Monday, August 29, 2016

Why Foreign investors are flocking to US Treasuries

The recent drop in the federal deficit has reduced government funding needs so the Treasury has reduced the issuance of bonds in recent years. In addition, tighter regulators force US financial institutions to hold more Treasury's.

Also, central bank QE has vacuumed up highly-rated sovereigns, creating shortages among private institutional and individual buyers. The Fed stopped buying securities in late 2014, but the European Central Bank and the Bank of Japan—which already owns 34% of outstanding Japanese government securities are plunging ahead. The resulting shortages of sovereigns abroad and the declining interest rates drive foreign investors to US Treasury's.

Also, as we’ve pointed out repeatedly over the past two years, low as Treasury yields are, they’re higher than almost all other developed country sovereigns, some of which are negative. So an overseas investor can get a better return in Treasury's than his own sovereigns. And if the dollar continues to rise against his home country currency, he gets a currency translation gain to boot.

Thursday, August 25, 2016

US Dollar and Treasuries are investment safe havens

We’ve also always liked Treasury coupon and zero-coupon bonds because of their three sterling qualities. First, they have gigantic liquidity with hundreds of billions of dollars’ worth trading each day, as noted earlier. So all but the few largest investors can buy or sell without disturbing the market.

Second, in most cases, they can’t be called before maturity. This is an annoying feature of corporate and municipal bonds. When interest rates are declining and you’d like longer maturities to get more appreciation per given fall in yields, issuers can call the bonds at fixed prices, limiting your appreciation. Even if they aren’t called, callable bonds don’t often rise over the call price because of that threat. But when rates rise and you prefer shorter maturities, you’re stuck with the bonds until maturity because issuers have no interest in calling them. It’s a game of heads the issuer wins, tails the investor loses.

Third, Treasurys are generally considered the best-quality issues in the world. This was clear in 2008 when 30-year Treasurys returned 42%, but global corporate bonds fell 8%, emerging market bonds lost 10%, junk bonds dropped 27%, and even investment-grade municipal bonds fell 4% in price.

Slowing global economic growth and the growing prospects of deflation are favorable for lower Treasury yields. So is the likelihood of further ease by central banks, including even a rate cut by the Fed, as noted earlier.

Along with the dollar, Treasury's are at the top of the list of investment safe havens as domestic and foreign investors, who own about half of outstanding Treasury's, clamor for them.

Wednesday, August 24, 2016

Historical Relationship between Inflation and War

We’ve argued that the root of inflation is excess demand, and historically it’s caused by huge government spending on top of a fully-employed economy. That happens during wars, and so inflation and wars always go together—going back to the French and Indian War, the Revolutionary War, the War of 1812, the Mexican War of 1846, the Civil War, the Spanish American War of 1898, World Wars I and II, and the Korean War. In the late 1960's and 1970's, huge government spending—and the associated double-digit inflation from the Vietnam War topped LBJ’s War on Poverty.


By the late 1970s, however, the frustrations over military stalemate and loss of American lives in Vietnam as well as the failures of the War on Poverty and Great Society programs to propel lower-income folks led to a rejection of voters’ belief that government could aid Americans and solve major problems. The first clear manifestation of this switch in conviction was Proposition 13 in California, which limited residential real estate taxes. That was followed by the 1980 election of Ronald Reagan, who declared that government was the basic problem, not the solution to the nation’s woes.

This belief convinced us that Washington’s involvement in the economy would atrophy and so would inflation. 

Given the close correlation between inflation and Treasury bond yields, we then forecast the unwinding of inflation—disinflation—and a related breathtaking decline in Treasury bond yields to 3%. At that time, virtually no one believed our forecast since most thought that double-digit inflation would last indefinitely. 

We’ve been bulls on 30-year Treasury bonds since 1981 when we stated, “We’re entering the bond rally of a lifetime.” It’s still under way, in our opinion. Their yields back then were 15.2%, but our forecast called for huge declines in inflation and, with it, a gigantic fall in bond yields to our then-target of 3%.

Monday, August 22, 2016

You want to own the longest maturity bond if you believe Interest Rates will go down

We’ve been pretty lonely as Treasury bond bulls for 35 years, but we’re comfortable being in the minority and tend to make more money in that position than by running with the herd. Incidentally, we continue to favor the 30-year bond over the 10-year note, which became the benchmark after the Treasury in 2001 stopped issuing the “long bond.” At that time, the Treasury was retiring debt because of the short-lived federal government surpluses caused by the post–Cold War decline in defense spending and big capital gains and other tax collections associated with the Internet stock bubble.

But after the federal budget returned to deficits as usual, the Treasury resumed long bond issues in 2006. In addition, after stock losses in the 2000–2002 bear market, many pension funds wanted longer-maturity Treasurys to match against the pension benefit liability that stretched further into the future as people live longer, and they still do.

