Archive for category: Investing

What Makes Me Wrong on Bonds?

It’s obvious to anyone reading this report over the past several weeks that I’m a big long-bond bear, that I think we’ve seen the “top” in Treasuries, and that a long decline in bond prices and a higher move in bond yields has begun.

I’m also aware that a “dovish” Bernanke this week could cause a short-term unwinding of the “higher-rates” trade and send TBF and TBT lower, while “yield-proxy” sectors like utilities and telecom and REITs rebound.  But, I believe that any such trade would just provide an excellent entry point for the larger trend of higher rates.

But, like any good trader, I’m constantly thinking about what would happen that would make me wrong about the direction in bonds.  Well, I thought about this over the weekend and there are three things that can happen that would make my opinion in bonds incorrect.

1. Scenario One:  Japanese & Emerging-Market Debt Enter a Crisis Phase. The swings we’ve seen in emerging-market debt and the Japanese yen have, so far, been volatile but contained.  But, if that volatility increases—and people begin to worry that emerging markets or Japan might lose the ability to sell debt and fund themselves—it would create a crisis. And in a crisis, money flows into U.S. Treasuries, as they remain the “safest” and most-liquid asset in the world. It would be the exact same thing that happened when Europe was in the depths of its crisis.  European investors bought Treasuries for return “of” capital, not return “on” capital.

2. Scenario Two:  Dis-Inflation Becomes “De-flation.” Fed President James Bullard has been one of the most-vocal of the Fed presidents voicing his concern for the low inflation readings globally.  Low inflation, in an environment of massive liquidity, reflects a lack of demand for money and potential deflation.  So, if the five-year inflation expectations on TIPS (one of the best measures of expected inflation), continue to decline—then the Fed will almost certainly abandon “tapering” and may even consider “more” QE.

3. Scenario Three:  The Economy Sees A Summer Swoon—Again.  I was speaking to a subscriber last week and he presented a counter argument from another analyst that basically said we’re in for years of 1%-2% GDP growth, low equity returns, and low bond returns.  So, not quite the 20+ year deflation of Japan, but not that much better, either.  In that scenario, there would be no Fed tapering and likely steady or more QE. Economic data will be the key to watch for this potential scenario.

I remain a bond bear and I believe I’m right on bonds, but I wanted these scenarios on paper so I can watch for them.  Having too much confidence in this business is as dangerous as having too little.

Away from the yen, the other focus in the currency markets was on the implosion we’re seeing in emerging market currencies.  The Indian rupee hit another all-time low vs. the dollar. The Brazilian real and South African rand hit four-year lows vs. the dollar, and even strong currencies like the Mexican peso got hit yesterday.

The reason for the weakness is this:  Since the Fed went to 0% interest rates and round after round of QE, investors have moved into higher-yielding emerging-market currencies over the past few years.  Well, now with the Fed potentially “tapering” and interest rates in the U.S. rising, investors are reversing the trade, as they no longer need to take the risk of being in emerging markets, as rates are rising here at home.

Emerging market debt has collapsed since May, and the decline is unnerving
equity investors.  This ETF needs to stabilize before we can sound an “all clear” in stocks.

Well, that’s causing the currencies of those emerging-market countries to drop as investors sell their bonds and reconvert those investments back into dollars.  Basically, “doomsayers” are saying the world’s major central banks, led by the Fed, have created a bubble in emerging-market credit, and now it’s popping.

The question I’m sure you’re asking right now is “Why the hell do I care about emerging-market credit?”  Well, you care because as these currencies and bonds plunge, it’s causing losses in the leveraged hedge funds that have put the trade on. That’s causing them to liquidate other holdings to cover the losses (like stocks and gold, for instance).

Point being, you should care for the same reason everyone should have cared when the mortgage-backed security markets started blowing up in ‘07, ‘08 and eventually led to the takedown of Bear, Lehman, etc.  I’m not saying it’s the same thing here at all—but it’s the leverage and the huge declines that are making people nervous.

So, while it’s not a disaster yet, this unwind out of emerging-market debt and currencies is having an effect on all asset classes.  It’s not anywhere near 1998-style proportions yet (the emerging market debt crisis), but it is unnerving investors, and weighing on other risk assets.  Bottom line is watch the PowerShares Emerging Markets Sovereign Debt ETF (PCY) and the iShares JPMorgan USD Emerging Bond Fund (EMB), the two emerging-market bond ETFs. Emerging-market bonds need to stabilize in order for equity markets to calm down a bit.

Bottom Line

Since the Fed “tapering” narrative began 3+ weeks ago, equity markets have basically been at the mercy of other markets (namely currencies and bonds), and that continued Tuesday.

The volatility in those markets is starting to unnerve investors, as watching major currencies and bonds gyrate around like penny stocks is a bit unsettling.

But so far, this is just part of an adjustment process that is to be expected as the market comes to terms with the prospects of higher interest rates going forward. Unless 1,600 is violated on the S&P 500, I don’t think that there’s any reason to materially reduce equity exposure at this point.

Continuing to focus on the clear trend of higher rates remains, in my opinion, a good place to slowly and methodically add exposure.  To that end, I do want to point out one ETF that rallied more than 1% yesterday and seems to be positioned to capitalize off this bond-market turmoil. The ProShares Short High Yield Bond Fund (SJB), the short junk-bond ETF, doesn’t trade with a lot of volume (90K shares yesterday) but it’s about the only way I know of for non-bond investors to get short exposure to the high-yield market, which is seeing a nasty sell-off as emerging-market debt and other high-yielding bonds get hit.

