Wednesday, January 25, 2006

The other hand of Bill Gross

I was just finishing reading the last paragraph of Bill Gross' (PIMCO) January Investment Outlook when my left, that is, other, hand suddenly began moving of its own accord. I tried to hold it back but it went straight for the keyboard, typing furiously. The following is the result of that possession.

Santa was so good to me this year that I began to stop questioning my assumptions in public. No more wasting time trying to induce from past conditions to suggest the path of the future, I would now simply deduce backward from the "conclusion" (that's according to my right hand) that bond yields were perpetually going lower. Induction is, after all, quite a difficult exercise, fraught with uncertainty and never proved until the event, while deduction is what everyone else seems to be doing - finding evidence which supports their already concluded conclusion.

Was it but 14 months ago that I wrote, with both my hands, the following sentences: It’s an uncertain world these days, with the polls split down the middle and Heisenberg long ago having declared that something can be here or not here at the same instant. And for those of you who have no idea what I’ve just said I can only offer you congratulations on your blissful certitude
. How I long for such days when, on the one hand, we had this, and on the other hand we had that.

Alas in the age of empire only the meek can speak their mind and think of various possible forward scenarios. As Einstein wrote, to punish me for my contempt for authority, fate made me an authority myself. Now I must do what authorities do, stay on message, but sometimes I'll let my left hand out for a walk, or a type.

In my latest IO I revealed one of my bond market timing tools, my holiday gift to you as my right hand put it. I'll let my right hand explain the model, that is what he does best. You can see the graph here (new window works best).

Imagine, if you will, purchasing (receiving) a 5-year interest rate swap at some time over the past few years. For those of you who don’t spend 12 hours a day in bond trading rooms, that means owning a 5-year fixed rate bond and financing it (paying) with 3-month Libor which increases in yield every time the Fed raises its benchmark. Instead of mark to market changes in the 5-year swap price, what I would like to promote here is the concept of an increasingly more expensive "cost" to owning this 5-year swap as its financing rate (3-month Libor) increases. A 5-year swap purchased when short rates were much lower and the yield curve more positive, produced positive carry and therefore generated "profits" for anyone holding this longer dated maturity when viewed from an income statement perspective. But if you narrow or eliminate that carry via higher short rates (and a flat yield curve) those "profits" disappear.

This 5-year swap concept is important because the U.S. economy operates in much the same way. With close to a 5-year average life, the entire U.S. bond market can be compared to a 5-year fixed swap. That means that companies, homeowners, and consumers that have borrowed money in recent years - (and purchased assets such as a home that are akin in my example to a 5-year swap) - are now being squeezed in a flat yield curve environment. Visualize a real life example in which you have "financed" a home with an adjustable rate mortgage (in my example you finance a 5-year swap with floating 3-month Libor). As the cost of the ARM increases with higher short rates, your excess income available to spend on discretionary items begins to shrink. If that ARM rate goes too high, you hunker down even more by not eating out, going to movies, or taking a vacation to exotic destinations. The economy in other words slows down.

How does this translate into a bond market timing tool? Chart I shows but one of a series of graphs PIMCO uses to indicate when enough is enough - the point at which adjustable short rates rise sufficiently to make the owner of a home or a 5-year swap, or more importantly the economy, cry "no más!" That point comes in this example when Fed Funds rise to meet the average cost of intermediate Treasury financing issued over the past 5 years and the spread between the two disappears.

As my right hand goes on to relate in that IO, the above could mean that bond yields have peaked because monetary conditions are now restrictive enough to dampen consumer demand. BUT, this is only one of many reads of this data and but one possible scenario going forward.

As my right hand casually noted, in brief, Much will depend on the future condition of the U.S. housing market and of course global economies - primarily of the Asian variety. Since even my right hand had to admit that "much will depend on ...
global economies - primarily of the Asian variety" let's spend a bit of time reflecting on what Bastiat might have called that which is unseen.

Let's consider a few reasons for the Fed's decision to not cross the "no mas" line in the graph above for the past 2 decades. My right hand noted that previous violations of that line were due to accelerating inflation, which my right hand suggested was not happening today by contrasting that experience with current conditions. I guess you now know that I keep my wallet in my left pocket and it is with my left hand that I pay those increasing costs.

But there may be other concerns staying the Fed's tightening hand. A scan of US Treasury data on the percentage of foreign holdings of total US marketable securities which rose from 12% in 1978 (when the debt to GDP ratio was roughly 33%, i.e. we're talking about 4% of GDP) to 35.2% in 2000 and to 52% in June 2004 (when the debt to GDP ration was roughly 63% so now we're talking about 33% of GDP, actually more as it has been another year) suggests a link.

Back when the US self financed, easing and tightening were exercises in shifting the internal flow of funds mainly by rewarding or punishing the financial sector's bond market exposure. It was, at times rancorous, but still a family affair. While some US institutions might post losses on their Treasury holdings, other US institutions which had been more cautious, gained.

As foreign holdings of US debt rose, however, tightening became an international issue. Suddenly the question arose, who will buy these securities if the Fed does what it used to and raised the cost of carrying the debt to punitive levels? After all the reason they sold the debt to foreign bidders in the first place was because US buyers couldn't be found. What happens if we scare off the foreign buyers altogether? Lefty here has another question, what happens if we don't scare them off and they keep financing us? That's right, Warren Buffett answered that one, sharecropper society.

But let's stick to the first question, what happens when the Fed punishes US Treasury debt holders? Firstly the American consumer slows down fairly quickly. This in turn means that Asian exports to the US slow and they will have fewer $s with which to buy Treasuries, even though their purchases are far more important now than ever before. Additionally, Asia will be sitting on a pile of securities which are losing value but which act as their reserve base. Are you getting the sense that this would not be an "orderly market" event? Think Thailand mid 1997 for a possible model.

Anyway, perhaps now you can see why we haven't had a real bear market in bonds since the early 80s. We would be biting the hand that feeds us and forcing ourselves to face an even bigger problem than the one we ignored in the late 70s.

Yet, despite the freedom from convertibility, and thus ability to extensively manipulate markets gained with the adoption of the second amendment to the IMF's articles of agreement, which, according to the IMF, eliminated the use of gold as the common denominator of the post-World War II exchange rate system and as the basis of the value of the Special Drawing Right (SDR), (I call it Humpty Dumpty finance, words mean whatever I want them to mean, nothing more and nothing less) we seem to have something of an inflation problem, albeit one that has
escaped detection by the BLS (gotta make sure Social Security recipients and TIPS holders don't unbalance the budget you know).

What we are left with are the Emperor's New Bonds. Everyone, including me, (with my left hand tied behind my back) will buy them and we will claim they are getting ever more valuable and yet they won't be. The currency devaluation the BLS can't quite seem to find will be eroding their true value, but we will all be too polite (and scared) to say so.