February 17, 2017
By Steve Blumenthal
“Perhaps the biggest risk facing investors this year and beyond is whether bond yields will suffer a sustained rise.
We are increasingly worried that the bond market is undergoing a secular pivot from bullish to bearish,
and that investors are facing an asymmetric risk profile with limited upside and plenty of downside.”
– Ned Davis Research, Featured Report (February 9, 2017)
Hat tip to my friends at 361 Capital for the photo.
We sipped the QE juice and loved the taste. Now we’re full… the game has changed. The Fed had assets worth $858 billion on its books in the week ended August 1, 2007 just before the start of the financial crisis, and the same stood at $2.24 trillion at the end of 2009. It stands at a surreal $4.5 trillion today. The Fed printed and bought $1.7 trillion in mortgage bonds and they bought government bonds. (See Understanding the Federal Reserve Balance Sheet.)
Slowdown, taper, reverse?
I believe we are facing a secular pivot in bonds. After 35 years of one of the greatest bull markets that sent rates from the mid-teens to near zero, it’s endgame. I’m pretty sure more than a few investors are unaware of the risk this poses. Inflation eats into returns and who wants to buy from your client that 2.4% yielding piece of paper when they can get 4%, 5% or 6%.
And speaking of 6%, it just might be here in a few short years.
Bloomberg wrote a piece this week entitled, “Everyone is Suddenly Worried about this U.S. Mortgage-Bond Whale.” A few highlights:
- Almost a decade after it all began, the Federal Reserve is finally talking about unwinding its grand experiment in monetary policy. And when it happens, the knock-on effects in the bond market could pose a threat to the U.S. housing recovery.
- The talk has prompted some on Wall Street to suggest the Fed will start its drawdown as soon as this year, which has refocused attention on its $1.75 trillion stash of mortgage-backed securities.
- While the Fed also owns Treasuries as part of its $4.45 trillion of assets, its MBS holdings have long been a contentious issue, with some lawmakers criticizing the investments as beyond what’s needed to achieve the central bank’s mandate.
- Yet, because the Fed is now the biggest source of demand for U.S. government-backed mortgage debt and owns a third of the market, any move is likely to boost costs for home buyers.
- In the past year alone, the Fed bought $387 billion of mortgage bonds just to maintain its holdings. Getting out of the bond-buying business as the economy strengthens could help lift 30-year mortgage rates past 6 percent within three years, according to Moody’s Analytics Inc. (emphasis mine)
The bottom line for bond investors is this: When interest rates rise, bonds lose value. I shared the next chart in July 2016 (interestingly just two days from the 1.37% low in yields). It shows how much money is lost for every 1% increase in rates. The top section is the 10-year Treasury. The bottom is the 30-year Treasury. As a quick aside, I know I’ve shared this chart with you several times, but I believe it is worth revisiting. I just don’t believe the average investor knows just how much risk they are taking on with their so called “safe” investments.
1.37% was the low yield back on July 13, 2016. The 10-year Treasury is currently yielding 2.42% and the 30-year is yielding 3.02%. That adds up to a -8.84% loss in value for the 10-year and call it a -16% for the 30-year. Maybe rates move back down, but I’m not so sure. I’m a bit more worried about what those losses will look like when yields rise to 3.4%, 4.4% and 5.4% (similar to where they were in 2007). -30% is a real risk.
As for equities, the number one rule many of us were taught is “Don’t Fight the Fed.” I like to add “trend” into that equation and, as you’ll see in the next chart, the math is compelling.
When the Fed raises rates (don’t fight them) and the trend turns negative, equities underperform. Focus on the red arrows. Two different time periods are measured, however, the message is the same. The big corrections come when both the Fed and trend turn negative. I wrote some time ago in OMR to “watch out for minus 2.” We currently sit at -1. I’ll share this chart from time to time – especially if -2 is triggered.
Here is how you read the chart:
- The top section plots the S&P 500 Index but focus on the middle section.
- NDR has a Multi-Cap Tape Composite Model to measure the technical health of the broad equity market. That model aggregates the signals of over 100 component indicators and generates a signal based on the percentage of the component indicators that are giving a bullish signal for the S&P 500. It measures momentum and trend.
- The Fed component is really an interest rate component, which measures the trend in rates by looking at the yield on the 10-year Treasury note. When the 10-week trend in yields are lower than their 70-week trend in yields, the S&P 500 has produced larger gains. When it is higher, the S&P 500 has performed poorly. It’s that simple.
