Rate Debate

You're begging me to go
You're making me stay
Why do you hurt me so bad?
--Pat Benatar

Why do bond interest rates go higher? The short answer is that creditors are less willing to take risk, and therefore demand more premium in order to lend. But what factors lead to creditor risk aversion?

One factor is future inflation expectations. If lenders perceive potential for increasing prices (e.g., devalued currency) in the future, then they will demand a higher coupon to compensate for the reduced purchasing power of the principal and interest returned to them down the road.

Another factor is general capacity to lend. Creditors may lack investment capital due to previous practices (e.g., excessive lending or borrowing against their book). If so, then lenders will raise the price of further lending to compensate for their balance sheet risk.

A third factor is creditworthiness of the borrower. Creditors will demand more premium if borrowers carry more risk of default. Think junk bonds.

When rates head higher, as they have for govies over the past week, the knee jerk explanation that pundits commonly assign to the phenomenon commonly relates to the first factor noted above. Higher rates are typically explained as heightened inflation expectations.

But the latter two factors, those less cited by the pundits, are tied to a deflationary environment. And in a world drowning in debt, these two factors seem to merit more attention.

Don't automatically connect higher interest rates to potential for more inflation.

Dukes of Hazard

We can dance if we want to
We can leave your friends behind
'Cause your friends don't dance and if they don't dance
Well they're no friends of mine
--Men Without Hats

In previous missives we made the case for a period of optimism, where bureaucrats, pundits, and investors would perceive that massive market interventions are working and that the worst is over. We appear to be in this period now, as bureaucrats chat things up and investors are jumping back into the pool--many with both hands and feet.

Echoing Mr P, my view is that any appearance of stability is merely an illusion, one that has been facilitated by throwing tens of trillion$ at a system that is effectively broken. More debt and spending can't solve a debt and spending problem. Current interventions merely serve to make the system more unstable down the road.

Instability favors extreme outcomes when potential energy turns kinetic. Two extreme scenarios seem plausible. One is a high inflation situation, where attitudes reverse towards greater risk seeking. Borrowing and debt expand--perhaps at even greater rates than those witnessed during the past few decades. Prices, particularly those linked to materials, scream higher. As commodity prices have just completed their biggest monthly jump in more than 30 years, market participants are casting a strong vote for this scenario.

The other plausible scenario is that after a stint of 'reflation,' a secular deflationary trend re-establishes itself. Credit markets, already up to their eyeballs in US debt, shut down for domestic borrowers. Borrowers, moreover, lose their appetite for risk, given the already extended state of their balance sheets. Prices of risky assets resume their decline.

I've waffled in my probability assignments toward these scenarios. For many years, I was entrenched in the deflation camp, which served my in pretty good stead. But after last year's collapse and the massive interventions brought on by past and current administrations, chances of the high inflation situation ratcheted higher in my eyes.

Now, however, I'm once again leaning towards the deflationary scene. There's still too much debt out there (not enough has been destroyed yet), and my sense is that borrowers and lenders are losing their appetite for risk. Most 'cash' out there is not free cash, but rather borrowed and linked to a liability. Rather than plowing this cash back into risky assets, there's a good argument to be made that people will use this cash to pay down debt. And because of the massive quantity of debt out there, this situation could last a long time.

As such, I've tilted my portfolio back towards the deflationary possibility. After shedding most of my commodity exposure after this recent run, I'm holding more cash than I have in a long time. Although I recently borrowed to buy a house, my plan is to chunk my mortgage down at an accelerated pace.

Should the inflation scenario win out, I'm holding a few dividend paying stocks as well as some gold as a hedge.

While financial markets can certainly run a while, my growing sense is that risk is high and getting higher.

position in gold

Rates of Change

There's no sense in pretending
Your eyes give you give away
Something inside you is feeling like I do
We've said all there is to say
--Tom Petty

The action in long bonds has to have bureaucrats quaking in their boots. Despite efforts to jam interest rates lower, yields are headed the other way as supply swamps demand.

This action further reflects the inevitable corner policymakers are painting themselves into. The more you try to keep interest rates low by printing money, the more bondholders want to sell their paper as it declines in value.

no positions

Regulation and Economic Hardship

Oh, it'll take a little time
Might take a little crime
To come undone now
--Duran Duran

A recent Fortune article that profiles banking entrepreneur Peter Fitzgerald offers industry-specific examples of how regulation can restrain standard of living over time. Standard of living advances through innovation that improves productivity. Regulation can impair innovation through the following mechanisms:

Distorting signals of value. When purchasing goods or services from sellers, buyers indicate their value preferences through their willingness to part with scarce monetary resources in the exchange. Sellers use this signal as confirmation that they are on the right track. Producers are thus motivated to do more of the same.