Maturity Matters

We also prefer the long bond because maturity matters to appreciation when rates decline. Because of compound interest, a 30-year bond increases in value much more for each percentage point decline in interest rates than does a shorter maturity bond.

Note that at recent interest rates, a one percentage point fall in rates increases the price of a 5-year Treasury note by about 4.8%, a 10-year note by around 9.5%, but a 30-year bond by around 24.2%. Unfortunately, this works both ways, so if interest rates go up, you’ll lose much more on the bond than the notes if rates rise the same for both.

If you really believe, as we have for 35 years, that interest rates are going down, you want to own the longest-maturity bond possible. This is true even if short-term rates were to fall twice as much as 30-year bond yields. Many investors don’t understand this and want only to buy a longer-maturity bond if its yield is higher.

Others only buy fixed-income securities that mature when they need the money back. Or they’ll buy a ladder of bonds that mature in a series of future dates. This strikes us as odd, especially for Treasury's that trade hundreds of billions of dollars’ worth each day and can be easily bought and sold without disturbing the market price. Of course, when you need the cash, interest rates may have risen and you’ll sell at a loss, whereas if you hold a bond until it matures, you’ll get the full par value unless it defaults in the meanwhile. 

But what about stocks? They have no maturity, so you’re never sure you’ll get back what you pay for them.

via forbes

Wednesday, August 17, 2016

Stocks vs Bonds vs Jeremy Siegel

I was invited by Professor Jeremy Siegel of Wharton for a public debate on stocks versus bonds. He, of course, favored stocks and I advocated Treasury bonds.

At one point, he addressed the audience of about 500 and said, “I don’t know why anyone in their right mind would tie up their money for 30 years for a 4.75% yield [the then-yield on the 30-year Treasury].” 

When it came my turn to reply, I asked the audience, “What’s the maturity on stocks?” I got no answer, but pointed out that unless a company merges or goes bankrupt, the maturity on its stock is infinity—it has no maturity. My follow-up question was, “What is the yield on stocks?” to which someone correctly replied, “It’s 2% on the S&P 500 Index.”

So I continued, “I don’t know why anyone would tie up money for infinity for a 2% yield.” I was putting the query, apples to apples, in the same framework as Professor Siegel’s rhetorical question. “I’ve never, never, never bought Treasury bonds for yield, but for appreciation, the same reason that most people buy stocks. I couldn’t care less what the yield is, as long as it’s going down since, then, Treasury prices are rising.”

Of course, Siegel isn’t the only one who hates bonds in general and Treasuries in particular. And because of that, Treasuries, unlike stocks, are seldom the subject of irrational exuberance. Their leap in price in the dark days in late 2008 is a rare exception to a market that seldom gets giddy, despite the declining trend in yields and related decline in prices for almost three decades.

Stockholders inherently hate Treasuries. They say they don’t understand them. But their quality is unquestioned, and Treasuries and the forces that move yields are well-defined—Fed policy and inflation or deflation are among the few important factors. Stock prices, by contrast, depend on the business cycle, conditions in that particular industry, Congressional legislation, the quality of company management, merger and acquisition possibilities, corporate accounting, company pricing power, new and old product potentials, and myriad other variables.

Also, many others may see bonds—except for junk, which really are equities in disguise—as uniform and gray. It’s a lot more interesting at a cocktail party to talk about the unlimited potential of a new online retailer that sells dog food to Alaskan dog-sledders than to discuss the different trading characteristics of a Treasury of 20- compared to 30-year maturity. In addition, many brokers have traditionally refrained from recommending or even discussing bonds with clients. Commissions are much lower and turnover tends to be much slower than with stocks.

Stockholders also understand that Treasury's normally rally in weak economic conditions, which are negative for stock prices, so declining Treasury yields are a bad omen. It was only individual investors’ extreme distaste for stocks in 2009 after their bloodbath collapse that precipitated the rush into bond mutual funds that year. They plowed $69 billion into long-term municipal bond funds alone in 2009, up from only $8 billion in 2008 and $11 billion in 2007.

Another reason that most of those promoting stocks prefer them to bonds is because they compare equities with short duration fixed-income securities that did not have long enough maturities to appreciate much as interest rates declined since the early 1980's.

Investment strategists cite numbers like a 6.7% annual return for Treasury bond mutual funds for the decade of the 1990's while the S&P 500 total annual return, including dividends, was 18.1%. But those government bond funds have average maturities and durations far shorter than on 30-year coupon and zero-coupon Treasury's that we favor and which have way, way outperformed equities since the early 1980's.

Monday, August 15, 2016

Monetary easing world-wide and more on the way

In response to Brexit, the Bank of England has already eased, not tightened, credit with more likely to follow. The European Central Bank is also likely to pump out more money as is the Bank of Japan as part of a new $268 billion stimulus package. Meanwhile, even though Fed Chairwoman Yellen has talked about raising interest rates later this year, we continue to believe that the next Fed move will be to reduce them.

