Weekly Relative Value

Transcription

1 Are Long Term Treasury Bonds Cheap? At the start of 2014, the 10-year and 30 year Treasury yields were 3% and 4%, respectively. And just about everyone expected rates to keep rising. This was the year that the bond bubble would burst and enter the often forecasted bear market. It surely has not turned out that way. We are past mid-year, yet long term bond yields are now sharply lower than they were at the start of The yield on the key 10 year Treasury benchmark has declined to 2.44%. More impressive, the yield on the long bond (30 year Treasury) is currently 3.24% versus 4.00% at the beginning of the year. In fact, on a total rate of return basis, long Treasuries are the best performing asset class. Thus, those managers that took the bet on bonds so far in 2014 have been smiling happily to the bank. So why have economists so badly missed the mark (again)? Much of this almost universal bearish perspective is tied to the view that growth is picking up and inflation is rising. However, as we have highlighted numerous times in this space, the numbers do not bear out on this. Despite the more promising green shoots the U.S. economy is not yet out of the woods. Treasuries Continue to Rally Jobs are Not Enough One of the so-called green shoots has been the improving labor markets. Unquestionably job creation in the U.S. has improved and the official unemployment level is at 6.1%; near six year low. However, much of this decline is attributable to people dropping out of the work force. Additionally, concerns still remain in the types of jobs being created and the level of wages being paid. We do have more people working, and working is always better than not working. However, the jobs we are creating are not going to get us anywhere near optimal growth. They are part time minimum wage jobs for the most part, again, better then unemployed, but not the kinds of jobs we're looking for.

2 In aggregate, the economy s performance has been less than stellar. The recovery from the recession of has been the weakest of the post-war era, and evidence is mounting that America s potential growth rate has plummeted. In the first quarter, gross domestic product fell by 2.9% at an annual rate, the worst showing since the recession. This was a result in part of bad weather. Yet, the second quarter will only be strong enough to make up the ground lost in the first. Economists had thought 2014 would be the best year since the recession; with growth in the first half of around zero, it is shaping up to be the worst. The past four quarters have recorded a nominal top-line gross domestic product (GDP) expansion of only 2.9%. Adjusting for inflation the average four-quarter growth rate in real GDP is 1.8%, well below the 4.2% average in all of the previous post-war expansions. Consensus expectations for 2014 US GDP growth have collapsed from over 3.00% to a mere 1.7% now. The International Monetary Fund recently cut its estimate of the country s potential rate of growth to 2%. This tortoise like growth is even more perplexing when factoring in six years of zero interest rates, deficit spending totaling $6.27 trillion and the $3.6 trillion Federal Reserve s quantitative easing policy. Many would assume that such massive stimulus would be associated with a booming economic environment, not a slowing one. Not so! Achilles Heel So what is wrong with the U.S. economy? First, and foremost, the U.S. and the rest of the developed world is buried in debt. It puts tremendous downward pressure on final demand across the globe. According to research by Stacy Hunt Ph.D at Hoisington Investment Management the U.S. economy is once again starting to increase its leverage. Total debt rose to 349.3% of GDP in the first quarter, up from 343.7% in the third quarter of 2013.

3 Indeed, the economy gets a temporary boost when we borrow more to buy stuff. A case in point: Consider the explosion of sub-prime auto loans. The NY Times reported that auto loans to people with tarnished credit have risen more than 130% in the five years, with roughly one in four new auto loans last year going to borrowers considered subprime people with credit scores at or below 640. Many of these loans have extended terms and exorbitant rates. While this helps dealers to sell cars today, sooner or later the bill needs to be paid (or maybe not). According to Experian repossessions increased nearly 78% to an estimated 388,000 cars in the first three months of the year from the same period a year earlier. Also during this period, the number of borrowers who are more than 60 days late on their car payments also jumped in 22 states. When you take on debt it must create an income stream that services the debt and repays the principle when it doesn't, then economic growth will eventually slow. Using debt to purchase things today that you cannot afford is very damaging long term. That appears to be where we are today. There is now a negative feedback loop of increasing debt levels on economic growth. In other words debt is future consumption denied. Are Long Term Rates Impeding Growth? Again, taking from Stacy Hunt s most recent quarterly report: Empirical studies demonstrate that the neutral rate of interest, a level that does not tend to slow or accelerate economic activity, should approximate the growth rate of nominal GDP. Interest rates higher than the topline growth rate of the economy, which is the case today, would mean that resources from the income stream of the economy would be required to pay for the higher rate of interest, thus slowing the economy. The following graph clearly shows the relationship between GDP and long term corporate bond yields. Prior to the 1980s when rates were below nominal growth rates the economy accelerated at a quicker pace. However, for the past 30-plus years interest rates have remained

4 higher than nominal growth, and not surprisingly, nominal growth has declined in tandem. Currently, long term interest rates are significantly higher than nominal growth which suggests that rates may actually need to decline further for the economy to reaccelerate. Are Long Term Rates Slowing Economic Growth? It's easy to see what's happening with debt and the real economy: debt is skyrocketing throughout the G-7 countries while real growth is stagnant. It is no accident that yields here have been trending lower for the last thirty years. Has anything changed that these trends will be reversed? No. Until this debt is reduced we will likely not exit "The New Normal" anytime soon. Update on Europe We need to congratulate Germany on its World Cup win. But unfortunately unlike its soccer team, Germany (the only European engine of growth) is now at risk as growth collapses and too fast for comfort when we look at Eurozone GDP.

