Uncharted Waters

It does not matter how you measure it, the US Treasury yield curve is at its steepest level ever.  Away from that, the value for expected five-year inflation, five years from now is at its highest level ever, excluding the noise that we had as our markets crashed in the fourth quarter of 2008.

This concerns me.  Anytime we hit new extremes on critical financial variables, it makes me think, “What next?”  Treasury yield curve slope and inflation expectations are fundamental.  Reaching unprecedented levels is a big thing.

Could the US Government ever face the possibility that it could not meet its obligations?  I think so, and a record wide yield curve is one of the things that I would see prior to such troubles.

Last week, I had dinner with my friend Cody Willard.  His favorite idea was shorting long bonds.  I indicated that I had some leaning that way but could not go  all the way on that idea, as the Federal Reserve had the option of inflating during the Great Depression, and did not do so.  Cody said something to the effect of “but we have so much less flexibility today.”  Can’t argue with that, though I wonder whether politicians and bureaucrats favor foreign claims over domestic claims.  Would they bankrupt Americans to pay off foreign claimants?  Yes, they might do that.  It has happened before.

Cody might be on the right track, but the steepness of the yield curve may fight him.  It is very, very hard to get a yield super-steep without something breaking — inflation running rampant, etc.

The greater worry from my angle is the US pursuing Japanese solutions that have failed miserably over the past 20 years.  Japan continues to follow failed Keynesian ideas, fostering a low return on asset culture, with all of the failed projects financed by very low interest rates.  Now we do the same.  The Fed runs a low interest rate policy via Fed Funds and buying mortgage bonds.

All that does is reinforce mediocrity by enabling assets with low returns to be financed and survive.  Better that many of those should die, and the capital be released to more profitable uses.

All of this is the price for not allowing recessions to be deep — now we have to clear away bad loans bigtime.  But who has the courage to do that?  Certainly not our government.  They avoid all short-term pain, leading to long-term problems.

That’s where we are now, in uncharted economic waters.

12 Comments

  • Bob_in_MA says:

    David: “It is very, very hard to get a yield super-steep without something breaking — inflation running rampant, etc.”

    At the risk of sounding like an idiot, how does the steepening itself cause rampant inflation? Or is it that the steepening is a symptom of a problem that will lead to the jump in inflation?

    One last question, what were the periods of the previous peaks in the spread?

  • The steepening is consistent with investors predicting greater inflation in the future or capital scarcity.

    The prior peak was in 2003, after the Fed loosened to 1%.

  • Lord says:

    The whole point is there are no more profitable opportunities and haven’t been for the last decade.

  • Lurker says:

    IMO shorting the long bond here is going to be painful.

    When the Fed does start raising, the short end will move faster and farther than the long end, as the slope regresses to the mean (typically under 100 bps).

    By buying long Ts here, and trading out of them in 2-3 years, one gets minimal risk of capital loss and a good chance at capital gain!, with an awesome 300 bps of yield capture for the 2-3 year period.

    IMO shorting the long bond here is going to be painful.

    When the Fed does start raising, the short end will move faster and farther than the long end, as the slope regresses to the mean (typically under 100 bps).

    By buying long Ts here, and trading out of them in 2-3 years, one gets minimal risk of capital loss and a good chance at capital gain!, with an awesome 300 bps of yield capture for the 2-3 year period.

    Understand that the proper comparison is NOT what 10-year yields look like 3 years from now. The PROPER comparison is what SEVEN-year money looks like 3 years from now.

    You mention 2003 – another time in which I heard a LOT about coming inflation, etc., blah, blah, short the long bonds, yada, yada – how do 10YTs bought coming out of the recession of 2003 look right now?

    How about the early 1990s? Same situation.

    Ten-year money bought in late 1972 – same situation.

    Tell Cody if he’s hot to short some T’s, put on a spread – short the short money and long the long money. Or just short the short money. The long end ain’t gonna move as fast as he thinks, with the spread this steep.

  • Lurker — two good articles on the topic:

    Top hedge funds bet on big rise in yields

    Top Ten Reasons Why the Yield Curve Will Flatten (Hint: This Is a Different Sort of Recession)

    I am more reluctant to speculate on the yield curve at present. It is more complex than it seems.

  • Lurker says:

    You’re right that it’s more complex than it seems. There’s a nice little feedback loop between different time-range inputs of CPI changes, the level of yield, the slope of the curve, the corporate and junk spreads, and other factors, that influence the decision of “where to be” in fixed income for any particular timeframe. But 3 looks at CPI changes combined with the other 4 factors can do a lot for predicting 1, 5, and 10-year payoffs on different lengths of Ts Vs corps and junks.

    I had read the first article previously but missed Goldman’s piece. Note that the primary tool used by the HF PMs in the first article is OPTIONS and not an outright short position. BTW, if you’d like to show a little love to Goldman, it’s always worth finding the article at HIS site and making a link to it, rather than linking to SA. SA gets enough traffic, don’t you think?

    To be clear, I don’t advocate or currently hold any position on Ts at any part of the curve. Taking a position requires a frame of reference regarding timeframe, and for a trader on my timeframe, there are other fish to fry, with better risk/reward ratios. Hint: I’m fully in EM equities at the moment.

