just 2.2%. The 30-year bond (ICAPSD:30_YEAR) pays a mere 3.5%. These are at, or near, historic lows.

The “real yield” on inflation-protected Treasuries, known as TIPS, has collapsed as well. Short-term TIPS now lock in a guaranteed loss of purchasing power. Even long-term TIPS don’t pay you much over inflation.

In the circumstances, it’s easy for commentators to throw rotten eggs at Gross.

But successful investment management is like successful poker playing. It isn’t about predicting the future. It’s about understanding the odds — and the other players. And when Gross got out of Treasuries he was making a reasonable decision, based on the prices at the time and the scenarios in front of him.

Uncle Sam is basically broke. The national debt, which was $3 trillion a generation ago, is up to about $15 trillion. Within five years it is forecast to pass $20 trillion.

More importantly, our political system has become a farce. Neither party has any serious intention of dealing with the deficit. Witness the childish and surreal attitudes toward taxes and the Pentagon.

The “super committee” created a month ago is just a feel-good bedtime story you tell to children, which is who we now are.

In the circumstances the only recourse left is for Ben Bernanke to clip the coins — in other words, to print more dollars to cover the shortfall.

Sooner or later that is going to smoke bondholders. It has already trashed the U.S. dollar.

Why would anyone lend to such an entity for 30 years at 3.5% interest? Or even for 10 years at 2.2%?

As the late Herbert Yardley once wrote, in the classic “Education of a Poker Player,” I wouldn’t bet on that hand with counterfeit money. You’re taking on the risk of a big loss in return for the hope of a small gain.

If you’re playing your hand on behalf of widows, orphans and other bond-fund investors, you don’t try to bluff too often. And you don’t draw to an inside straight.

Why have Treasuries boomed?

I suspect there are three reasons.

First, investors around the world still believe in the American Empire. They haven’t worked out that the game is up. And so when they smell crisis they still run to the Treasury market.

Second, many investors here are still hung up on Modern Portfolio Theory, which tells them aging Baby Boomers should be buying more bonds, regardless of the price. Every month they sock more money into their bond funds, merrily trusting that “bonds are safe.” Tell that to anyone who bought government bonds in the Fifties, before the great inflation. Tell that to anyone who has lent money to any number of European governments — from Greece to Ireland to Italy.

The third reason? Many private investors are succumbing, once again, to the biggest single mistake in the markets — performance chasing. In effect they are saying: “Look — bonds have done really well, so we should get on board!” You may be surprised that anyone could be so foolish, but believe me, an amazing number of investors really do think that way. The momentum can even make them look good — for a while.

Diehard bears argue that US Treasurys will keep rising, just as Japanese Government Bonds did in the Nineties, to the point where long-term yields fell below 1%.

But there are problems with that analogy. Yes, the Japanese government ran huge deficits while its bonds boomed. But Japanese society didn’t: The country ran a trade surplus every year, and households saved and saved. The contrast with the ailing American Empire could scarcely be more stark.

If you want to own government bonds, you’re probably better off buying them from a country with a grown-up political system. Norway’s bonds actually pay a higher rate of interest than Treasuries — and Norway has a balanced budget, and no national debt. No kidding.
I got nothing against Norwegian bonds as Norway's new oil finds shield it from economic gloom. But the article above is fraught with mistakes. First, I don't care about what any credit agency says, the United States of America isn't broke, will never be broke and will never default on its debt. The tea party wanted this t happen but it won't.

Second, don't fight the Fed. Ever heard of that mantra? Even the biggest and most aggressive hedge fund in the world is no match for the Fed. The Fed doesn't collect 2 & 20, but their job is to make sure banks make a killing by borrowing at zero at the short end, investing in bonds, locking in spread, and trading risk assets all around the world.

Just look at the OCC's latest quarterly report on bank trading and derivatives activity for Q1 2011. Here are the highlights:
  • U.S. commercial banks reported trading revenues of $7.4 billion in the first quarter, 10% lower than $8.3 billion in the first quarter of 2010. Trading revenues in the first quarter of 2011 were 113% higher than in the fourth quarter of 2010.
  • Trading risk exposure, as measured by value-at-risk (VaR), has declined for each of the five major dealers on a year-over-year basis. Aggregate average VaR at these banking companies has fallen 21%, from $852 million in the fourth quarter of 2010, to $677 million.
  • Credit exposure from derivatives decreased in the first quarter. Net current credit exposure fell 6% or $23 billion from the fourth quarter of 2010, to $353 billion.
  • The notional value of derivatives held by U.S. commercial banks increased $12.8 trillion, or 5.5%, from the fourth quarter of 2010 to $244 trillion. The notional value of derivatives is 12.7% higher than a year ago.
  • Derivative contracts remain concentrated in interest rate products, which comprise 82% of total derivative notional values. Credit derivatives, which represent 6.1% of total derivatives notionals, increased 5.3% to $14.9 trillion.
Unfortunately, the second quarter report has yet to appear but trading revenues were down. And keep this in mind, banks couldn't care less about lending money to small & medium-sized businesses (SMEs). Loans are long-term and illiquid. They want their investment bankers and prop traders to crank it up and start producing trading and investment banking revenues. The Fed is supporting them, giving the banks a 2-year green light to keep trading, trying to reflate risk assets and introduce mild inflation in the system.

Finally, and most importantly, in this environment, the main threat remains deflation, not inflation. In January 2009 I openly criticized this ridiculous notion that there is a bubble in bonds and continue to warn investors that this is the biggest misconception out there. If debt deflation grabs hold, you'll be lucky to lock in your money at a little over 2% over the next 10 years. And all those pensions piling into alternative investments are going to get clobbered as bonds outperform every other asset class. Below, I embedded the Jim Bianco interview. I doubt he buys the argument that bonds have peaked, but at least he doesn't see a second wave of the financial crisis any longer.

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