- The combined indicator can produce a score of -2 (both indicators are bearish) to +2 (both bullish) and overall have done a good job historically as a risk-on/risk-off indicator.
- The current reading is -1 (data shows we need to watch out for -2): refer to the red arrows.
Source: Ned Davis Research
Inflation pressures are high both here and in Europe. The Fed’s 2% inflation target was achieved in January. Janet Yellen’s unemployment target has long been met. She was on stage this past week.
She said this week is that the Fed’s main tool for setting monetary policy will remain the Fed Funds rate. They will not shrink their $4.5 billion balance sheet right now but will likely reduce it over time. That’s going to be very tricky to accomplish. For now, Yellen’s Fed will keep reinvesting the proceeds from maturing Treasuries and mortgage-backed securities to “maintain accommodative conditions.”
It is going to be hard for us to stop sipping the Kool-Aid. The markets remain addicted to the juice and the doctor continues to push the product. My personal view is that the Fed monetizes the debt and it evaporates away; however, I don’t believe the current structure of laws allows for this so let’s put that in the back of our minds for another day.
My stepson, Conner, is a Wikipedia stat man. I often call him “Rain Man” due to his amazing memory. I wish I had his quick recall. Anyway, on the way to school this morning, we were talking about the stock market (he owns Bristol-Myers Squibb and he’s happy with the move of late).
Out of nowhere Conner said, “The time to buy is when there’s blood in the streets.” He’s fascinated with the stories behind some of the world’s wealthiest people and he went on to tell me about Baron Rothschild, the 18th century banker that made a fortune buying in the panic that followed the Battle of Waterloo against Napoleon. “Blood in the streets” is one of Rothschild’s famous quotes. It seemed apropos for today.
I’m keeping one eye on the Fed, the other on trend and mentally preparing myself for a Baron Rothschild – Sir John Templeton like moment. It’s not now! I told Conner the buying opportunity of his lifetime is coming.
That potential remains ahead. Blood in the streets? The end of the great debt super cycle? Probable in my view. Three to five years? Maybe sooner? Don’t know. As the great Stan Druckenmiller commented a few years ago… Fed policy is, “fraught with unappreciated risk.”
And about the Fed… if you ever wanted to get a candid behind the curtain view of what we are dealing with inside the Fed, grab a coffee and I encourage you to go to your favorite book store and buy the just released book, Fed Up: An Insider’s Take on Why the Federal Reserve Is Bad for America by former Fed insider, Danielle DiMartino Booth. Below you’ll find a short summary. It’s an insider’s candid no-holds-barred, highly critical look at the Fed.
The book is outstanding… “Blood in the streets” – indeed.
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Included in this week’s On My Radar:
- Fed Up, by Danielle DiMartino Booth
- Charts of the Week — Inflation
- Trade Signals – High Inflationary Pressures
Fed Up, by Danielle DiMartino Booth
John Mauldin shared a post in his weekly Outside the Box this week. I’m going to shamelessly borrow from John’s piece: Here are the highlights:
Today’s Outside the Box is a special treat. My good friend and fellow Texan Danielle DiMartino Booth’s new book, Fed Up: An Insider’s Take on Why the Federal Reserve Is Bad for America, was out officially yesterday, on Valentine’s Day, and already there are dozens of reviews all over the internet.
Ten years ago, Danielle left a trading gig on Wall Street to work directly for Dallas Federal Reserve President Richard Fisher. She helped him gain insights into the economy and aided in crafting his speeches and writings. Those of us who knew her knew that she was a gifted writer; and when Fisher resigned and Danielle left the Fed, she started her own website and newsletter; and now her talent is apparent to many more people. She is the third most followed person on LinkedIn, after less than a year.
And then we come to her book. It’s a simply devastating account of what actually goes on inside the Federal Reserve. To say she eviscerates that august institution is to be kind. I saw her treatment of the Fed coming, because Danielle and I have shared many conversations in which we despaired of the impact the Federal Reserve is having on Main Street. But what do you expect when you have a bunch of Ph.D.s who share an economic philosophy and an attitude that lets them think they know just how to manage the US economy and control the price of the most valuable commodity in the world, the interest rate on the US dollar.
That low rates devastate middle-class savers and retirees (as they enrichen Wall Street and the big banks) seems not to register on the Fed’s cost-benefit analysis scale. I think longtime readers pretty well know how I feel about the Federal Reserve and their policies.