Shorting the high yield market has served as a good hedge against equity volatility,
and should continue to do so as long as currency and emerging market bond volatility weigh on stocks.

SJB is a volatile position and not for everyone. But if you’ve got some risk capital to put somewhere, it’s worth a look, as it should continue to benefit during this “adjustment period” and might serve as a good hedge. (It basically is acting like a short position on the market.)

“Bad” is Not “Good” Anymore.

Again, all this economic data coming with week is important because the world’s central banks are very, very data-dependent with regard to policy.  As the data goes, so will go markets.  But, and this is important: We are not in a “bad news is good for stocks” environment, especially here in the U.S.  Previously, markets have rallied because bad economic news meant more QE, which had been good for stock prices.  That is no longer true.  The market doesn’t want more stimulus and QE.  (That statement can be made globally, but it’s especially true here in the U.S.)  It is time for the domestic and global economy to turn for the better and for growth to re-engage.  That is the key to sustainably higher equity prices, and that’s why the data is important.

Despite the media reports, one thing that was not the reason for the strength in stocks yesterday was the weak ISM manufacturing PMI.  Again, bad economic news is not good for the market (as it has occasionally been in the past).  More QE isn’t the answer to a sustained rally from here—good economic growth is.  So, bad economic data this week is not good, regardless of the short term market reaction.

That said, the weak economic data yesterday was somewhat dismissed, but that’s mainly because of the looming jobs report Friday, which is far and away the “most important” economic report from a WWFD standpoint (What Will the Fed Do).

Bottom line is nothing much changed yesterday despite continued volatility.  This market remains very resilient and certainly isn’t going to go straight down, and yesterday’s rally is consistent with the choppy trading we’ve seen lately.

To me one of the biggest things that continues to stick out to me is the unwillingness of money managers to at least partially lock in 14% year to date returns on the third day of June, because everyone is so “sure” the market will eventually march higher, and as a result are happy to stay long through any correction.  I continue to think that selectively booking some profits at these levels, while staying broadly long, makes sense from a common sense and contrarian standpoint.    

Economics

Last Week

Last week was obviously all about the Fed, as Chairman Ben Bernanke’s testimony and the Federal Open Market Committee minutes were taken as “hawkish” by the market, which led to the Wednesday reversal and the first down week for stocks in five.

While pundits will debate the minutiae, the real takeaway from the Fed last week was that, on the margin, it seems more apt to taper QE rather than extend it. We can also conclude that, generally, Fed presidents are becoming a bit uncomfortable with the current program.

But, and this is the key, while the Fed is cautiously optimistic about the economy, its members want to see the improvement have some staying power, as they have been “faked out” by this economy a few times over the past several years.  As a result, they will err on the side of leaving the current QE program in place longer than they would like.

There are two takeaways then:  First, based on what we saw last week, we should expect “tapering” of QE to begin sometime in the September-to-December time frame, if the data continue to show improvement in the economy.  The Fed meeting on Sept. 18 is the date we should all circle as the first meeting where QE could potentially be tapered.

Second, the Fed is extremely data-dependent—as the data goes, so too will their decisions on when (and if) to actually taper the QE program.  So, economic data, especially jobs and inflation, are more important than usual this summer.

This Week

Domestically it’s a pretty quiet week, with the highlights being the jobless claims on Thursday and the monthly Personal Income and Outlays report Friday.

Jobless claims dropped last week and reversed about half of the surge we saw two weeks ago. Despite the volatility, the four-week moving average is still at a pretty low level (340k).  But, it’ll be important for markets to see the downtrend in claims resume, as the labor market is obviously important to the Fed.

Personal income and outlays is important not because of the spending numbers in the report, but more so because of the Personal Consumption Expenditure (PCE) price index, which is the Fed’s preferred measure of inflation.  Inflation is running low, and that has some at the Fed nervous about removing accommodation.

St. Louis Fed President James Bullard has been especially vocal about wanting to see inflation rise before “tapering” QE.  So, the PCE price index is important because, if it remains low, that may push back the date “tapering” begins.

Internationally it’s the same thing—the most-important factors in the short term are whether the European Central Bank will become more-accommodative and whether the Bank of Japan will continue its massive accommodation, add to it or even reduce it if Japanese bond yields continue to rise at the current pace.

So, while it’s a quiet week generally, the European Union’s HICP numbers Thursday (HICP is their measure of inflation) are key because inflation there is too low. Lower inflation implies a higher likelihood that we’ll see the ECB become more-accommodative over the coming months.

In Japan there is a lot of data this week (it’s by far the busiest region) with retail sales, Consumer Price Index, household spending and industrial production all hitting the tape. This data will show whether “Abe-nomics” is having the desired effect. Given the volatility we saw in Japan last week (in both the equity and bond markets) this data now takes on even more significance.

Don’t ignore Japan—last week it was a major influence on markets, and has the potential for a repeat performance this week.

Remember, this is all about central banks—and Japan currently is the one throwing its weight around the most.  If that appears to be changing or it looks like there’s instability in the Japanese markets, this will weigh on U.S. and European shares.