bonds


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The Trump rally raged on this week with all major U.S. indexes hitting record highs, but despite the historic run, David Stockman is doubling down on his call for investors to sell everything.

“This 5 percent eruption is meaningless. It’s some robo machine trying to tag new highs,” Stockman said Tuesday on CNBC’s “Fast Money,” in a dismissal of the S&P 500 rally.

“I see a recession coming down the pike in 2017. The stock market is going to go down and it’s going to stay down long and hard because, for the first time in 25 years, there’s nothing to bail it out.”

This echoed the initial call Stockman made Nov. 3, when he urged investors to sell stocks and bonds before the presidential election.

However, since the Nov. 8 election, the Dow Jones industrial averagehas gained 4 percent en route to surpassing 19,000. Additionally, theS&P 500 and Nasdaq also hit record highs in the same time period, gaining 3 percent and 4 percent, respectively.

Yet Stockman, who was director of the Office of Management and Budget under President Ronald Reagan, reaffirmed that markets are heading for disaster.

“My call stands. Sell the stocks, sell the bonds, get out of the casino,” Stockman explained to CNBC in an off-camera interview. “Bonds have already cratered by nearly $2 trillion worldwide and have miles to go. This isn’t a rotation into stocks, either. It’s the greatest sucker’s rally ever.”

Stockman, author of “Trumped: A Nation on the Brink of Ruin… And How to Bring It Back,” lamented that there will be no Trump stimulus or Reagan-style boom. He further added that he expects “an unprecedented fiscal bloodbath” resulting from the $20 trillion worth of debt that the U.S. currently has on the books.

“This isn’t Ronald Reagan with a clean $1 trillion balance sheet and with a fluke GOP and a Southern Democratic coalition that only materialized because he got shot,” Stockman said in reference to John Hinkley Jr. attempting to assassinate Reagan in Washington, D.C., in 1981. “Nor is it LBJ in 1965 with a thundering electoral mandate and a massive congressional majority for the Great Society.”

On the contrary, Stockman, who initially predicted that Trump would win the election, added that Washington will be in chaos by June. This is because he anticipates ongoing disruptions from the tea party, which Stockman doesn’t foresee as allowing additional deficit increases.

Furthermore, Stockman doesn’t believe that Trump can pass a bipartisan stimulus plan without capitulating on his promise to repeal and replace Obamacare. Additionally, Stockman cast serious doubt over Trump’s ability to enact a meaningful tax cut or to develop a major infrastructure program. If so, Stockman believes that could very well trigger a civil war within the Republican Party.

“So when the recession hits this summer, the Fed will be out of dry powder and fiscal policy will be paralyzed,” concluded Stockman. “This time the market will crash and stay crashed.”

Given this prediction, Stockman re-emphasized that gold and cash will be king and urged investors to shift their portfolios accordingly. He also recommend shorting the S&P 500 through ETFs such as the SH or theSDS.

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Jeff Gundlach, Wall Street’s bond god, thinks the world of monetary and fiscal policy is about to pivot.

“How in the world could we be talking about rates never going up when in fact rates have bottomed?” he asked the crowd of investors at the Grant’s Interest Rates Observer conference in New York City on Tuesday.

He explained that it was on July 6th when he decided that the narrative that benchmark interest rates around the world would stay lower for longer was “getting quite old.”

He cited several reasons: inflation is picking up, the dollar did not strengthen after the Federal Reserve raised rates the last time. Also there’s this:

“In the investment world when you hear ‘never’,” ( as in rates are ‘never going up’), “it’s probably about to happen,” said Gundlach, who is CEO of DoubleLine Funds.

Urgent

Now, an uptick in inflation and the dollar’s tolerance for higher rates are factors that don’t necessarily require urgency. And generally without urgency there is no change in policy. They are also factors he discussed in his last presentation, ‘Turning Points,’ back in September.

But there is one thing that has changed since then. That thing is Deutsche Bank.

“You cannot save your faltering economy by killing the financial system,” said Gundlach.

That is, in effect, what low rates do. Over the last few weeks the world has watched as Deutsche Bank has struggled to convince investors and the public that it is in a sound fiscal position. Two weeks ago the US threatened the bank with a massive $14 billion fine for transgressions that led up to the financial crisis, and the bank’s stock really started to plummet.

In euros, Deutsche Bank’s stock price has hovered near the single digits.

“There’s something about big banks being in the single digits that makes people nervous,” Gundlach said.

He believes that Germany will bail out Deutsche Bank, despite the fact that the government has said that it intends to do no such thing. The problem isn’t Deutsche Bank in his mind, though — it’s other banks in a similar position that don’t have countries like Germany to bail them out.