5 Industrial production in the Eurozone's three biggest economies Germany, France and Italy fell month-on-month. Germany's 1.4% decline was the biggest since May Germany's faltering economy has cast further doubt over the Eurozone's prospects for recovery this year, with no other big country strong enough to pick up the slack. Overall and despite negative interest rates, Europe remains on the precipice of a deflationary spiral as economic growth from Italy to France to Spain and now to Germany continues to be ratcheted lower. Nowhere is that more apparent than in German bunds, which registered a record-low yield of 1.13% for the benchmark 10-year maturity. Yields on French, Austrian and Belgian 10-year bonds also hit record lows. In fact, despite starting the year at already low yield levels, Eurozone Government bonds have managed the best first six months performance since introduction of the Euro (+7.05% - Merrill Lynch Eurozone Government bond index). Record Low European Yields The world is barely producing growth with zero interest rates how can ANYONE believe rates will go higher? Beats me! Global Growth Continues to Disappoint

6 It s All Relative Furthermore, with U.S. rates significantly higher than most of the developed markets around the world, makes the long end of the Treasury market looks very compelling. If nominal U.S. and European growth continues to decelerate (due to the high burden of debt) U.S. thirty-year bond yields are likely to remain very low and possibly converge towards the thirty-year yields in the Japanese and German economies. If so, the yield on the long bond could fall by over 100 basis points from here. Sounds far-fetched? Possibly, but then again maybe not! The U.S. Market is one of the Highest Yielding Markets in the World Market Outlook and Portfolio Strategy Bond markets globally were largely unchanged for most of the week, as economic data were mixed, although on Thursday markets were roiled by an uptick in risk aversion driven by geopolitics. Late in the week, geopolitical concerns stemming from expanded U.S. sanctions against Russia, a downed passenger jet in Ukraine and Israel s invasion of Gaza led to a risk flare across global markets. The Treasury market was also helped by confirmation that China keeps buying Treasuries. The Treasury Department reported that China had upped its holdings of Treasuries by $107 billion during this year's first five months to $1.27 trillion, just under 11% of Treasury debt outstanding. So, for those wondering who will fill the void as the Fed exits QE, we now know. This is another reason yields won't rise significantly. The 10-year Treasury ended the week at 2.44%- a 13 month low. The global bond markets ultralow yields bespeak a grudging acceptance of decidedly less-thanexuberant conditions in the U.S and elsewhere. Interestingly, even with the 10-year note under 2.5% and the 30-year bond under 3.3%, these low borrowing costs aren't helping even the most interest-sensitive sector, home building. Housing starts and building permits dropped in June, and there were no reports of bad winter weather during the month.

7 In terms of portfolio strategy, we continue to believe that the 10-year Treasury remains solidly entrenched in the 2.5-3% trading range we have been in for quite some-time. While we are hardly bearish on the bond markets, we believe that better investment opportunities will avail themselves in the not too distant future. That said, any short-term sell-offs may provide an attractive entry point for those credit unions looking to put excess cash reserves to work. Conversely, for those credit unions that have strong loan demand and pressed for liquidity we continue to believe that select profit taking maybe advisable. In terms of relative value, valuations across all short duration high quality assets are stretched. In other words, finding attractive risk return trades remains quite challenging in today s stretch for yield environment. As such, we continue to caution investors reaching for yield. This is a period when less can be more. Therefore, do not push the envelope to pick up a few extra basis points. In many cases, you are simply not paid to do so. As always, any investment should be viewed in the context of the risk management of the total balance sheet. To help identify and quantify the most risk appropriate sectors and securities we show below various spread metrics of various fixed income sectors. We also show prospective total returns (36 month time horizon) of these sectors, assuming 1) parallel yield curve shifts from -50 to +400 basis points; and 2) under various yield curve configurations (see second table). Note: at this time in the rate cycle with many projecting a turn in monetary policy, it is critical to understand how sectors and securities perform should the fed funds rate rise and the yield curve change shape (i.e. flatten, steepen etc.). Table 1 Total Rate of Return (36-Month Time Horizon) Parallel Yield Curve Shift Yield G-SpreadI-Spread Z-Spread Eff Dur Bullets 3 Year Bullet Year Bullet Year Bullet Year Bullet Y MBS 2.5's 's 's Y MBS 2.0's 's 's Y MBS 3.5' 's Y MBS 4.0's 's 's Cash

8 Table 2 Total Rate of Return (36 Month Time Horizon) Yield G-SpreadI-Spread Z-Spread Eff. Dur. No Change New Neutral Normal Japan 1994 Bear Bullets 3 Year Bullet Year Bullet Year Bullet Year Bullet Y MBS 2.5's 's 's Y MBS 2.0's 's 's Y MBS 3.5' 's Y MBS 4.0's 's 's Cash More Information For more information about credit union investment strategy, portfolio allocation and security selection, please contact the author at tom.slefinger@balancesheetsolutions.org or (800) , ext Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and Registered Representative of ISI, has more than 30 years of fixed income portfolio management experience. He has developed and successfully managed various high profile domestic and global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually all types of domestic and foreign fixed income securities, foreign exchange and derivatives in institutional environments. At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily involved in analyzing portfolios, developing investment portfolio strategies and identifying appropriate sectors and securities with the ultimate goal of optimizing investment portfolio performance at the credit union level.

9 Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or particular needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. Investors should understand that statements regarding future prospects might not be realized. Please contact Balance Sheet Solutions to discuss your specific situation and objectives.