Regulation distorts this signal. In the banking industry, for example, government sponsored insurance has decreased consumer due diligence when making banking purchases. Less informed buyer choices have supported inefficient operators, many of which lie at the center of our current systemic problems. As noted by Mr Fitzgerald, "The reason we got into this situation is in part that people didn't care what their bank's balance sheet looked like because their accounts were FDIC-insured." This, of course, is the moral hazard principle in motion.

Raising barriers to entry. Research suggests that major innovation often springs from new entrants to an industry rather than from existing firms. Because they are less restrained by historical commitments that shackle incumbant operators, new enterprises tend to be more creative in producing output that meets consumer needs.

Regulation commonly raises industry entry barriers. Costs of regulatory compliance, such as the myriad reporting systems required for financial services firms such as Morgan Stanley (MS), may be considerable. High costs discourage would-be entrants.

Regulation also prevents weak incumbants from failing, which reduces potential for enterprising firms to acquire market share from less efficient competitors. It should be obvious by now that our current regulatory scheme makes it very difficult for institutions such as Bank of America (BAC) or Citigroup (C) to fail regardless of the degree of managerial imprudence. Regulatory protection of incumbant franchises is likely to turn away many enterprising entrants.

Regulating markets is often deemed necessary to protect individuals from big bad corporations. Ironically, it is regulation itself that can perpetuate corporate bigness and badness.

no positions

Break It Down Again

When it's all mixed up
Better break it down
In the world of secrets
In the world of sound
--Tears For Fears

Have been updating personal financial info following a distracting move-laden couple of months. One core metric I like to track is personal asset allocation. Here's where it stands:

50% cash
26% equities
14% real estate
10% precious metals

This mix feels pretty good right now, as it balances more exposure to real estate (new house purchase) with more cash.

All commodity related ETFs/ETNs have been liquidated. I may re-enter this area at some point but not right now.

Equity positions consist of stocks in the pounded down pharma sector (MRK). I like valuations here, plus fat yields provide a nice cash payout, particularly considering fixed income rates.

After liquidating metal ETFs, remaining exposure to gold and silver is physical bullion.

Not sure why, but I like the feeling of cash right now, despite the spectre of big time inflation down the road.

positions in MRK, gold, silver

The Defcon Dollar

"Mr Hunter, we have rules that are not open to interpretation, personal intuition, gut feelings, hairs on the back of your neck, little devils or angels sitting on your shoulder. We're all very well aware of what our orders are and what those orders mean. They come down from our Commander in Chief. They contain no ambiguity."
--Captain Frank Ramsey (Crimson Tide)

The most important chart in my world right now is the USD, which has been leaking oil at an increasing rate over the past couple of weeks.

A couple months back, bureaucrats and pundits were citing dollar strength as a sign that the basic fundamentals of the US economy were strong. This was and is a delusion. The dollar was rallying as folks delevered. They needed to buy dollars to cover USD denominated debt.

To the extent that this debt covering deflationary phase is over for now, we should expect the artificial bid underneath the dollar to dissipate.

Add to that increasing unease among our foreign creditors about holding dollar denominated assets as we print trillion$ to paper our way out of our problem. Ten year yields are now heading higher, indicative of supply over demand.

Importantly, higher yields are occuring despite Fed efforts to buy bonds to artificially suppress interest rates.

This may or may not be the beginnings of 'The Big One.' Perhaps it's just markets taking a respite from a secular deflationary grind. But the current situation exemplifies the ultimate consequences of trying to print your way out of a debt problem.

In such a case, a collapsing currency and higher interest rates are inevitable.

position in USD

Break Dancing

"I've been to every city in Mexico. I came across an unclaimed piece of meat in Baja, turned out to be Rosie. I guessed he picked a knife fight with somebody better. Found one of your passports to Sumatra, I missed you by about a week at Fiji. But, I knew you wouldn't miss the fifty year storm, Bodhi. "
--Johnny Utah (Point Break)

Nice data indicating the reduction in various risk spreads over the past few months. The 'green shoots' sprouting from this info are prompting many to conclude that the worst is over for the credit markets and that a turnaround is forthcoming.

In the near term, my sense is that market participants might channel this optimism into significantly higher prices. This is why I can't get too bearish right now and may in fact play the upside to some degree.