You can go to the Amazon page for Fed Up and read most of the book’s first chapter, but I persuaded Danielle to let me take you right to the end of the book and her summary of how the Fed should be reorganized. This is a powerful to-do list that I hope every Congressman and Senator will read. It is crucially important that they reorganize this institution that is playing havoc with Main Street. After you read Fed Up, I think you too will be ready to join the movement to demand the restructuring of our central bank. We should remove the Fed’s dual mandate, reinforce its oversight functions, and so forth, while understanding that there is a role for an independent central bank – just not the role subscribed to by the academics who currently run the Fed.
Following is the final chapter and summary of how the Fed should be reorganized:
“If it were possible to take interest rates into negative territory, I would be voting for that.”
Janet Yellen, February 2010
As her fame has grown, Janet Yellen is recognized in restaurants and airports around the world. But her world has narrowed. Because the Fed chairman can so easily move markets with a few casual words, Yellen can’t get together regularly and shoot the breeze with businesspeople or analysts who follow the Fed for a living. She must rely on her instincts, her Keynesian training, and the MIT Mafia.
“You can’t think about what is happening in the economy constructively, from a policy standpoint, unless you have some theoretical paradigm in mind,” Yellen had told Lemann of the New Yorker in 2014.
One of Lemann’s final observations: “The Fed, not the Treasury or the White House or Congress, is now the primary economic policymaker in the United States, and therefore the world.”
But what if Yellen’s theoretical paradigm is dead wrong?
The woman who “did not see and did not appreciate what the risks were with securitization, the credit rating agencies, the shadow banking system, the SIVs … until it happened” has led us straight into an abyss.
It’s time to climb out. The Federal Reserve’s leadership must come to grips with its role in creating the extraordinary circumstances in which it now finds itself. It must embrace reforms to regain its credibility.
Even Fedwire finally admitted in August 2016 that the Federal Reserve had lost its mojo, with a story headlined “Years of Fed Missteps Fueled Disillusion with the Economy and Washington.” In an effort to explain rising extremism in American politics in a series called “The Great Unraveling,” Jon Hilsenrath described a Fed confronting “hardened public skepticism and growing self-doubt.”
Mistakes by the Fed included missing the housing bubble and financial crisis, being “blinded” to the slowdown in the growth of worker productivity, and failing to anticipate how inflation behaved in regard to the job market. The Fed’s economic projections of GDP and how fast the economy would grow were wrong time and again.
People are starting to wake up. A Gallup poll showed that Americans’ confidence that the Fed was doing a “good” or “excellent” job had fallen from 53 percent in September 2003 to 38 percent in November 2014. Another poll in April 2016 showed that only 38 percent of Americans had a great deal or fair amount of confidence in Yellen, while 35 percent had little or none – a huge shift from the early 2000s when 70 percent and higher expressed confidence (however misguided) in Greenspan.
In early 2016, Yellen told an audience in New York that it was too bad the government had leaned so heavily on the Fed while “tax and spending policies were stymied by disagreements between Congress and the White House.” Maybe if she hadn’t been throwing money at them, lawmakers might have gotten their house in order.
“The Federal Reserve is a giant weapon that has no ammunition left,” Fisher told CNBC on January 6, 2016.
The Fed must retool and rearm.
First things first. Congress should release the Fed from the bondage of its dual mandate.
A singular focus on maintaining price stability will place the duty of maximizing employment back into the hands of politicians, making them responsible for shaping fiscal policy that ensures American businesses enjoy a traditionally competitive landscape in which to build and grow business.
The added bonus: shedding the dual mandate will discourage future forays into unconventional monetary policy.
Next, the Fed needs to get out of the business of trying to compel people to spend by manipulating inflation expectations. Not only has it introduced a dangerous addiction to debt among all players in the economy, it has succeeded in virtually outlawing saving.
Most seniors pine for a return to the beginning of this century when they could get a five-year jumbo CD with a 5 percent APR, offset by inflation somewhere in the neighborhood of 2 percent. Traditionally, 2 to 3 percentage points above inflation is where that old relic, the fed funds rate, traded. The math worked.
Under ZIRP, only fools save for a rainy day. The floor on overnight rates must be permanently raised to at least 2 percent and Fed officials should pledge to never again breach that floor. Not only will it preserve the functionality of the banking system, it will remind people that saving is good, indeed a virtue. And that debt always has a price.
Limit the number of academic PhDs at the Fed, not just among the leadership but on the staffs of the Board and District Banks. Bring in more actual practitioners – businesspeople who have been on the receiving end of Fed policy, CEOs and CFOs, people who have been on the hot seat, who have witnessed the financialization of the country and believe that American companies should make things and provide services, not just move money around.
