We began thinking of the outline for this letter Sunday morning. The plan was to explain the funky impact Quantitative Easing has had on interest rates and the Treasury bond market. We also planned to discuss the most crowded trade we have ever seen in my career. We were sidetracked and never got the outline on paper let alone finish the letter. Our procrastination worked out well as Standard & Poor’s dropped a tank of cold water on the elephant in the living room Monday morning.
They downgraded the outlook on US debt to negative, essentially saying our balance sheet was too imbalanced. The move left open the possibility that there is a one in three chance we could experience an actual downgrade from the Holy Grail AAA rating in the next couple of years if the current deficit trajectory did not change. A downgrade would not be a good thing. We would have to pay higher interest rates on our already burgeoning debt. Other currencies might replace our dollar as the most important trading currency. The possibility of a default becomes more real (We personally doubt that since we have the most effective printing press). The markets were not thrilled about the release as the Dow dropped 240 points early in the session and bonds were off precipitously also. By the end of the day the Dow had gained back 100 points and the bond market had turned positive by mid-day. We believe the markets rebounded because the possibility that we have finally received a wakeup call that confirms the recent voter back lash regarding the deficits. Is it possible that some substantive and bipartisan action will emerge? If so it appears the sincerity of our austerity will soon be tested. Belt cinching has not been one of our culture’s strong suits.
Back to the original outline: As you recall the strategy of QE1&2 was for the Fed to buy Treasury securities and other assets to inject liquidity into stocks, commodities, and especially real estate. Well two out of three was not bad as the stock market doubled and commodities like oil, gold, silver and copper doubled or better. Our dollar did what most anticipated and dropped considerably, nearly 10% since last summer. The weaker dollar does help our multi-national corporations sell more products abroad. All these factors are often the seeds for inflation and inflation is kryptonite to Treasury bonds. The latest gov’t inflation data show modest increases. Trips to the grocery store and gas station show a more pronounced dent to the wallet. Some believe gov’t data is massaged a little bit.
The combination of inflation heating up, a weaker dollar, the Fed ending QE2 and their purchase of Treasury securities has a consensus convinced that interest rates are headed higher and the price of Treasury bonds falling, ending their long term bull market. We have been in the investment business for twenty five years and followed the market closely for fifteen and we have never seen a consensus so broad and deep. This is the most crowded trade we have ever seen! We guess we should say this is the most “least” crowded trade since no one wants to own Treasury bonds. The reason for their position does make sense and there are some smart players in the crowd. You cannot listen to CNBC for any extended period of time without a talking head declaring interest rates are headed higher with absolute certainty. Some of our worst trades have been those we’ve been most certain about.
What we found unusual about the QE strategy is the one asset the Feds were actually purchasing, Treasury securities, decreased in value. One of the biggest players in the world actually drove the price of the target asset down! QE1 initially saw a rise in Treasury prices only to fall significantly thereafter. QE2 brought a rout in Treasuries pretty much from the get go. First the rumor at the Fed’s Jackson Hole retreat last August and then the official announcement in November brought a steeper decline. What was even more of a head scratcher is that when the Fed stopped buying the bonds increased in price? Huh?
Apparently Treasury bondholders thought the Fed buying gobs of Treasury securities would lead to the inflation described above. So they gladly sold their holdings to the Fed. The chart to the left shows the 30 year Treasury bond on a weekly basis going back to September of 2008. QE began in late November of that year and ended in March 2009. Again QE2 was a rumor in August 2010 and became official in November. As you can see Treasury bonds dropped in price (interest rates rose) after the Fed began buying those very securities. When QE! Ended Treasuries rose and the stock market suffered a 10- 15% correction.
The end of QE 2 is now in sight, June 30th, and the consensus is saying get out or even short sell these Treasuries. I am climbing out on a limb and thinking this might be a decent time to own US Treasury bonds for the following reasons;
1. S&P downgrade will hopefully create substantive deficit measures in DC, bonds should like that
2. The consensus is often wrong especially when certainty is involved
3. If the consensus has sold their Treasuries over the last year, there is little selling pressure left
4. If the end of QE2 is similar to the end of QE1 we should see bonds rise and rates fall
5. When QE1 did end most commodities fell in price, dampening inflation fears
6. Wages are one of the biggest drivers of inflation and employment is still limping at best
7. The blue half moons in the chart below indicate a prelude to a rally in Treasuries. A few indicators we use (not shown) were flashing buy signals then. We currently have a similar set up as shown by the green half moon
An interview last week on CNBC with Jeffrey Gundlach highlighted several of these points and if you are intrigued more with QE and how it has affected stocks and bonds you can watch it here. Mr. Gundlach was named Fixed Income Manager of the Decade (2000-2010) by Morningstar. Again we believe the more you understand these connections and relationships the better investment decisions you will make.
Did You Know
It All Adds Up - The US government had a $188 billion deficit in March 2011, extending its streak of consecutive monthly deficits to 30, an all-time record Net interest costs of the federal government (i.e., interest paid to holders of Treasury debt) are projected to be $225 billion during fiscal year 2011 (i.e., the 12 months ending 9/30/11), then rising to $792 billion during fiscal year 2021, a +252% increase over the decade The Fed announces its plan to raise, lower or maintain short-term interest rates at the end of every Fed meeting. This practice did not exist until 1994. On 3/24/11, the Fed announced plans to hold quarterly news conferences where the Fed chairman will answer questions about Fed policy decisions. The first ever quarterly news conference will take place on 4/27/11. The Fed was created in 1913. (source: Federal Reserve).
Final Thought
“In the field of political discourse if you find yourself discussing personalities, parties, and politics more than the specifics of issues you are probably more part of the problem than the solution” – We Thought It Up
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