He mentioned Credit Suisse, arguing that Switzerland can’t handle a banking catastrophe its size.

So what will the new world order be if rates must go up to save international banks?

“I can bring back inflation by 5:00 pm by giving everyone $1 billion. The lines at BMW lots would be a sight to see,” he joked.

What he’s saying is that now is the time to pivot to fiscal stimulus. Both presidential candidates Donald Trump and Hillary Clinton have talked about spending hundreds of billions on infrastructure and other investments. Meanwhile, US debt to GDP has been stable since 2011, and no one is really talking about the deficit anymore.

Here’s a key chart he showed to the crowd. It was also in his last presentation:

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Demand for stocks that offer high dividends and for bonds saddled with record-low — and even negative — yields has shaken up the traditional use of bonds and stocks in portfolios.

“Investors are buying bonds for capital appreciation and stocks for income. The world has turned upside down,” said James Abate, chief investment officer at Centre Asset Management LLC.

The shift, according to Abate, has been fueled by central-bank stimulus inflating government-bond prices across the world, pushing yields on nearly $12 trillion of government debt into negative territory.
And as bond yields tumble, more and more equities are yielding more than government bonds, spurring demand for companies offering sustainable income in the form of dividend payments.

“It is a poison brew that central banks keep serving us,” Abate said.

Treasury yields have tumbled for six straight weeks, falling to record-low levels on Friday despite hiring news that suggested the economic expansion remains intact. On Monday, as the S&P 500 marched to an all-time high, yields moved somewhat higher but were still hovering near all-time lows.

Meanwhile, since the beginning of 2016, so-called dividend aristocrats SPDAUDP, +0.58% , which include companies that have raised dividends for at least 25 consecutive years, have outperformed the main stock indexes, rising 12.5% so far this year, compared to 4.8% for the S&P 500 SPX, +0.78% and the Dow industrials DJIA, +0.69%

On the corporate side, the yields on higher-rated, investment-grade corporate bonds have also been dragged lower in the global bond rally, mainly due to foreign demand from investors fleeing negative interest rates abroad.

As a result, a rough survey by Jefferies’ global equity-strategy team showed that at least one-third of S&P 500 stocks offer dividends higher than the same company’s bond yield.

And yet, investors don’t seem to be discouraged by anemic yields and demand for bonds “seems to be insatiable,” said Aaron Kohli, interest-rate strategist at BMO Capital Markets, who thinks the bond market is now expensive.

Last week, inflows to U.S. fixed-income funds and ETFs jumped to $7.95 billion, the highest inflow since February of 2015, according to a report by Bank of America Merrill Lynch released Thursday and charted below.

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“There’s a perception there’s a greater fool behind you,” Kohli said, pointing to the strategy of buying a bond with the intention to sell later at a higher price.

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Not to worry just yet, just returning to trend.

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To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.

The real interest rate does not have to be consistent with full employment of labour. The real interest rate can be equivalent to the profit margin, or, average profit margin, of productive business.

When business profits are high, the economic incentive to borrow money rises. Consumers demand more of the good or service that can currently be supplied, therefore prices [and profits] reflect this. New entrants, attracted by the high profit margin enter the field, or, established business expands using borrowed capital. As more businesses enter profitable areas of business, demand for capital rises, which causes a rise in the cost of capital, unless savings increase [supply of capital] commensurate with the demand for capital.

If business profitability is lower than the cost of capital, business will not borrow. If the supply of capital should rise, then the cost of capital will fall. If the cost of capital falls below the profit margins of business, once again there will be a potential demand for capital.

Employment is a cost of production. Employers will hire labour to the point of marginal profit of labour. When that point is reached, no further labour will be engaged. Again, the higher the profitability of the business, the higher the marginal productivity of labour will be and the higher the employment in that business will be.

When the Federal Reserve sets interest rates and set them low as in ZIRP, the cost of capital is set below the profit margins of almost all productive business. No longer is capital allocated to business with the highest profit margins, which are the businesses with the highest consumer demand, capital is allocated to sub-optimal business with low consumer demand.

This ties up and increases the costs of raw materials used in production away from profitable business to marginal business. ZIRP is counter productive. ZIRP distorts the market. ZIRP prolongs the life of low profit businesses [businesses with low demand for their goods and services] and increases the costs of production of profitable businesses through increased competition [prices] in higher stages of production.

Bernanke misunderstands the effect of artificially created low interest rates by the Federal Reserve. The necessity of lowering interest rates in 2008 was caused by a liquidity crisis. A liquidity crisis is a result of fractional reserve lending, which in the 2008 crisis was driven largely through real property speculation.