Governors should be given terms of five years, like District Bank presidents, with term limits to bring in new blood and fresh ideas.
Grant all the District Bank presidents, not just New York’s, a permanent vote on the FOMC. Why should Wall Street, not Main Street, dominate the Fed’s decision making?
While we’re at it, let’s redraw the Fed’s geographical map to better reflect America’s economic powerhouses.
California’s economy alone is the sixth biggest in the world. Add another Fed Bank to the Twelfth District to better represent how the Western states have flourished over the last hundred years.
Why does Missouri have two Fed banks? Minneapolis and Cleveland can be absorbed into the Chicago Fed. Do Richmond, Philadelphia, and Boston all need Fed District Banks? Consolidate in recognition of the fact that it isn’t 1913 anymore.
Slash the Fed’s bloated Research Department. It’s hard to argue that a thousand Fed economists are productive and providing value-added insight when their forecasting skills are no better than the flip of a coin and half of their studies cannot be replicated.
Send most of the PhD economists back to academia where they belong. Require the rest to focus on research that benefits the Fed, studying how its policies impact American taxpayers and citizens. (Did the Fed do any studies about how ZIRP and QE would impact banking and consumers before it imposed them? No.)
Now take all the money you’ve saved and aim it squarely at Wall Street investment banks intent on always staying one step ahead of the Fed’s regulatory reach. Hire brilliant people for the Fed’s Sup & Reg departments and pay them market rates. Rest assured this will be ground zero of the next crisis.
And mix it up. One of Rosenblum’s students applied for a job at the New York Fed. He came from a blue-collar background, spent seven years in the military, and earned his MBA from SMU on the GI Bill. Smart guy. But he couldn’t get to first base at the New York Fed. They hire people from Yale and Harvard and NYU – people just like themselves. Others need not apply.
Then the top Ivy Leaguers stay for two years and move on to bigger money at Citibank or Goldman Sachs. It’s a tribe that’s been bred over ninety years and slow to change.
But if the culture of extreme deference at the New York Fed (which also exists in District Banks to a lesser degree) is not quashed, regulatory capture will continue with disastrous results. The Fed must give bank examiners the resources they need to understand the ever-evolving financial innovations created by Wall Street and back them up when they challenge high-paid bankers who live to skirt the rules.
Regulators must focus on the big picture as well as nodes of risk. Interconnectedness took down the economy in 2008, not just the shenanigans of a few rogue banks.
Focus on systemic risk and regulation around the FOMC table. Create a post with equal power and authority to that of the chair to focus on supervision and regulation. Yellen talks about monetary policy ad nauseam, but when challenged by the press or Congress on regulatory policy she stumbles and mumbles and does her best doe-in-the-headlights impersonation. Markets need predictability and transparency when it comes to Fed policy, not guesswork, parsing of the chair’s words, and manipulation of FOMC minutes.
Finally, let nature take its course. Reengage creative destruction. Markets by their nature are supposed to be volatile. Zero interest rates prevent the natural failures of weak companies, weighing down the economy with overcapacity for generations.
Recessions might have been more frequent, the financial losses greater for some, but if the Fed had let the economy heal on its own, America would have been stronger in the end and the bedrock of our nation, capitalism, would not have been corrupted.
I could never have imagined how my near decade-long journey at the Federal Reserve would play out.
In the beginning, I had been a “risk radar” to benefit myself and those closest to me. I wanted to stay out of debt and make certain that my children had great educations and a foundation of financial savvy so that they could pursue their versions of the American dream.
But I realize now the stakes are much higher.
We’ve become a nation of haves and have-nots thanks to Fed policies that benefit the wealthiest investors, punish the savers and the retired, and put the nation’s balance sheet at risk.
As consumers on the receiving end of Fed policies, we must reform our education system so that the American dream can be accessible to everyone. We must campaign for Congress to stop hiding behind the Fed’s skirts.
And we must demand that the Fed stop offering excuse after excuse for its failures. Short-term interest rates must return to some semblance of normality and the Fed’s outrageously swollen balance sheet must shrink in size. And most of all, the Fed must never follow Europe by taking interest rates into negative territory.
No more excuses. The Fed’s mandate isn’t to have a perfect world. That only exists in fairy tales, dreams and the Fed’s econometric models.
SB here: I pre-ordered and my copy arrived this week. I’m taking it home and will read it this weekend. Probably with a glass of red wine in hand. I may need it!