But keep in mind what's tightening these spreads: massive money printing and borrowing. Over consumption and debt were the drivers behind the recent collapse. We're now feeding more of the same into the system. To the extent that this stimulus reflates the monetary system, then we're destined for another ride lower.

When? Wish I knew, cookie. But my sense is that is could be the Fifty Year Storm.

Short Story

The times are tough now, just getting tougher
This old world is rough, it's just getting rougher
Cover me, come on baby, cover me
--Bruce Springsteen

A week or so back, I went short the S&P for the first time in quite a while. Just a token position at a technically overbought juncture. I covered a couple days later after we came off a percent or two.

At some point, my sense is that there may be a huge downside wave to ride. However, this may not be this year's business.

If/when the break occurs, I hope to be fortunate enough to recognize it. Meanwhile, I want to hone my short side mechanics.

no positions

Super Cycle

What goes up must come down
Spinning wheel got to go round
Talking 'bout your troubles it's a crying sin
Ride a painted pony
Let the spinning wheel spin
--Blood, Sweat & Tears

While engulfed in the moving process over the past week, I've been fairly active with my book. Primarily, I've unloaded most of my commodity ETF/ETN exposure. I've had a love/hate relationship with these vehicles over the years and currently I'm biased toward the darkside.

Most of these funds invest in commodity futures. As such, you're subject to tracking error over time if (when) the funds roll their front month contracts into out month paper. When out month prices are higher than front month prices (a.k.a. 'contango') by a lot, then you can really get nicked by the 'negative roll yield.' Check out, for example, a ratio chart of USO to crude oil over the last 2-3 years to see what I mean.

Exchange traded notes (ETNs) carry an additional risk. An ETN is a security meant to reflect the price of the underlying commodity or group of commodities. The issuer invests in futures, but what you own is the issuer's promise to pay the underlying asset value. As such, this derivative carries counter party risk. If the issuer goes belly up, then you could be out of luck (and capital). Recent concerns with the Roger Commodity Index series of ETNs (funds I have been involved with), reminded me of this risk.

As such, I've unwound most of my 'paper' commodity exposure into the most recent lift higher, save for token positions in silver and energy. Should prices continue higher, I may let the rest of it fly as well.

I remain bullish on commodities, but primarily in the stuff I can touch and feel--not the paper derivatives. Perhaps I need to build a warehouse so I can take delivery of the physical commodities themselves.

Will worry about that once I get the new house in order. And with that, I'm off to clean some bathrooms.

positions in DBE, RJN, SLV

Care Package

Who would be the fool to take you
Be more than just kind
Step into a life of maybe
Love is hard to find
--Culture Club

Am jammin' with a house move and final exams, but wanted to include this snippet from Richard Russell's missive last nite:

"This government will stop at nothing even including manipulation. What the Fed does not want is a swooning stock market, surging gold, or sinking bonds. I think all three are now being manipulated. Pressure from various sources continues on gold, and we know the Fed is buying bonds. When an item is manipulated, the aftermath always ends unpleasantly. I expect "unpleasantness" ahead. In my opinion, big money and veteran investors have joined China in worrying about the dollar. It's a major reason why they distrust this market."

I do believe Mr P is hinting at similar.

While markets may jam higher over the near to intermediate term, be careful about sounding the all clear signal. Behind the scenes, risk is increasing.

Yield Sign

Here comes the rain again
Falling on my head like a memory
Falling on my head like a new emotion
--Eurythmics

The most important technical happening to me last week was the breakout in long bond yields. Yields on ten year govies now stand above 3%.


To be sure, there's a fair amount of tranched resistance above, but if this move has legs then the spectre of inflation will move to the forefront.

Rising t-note yields also make me glad that my mortgage rate locked where it did.

The Highbrow State

"You are the top one percent of Naval aviators--the elite."
--Commander Mike 'Viper' Metcalf (Top Gun)

Business Week recently ran this cover question: "What good are economists anyway?" The story argued that, although economists failed to forecast the recent collapse and in fact implemented policies that contributed to the meltdown, we need their help to get us out of the mess.

This, of course, is the kind of thinking that got us into the mess to start with--not just economically but on a broader social basis. There is a general belief among many if not most bureaucrats and their intellectual following that they know better than the common everyday actors that comprise society. These elitists believe that they are smarter than the average citizen, and that it is their role to 'govern' the citizenry.

The hubris of this attitude flies in the face of America's founding, which was motivated by the desire to throw off highbrow government in favor liberty.

To the extent that we continue to permit the elite 'experts' to make our decisions for us, we're destined to retrace a path towards despotism--a path that our Founders smartly altered on our behalf over two hundred years ago.