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Interest rates around the world, both short-term and long-term, are exceptionally low these days. The U.S. government can borrow for ten years at a rate of about 1.9 percent, and for thirty years at about 2.5 percent. Rates in other industrial countries are even lower: For example, the yield on ten-year government bonds is now around 0.2 percent in Germany, 0.3 percent in Japan, and 1.6 percent in the United Kingdom. In Switzerland, the ten-year yield is currently slightly negative, meaning that lenders must pay the Swiss government to hold their money! The interest rates paid by businesses and households are relatively higher, primarily because of credit risk, but are still very low on an historical basis.

Low interest rates are not a short-term aberration, but part of a long-term trend. As the figure below shows, ten-year government bond yields in the United States were relatively low in the 1960s, rose to a peak above 15 percent in 1981, and have been declining ever since. That pattern is partly explained by the rise and fall of inflation, also shown in the figure. All else equal, investors demand higher yields when inflation is high to compensate them for the declining purchasing power of the dollars with which they expect to be repaid. But yields on inflation-protected bonds are also very low today; the real or inflation-adjusted return on lending to the U.S. government for five years is currently about minus 0.1 percent.

Why are interest rates so low? Will they remain low? What are the implications for the economy of low interest rates?

If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates, as the figure above shows. But what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or nominal, interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.

To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.

If the Fed wants to see full employment of capital and labor resources (which, of course, it does), then its task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or—more realistically—its best estimate of the equilibrium rate, which is not directly observable. If the Fed were to try to keep market rates persistently too high, relative to the equilibrium rate, the economy would slow (perhaps falling into recession), because capital investments (and other long-lived purchases, like consumer durables) are unattractive when the cost of borrowing set by the Fed exceeds the potential return on those investments. Similarly, if the Fed were to push market rates too low, below the levels consistent with the equilibrium rate, the economy would eventually overheat, leading to inflation—also an unsustainable and undesirable situation. The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.

This sounds very textbook-y, but failure to understand this point has led to some confused critiques of Fed policy. When I was chairman, more than one legislator accused me and my colleagues on the Fed’s policy-setting Federal Open Market Committee of “throwing seniors under the bus” (to use the words of one senator) by keeping interest rates low. The legislators were concerned about retirees living off their savings and able to obtain only very low rates of return on those savings.

I was concerned about those seniors as well. But if the goal was for retirees to enjoy sustainably higher real returns, then the Fed’s raising interest rates prematurely would have been exactly the wrong thing to do. In the weak (but recovering) economy of the past few years, all indications are that the equilibrium real interest rate has been exceptionally low, probably negative. A premature increase in interest rates engineered by the Fed would therefore have likely led after a short time to an economic slowdown and, consequently, lower returns on capital investments. The slowing economy in turn would have forced the Fed to capitulate and reduce market interest rates again. This is hardly a hypothetical scenario: In recent years, several major central banks have prematurely raised interest rates, only to be forced by a worsening economy to backpedal and retract the increases. Ultimately, the best way to improve the returns attainable by savers was to do what the Fed actually did: keep rates low (closer to the low equilibrium rate), so that the economy could recover and more quickly reach the point of producing healthier investment returns.

A similarly confused criticism often heard is that the Fed is somehow distorting financial markets and investment decisions by keeping interest rates “artificially low.” Contrary to what sometimes seems to be alleged, the Fed cannot somehow withdraw and leave interest rates to be determined by “the markets.” The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere. So where should that be? The best strategy for the Fed I can think of is to set rates at a level consistent with the healthy operation of the economy over the medium term, that is, at the (today, low) equilibrium rate. There is absolutely nothing artificial about that! Of course, it’s legitimate to argue about where the equilibrium rate actually is at a given time, a debate that Fed policymakers engage in at their every meeting. But that doesn’t seem to be the source of the criticism.

The state of the economy, not the Fed, is the ultimate determinant of the sustainable level of real returns. This helps explain why real interest rates are low throughout the industrialized world, not just in the United States. What features of the economic landscape are the ultimate sources of today’s low real rates? I’ll tackle that in later posts.

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Bond-market crashes have actually been relatively rare and mild. In the US, the biggest one-year drop in the Global Financial Data extension of Moody’s monthly total return index for 30-year corporate bonds (going back to 1857) was 12.5% in the 12 months ending in February 1980. Compare that to the stock market: According to the GFD monthly S&P 500 total return index, an annual loss of 67.8% occurred in the year ending in May 1932, during the Great Depression, and one-year losses have exceeded 12.5% in 23 separate episodes since 1900.

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