Charts of the Week — Inflation
Source: Ned Davis Research
Keep an eye on the 2.74% yield level. A break above that level with a further break above 3.04% would, in my view, confirm a change in trend.
Source: Ned Davis Research
Secular bond bear markets see periods of rising inflation. To which, we are seeing some early signs.
Manufacturers are busy. Note the work hours component is strong.
Inflation hit the Fed’s goal of 2% in January.
Source: Bloomberg; Bureau of Economic Analysis
Leading to comments from Fed officials like this:
Source of many of these charts – The Daily Shot, WSJ (a great daily read for WSJ subscribers).
Most economists are calling for a modest rise in inflation. Somewhere in the 2% range. NDR has a fairly benign outlook for 2017 – somewhere in the 2.1% to 2.3% range but sees great risk in 2018.
Looking at where market participants are placing their bets, TIPS (Treasury Inflation Protection Securities) and inflation swaps are signaling long-term inflation in the 2.10% to 2.50% range.
It may be early in the move, but this is most certainly a risk worth noting. Keep it On Your Radar. I’m happy Susan and I refinanced our mortgage back in July and I’m happy that our tactical bond trading strategies have navigated the early up interest innings well.
As you’ll see next in the Trade Signals section, the bearish trend for bonds remains… though HY and convertible bonds continue to be in up trends.
Major point here is: Coming off of a 5,000-year low in interest rates is no small thing. Risk is asymmetrically largely skewed to the upside (yields) and downside (bond returns).
Trade Signals – High Inflationary Pressures
S&P 500 Index — 2,340 (2-15-2017)
Click here for the charts and explanations.
It will be 65 degrees in Philadelphia this weekend! Brianna is coming home from New York and the plan is to play a little golf. The bigger plan is a birthday celebration Sunday evening for Brie and Susan’s oldest boy Tyler. Steak and lobster is on the menu. I just love when we get together for big dinners and this weekend all eight of us are home.
Maybe we can get a fire going outside though it is a bit too soon to bring out the patio furniture. Happily that day should be here soon enough.
I’ll be presenting at a meeting in Kansas City on February 23. I’ll be in front of a large group of individual investors and, frankly, I love those presentation opportunities the most. We’ll look at the latest valuation and forward return assumptions as well as discuss the risks in bonds.
Mauldin and I are presenting on March 14 and 15 in the metropolitan NYC area along with Josh Jalinski, “The Financial Quarterback.” Josh is a popular financial radio talk show host on iHeart Radio and works closely with Mauldin Solutions and CMG. We’ll be presenting the Mauldin Solutions Core Strategy.
If you’re an individual investor and are interested in attending, please call 888-988-5674 (JOSH) to reserve a seat. Let Josh’s team know I sent you to him and please feel free to email me if you’d like to learn more.
Dallas follows for an advisor event on March 28-29. If you are an independent advisor and you’d like to learn more about the Mauldin Solutions Core Strategy, John and team will be hosting a series of due diligence meetings in Dallas. The strategy will be available on certain platforms in March. Details to follow.
Years ago I worked for Merrill Lynch and then Prudential Securities. Do you remember the tagline, “When EF Hutton talks, people listen?” George Ball, chairman of Tectonic Holdings, ran EF Hutton and is largely responsible for creating that slogan. George left EF Hutton and became president of Prudential Securities. He was my boss when I worked there. We met several times at company retreats and events. I was one of thousands of brokers but felt I got to know him after listening to him on the squawk box that sat atop each rep’s desk. Remember those? Seems so long ago.
Anyway, Tectonic Advisors is one of the ETF strategists in the Mauldin Solutions Core Strategy, along with CMG. I’ve recently had a chance to reconnect with George at the Inside ETFs Conference last month. What a powerful and engaging human being and what great joy for me to speak with him again. Much more to share with you in the weeks ahead.
Hope you have some fun plans for your weekend ahead. Call your favorite mentor and tell him or her what you love about them. I bet it will lift you both. Wishing you the very best!
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With kind regards,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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From an investment management perspective, I’ve followed, managed and written about trend following and investor sentiment for many years. I find that reviewing various sentiment, trend and other historically valuable rules-based indicators each week helps me to stay balanced and disciplined in allocating to the various risk sets that are included within a broadly diversified total portfolio solution.
My objective is to position in line with the equity and fixed income market’s primary trends. I believe risk management is paramount in a long-term investment process. When to hedge, when to become more aggressive, etc.
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