Major central banks have already driven their reference rates to essentially zero and now negative in Japan and Europe while quantitative easing exploded their assets. The Bank of England immediately after Brexit moved to increase the funds available for lending by UK banks by $200 billion. Earlier, on June 30, BOE chief Mark Carney said that the central bank would need to cut rates “over the summer” and hinted at a revival of QE that the BOE ended in July 2012.


via John Mauldin, Forbes

Monday, August 8, 2016

More QE and loose monetary policies could be ahead in US and Europe

Several years of rock-bottom interest rates around the world haven't been all bad. They've helped reduce government borrowing costs, for sure. Central banks also send back to their governments most of the interest received on assets purchased through quantitative-easing programs. Governments essentially are paying interest to themselves.
Janet Yellen - Chairwoman of US Federal Reserve

What is Helicopter Money? 

Since the beginning of their quantitative-easing activities, the Federal Reserve has returned $596 billion to the U.S. Treasury and the Bank of England has given back $47 billion. This cozy relationship between central banks and their governments resembles “helicopter money,” the unconventional form of stimulus that some central banks may be considering as a way to spur economic growth.

I’m looking for more such helicopter money -- fiscal stimulus applied directly to the U.S. economy and financed by the Fed --no matter who wins the Presidential election in November.

It’s called helicopter money because of the illusion of dumping currency from the sky to people who will rapidly spend it, thereby creating demand, jobs and economic growth. Central banks can raise and lower interest rates and buy and sell securities, but that’s it. They can thereby make credit cheap and readily available, yet they can’t force banks to lend and consumers and businesses to borrow, spend and invest. That undermines the effectiveness of QE; as the proverb says, you can lead a horse to water, but you can't make it drink.

Furthermore, developed-country central banks purchase government securities on open markets, not from governments directly. You might ask: "What’s the difference between the Treasury issuing debt in the market and the Fed buying it, versus the Fed buying securities directly from the Treasury?" The difference is that the open market determines the prices of Treasuries, not the government or the central bank. The market intervenes between the two, which keeps the government from shoving huge quantities of debt directly onto the central bank without a market-intervening test. This enforces central bank discipline and maintains credibility.

In contrast, direct sales to central banks have been the normal course of government finance in places like Zimbabwe and Argentina. It often leads to hyperinflation and financial disaster. (I keep a 100-trillion Zimbabwe dollar bank note, issued in 2008, which was worth only a few U.S. cents as inflation rates there accelerated to the hundreds-of-million-percent level. Now it sells for several U.S. dollars as a collector’s item, after the long-entrenched and corrupt Zimbabwean government switched to U.S. dollars and stopped issuing its own currency.)

Argentina was excluded from borrowing abroad after defaulting in 2001. Little domestic funding was available and the Argentine government was unwilling to reduce spending to cut the deficit. So it turned to the central bank, which printed 4 billion pesos in 2007 (then worth about $1.3 billion). That increased to 159 billion pesos in 2015, equal to 3 percent of gross domestic product. Not surprisingly, inflation skyrocketed to about 25 percent last year, up from 6 percent in 2009.

To be sure, the independence of most central banks from their governments is rarely clear cut. It’s become the norm in peacetime, but not during times of war, when government spending shoots up and the resulting debt requires considerable central-bank assistance. That was certainly true during World War II, when the U.S. money supply increased by 25 percent a year. The Federal Reserve was the handmaiden of the U.S. government in financing spending that far exceeded revenue.

Today, developed countries are engaged not in shooting wars but wars against chronically slow economic growth. So the belief in close coordination between governments and central banks in spurring economic activity is back in vogue -- thus helicopter money.

All of the QE activity over the past several years by the Fed, the Bank of England, the European Central Bank, the Bank of Japan and others has failed to significantly revive economic growth. U.S. economic growth in this recovery has been the weakest of any post-war recovery. Growth in Japan has been minimal, and economies in the U.K. and the euro area remain under pressure.

The U.K.'s exit from the European Union may well lead to a recession in Britain and the EU as slow growth turns negative. A downturn could spread globally if financial disruptions are severe. This would no doubt ensure a drop in crude oil prices to the $10 to $20 a barrel level that I forecast in February 2015. This, too, would generate considerable financial distress, given the highly leveraged condition of the energy sector.

Both U.S. political parties seem to agree that funding for infrastructure projects is needed, given the poor state of American highways, ports, bridges and the like. And a boost in defense spending may also be in the works, especially if Republicans retain control of Congress and win the White House.

Given the "mad as hell" attitude of many voters in Europe and the U.S., on the left and the right, don't be surprised to see a new round of fiscal stimulus financed by helicopter money, whether Donald Trump or Hillary Clinton is the next president.

Major central bank helicopter money is a fact of life in war time -- and that includes the current global war on slower growth. Conventional monetary policy is impotent and voters in Europe and North America are screaming for government stimulus. I just hope it doesn’t set a precedent and continue after rapid growth resumes -- otherwise, the fragile independence of major central banks could go the way of those in banana republics.