    If a person were to ask my opinion about Ts specifically, the first question I would ask is:

    “what is the timeframe and intent?”

    Trade and monitor daily?

    Trades on a longer timeframe like months or years?

    Hold to maturity?

    For example, if someone were to suggest buying 30-year money right now, and holding to maturity, I would have very little to say to discourage them. In 30 years, odds are we’ll see 5 or 6 Fed rate cycles and 4 or more recessions. I think there’s a very good chance, with this curve and those rates, that their 30-year money will outpace the CPI over three decades and outperform a 30-year horizon of other maturity strategies.

    On the other hand, I think 10-year money bought now and held to maturity will likely lose out to the 5-year or 1-year strategies, over a decade. Even though a 10-year bought today will likely live through another recession and two full Fed rate cycles …

    But on the third hand – and most actuaries have three or more hands – there’s a spot for a one-to-three-year trade going long the long money, getting yield capture, and selling your 3-year-old 10-year-T at 7-year rates for about par, give or take. If I were talking to institutional money about Ts, this would be my suggestion.

  • Lurker, you are right. I didn’t remember he had his own site. I myself prefer it when people link here rather than to SA. Link love for David Goldman, who I have met and is a genuinely nice guy:

    Dave’s Top 10 Reasons to Expect the Yield Curve to Flatten.

    Cool ideas you propose — and I will think about them.

  • Greg says:

    Lurker — haven’t we seen this movie before? Buy long term assets (10yr or 30yr), and plan to sell to a bigger dummy in 2-3yrs?

    This was the logic used by every big bank — they all knew the subprime mortgage assets were junk, but they could finance them short term and collect a spread. When and *IF* the time came, they could always dump the assets for a tidy profit. Ooops

    If inflation continues to pick up — actually with two wars, massive government spending of money we don’t have, etc — higher inflation is a sure thing, the only question is how much higher?

    If the curve stays “as is”, then a 10yr rolling down to 7yrs might be interesting — but the success or failure of the trade depends on inflation not getting out of control when the President has formally announced $1.5 trillion deficits and the ramping up of Afghanistan and a very slow wind down of Iraq (if Iran cooperates) and he also wants a giant new entitlement health care system.

    In short, your trade depends 100% on the whims of politicians — which is a terrible bet.

    Goldman’s contention that inflation “cannot” pick up because of high un-employment is absurd. That very scenario already happened in the 1970s — the last time we had war, entitlements, out of control spending, and a government that most people did not trust.

    Plus ca change, plus ca meme chose.

    Certificates of confiscation — yours

  • Greg, that’s the other side of it, which is why I have a hard time signing on in full to the deflationists. Or the inflationists.

    Certificates of confiscation. Seventies.

    Preserving value. Thirties.

    Today? Personally I like Non-US, non-Euro debt at present, and I owe my readers a post on good funds in that area. What a mess.

  • Lurker says:

    “Certificates of confiscation. Seventies.”

    Ten-year money traded as I suggest, coming out of the recession in the early seventies, returned better than a rolling 1-year strategy did. Precisely for the same reasons I outline, a steep curve flattens as short rates rise, the long end doesn’t rise (or doesn’t rise as much) and the yield capture + duration shortening generate a capital gain (or protection of capital).

    “Certificates of confiscation. Seventies.”

    David – imagine a 30-year Treasury bought in 1977, with the yield reinvested in the longest-duration money available, and with the principle rolled back into another long-duration bond at maturity in 2007. How, exactly, did that money perform? Relative to the CPI changes, cumulative, since 1977?

    I just betcha when you look at it, it won’t look like “confiscation” any more.

    “Certificates of confiscation — yours”

    Greg, how does a 10-year purchased the LAST time I heard this talk look right now? Coming out of 2003? Purchases of 10YT coming out of recession in 2003 are now THREE-YEAR notes with coupons of around 4%.

    We can look at the historical record of long money bought deep after recessions have been recognized, when curves are very steep, and find the same example over and over again. It’s worked, for those willing to try it, multiple times.

    “Plus ca change, plus ca meme chose.”

    About the “yours” crack – it’s an academic discussion to me. Re-read my comments re: EM equities. Better places to be.

    Leaving the academics of Ts behind, if stuck in FI, I agree with David that junk and EM debt is the place to be, but I mourn for those stuck in any one single asset class long-term.

  • Greg says:

    Lurker, I don’t think anyone reading this site is confined to 1yr or 10yr Treasuries; as you point out, “none of the above” is a far better choice

    Buying a 30yr in 1977? Bad example for two reasons. First, while history repeats (rhymes?), we don’t know if this is 1972-1974 or 1977. Second, you are making a very crazy assumption that someone would buy a 30yr in 1977 and hold it as rates went from 4.5% to 15%. Few, if any, investors would have that kind of staying power. Anyone managing money professionally would be fired years before that trade came back. Its a fine academic question, but not something anyone in the real world would do.

    Buying a 10yr in 2003? While I am undecided on the 1970s “model”, I can definitely rule out 2003 is a guide. We never came out of recession in 2003, we just levered up like crazy. Levering up today isn’t possible. 2003 might repeat years from now, but no one is levering up today. The Fed is out of ammunition (and ideas). The government is fighting the last war (fiscally and militarily) and losing both.

    I don’t know if inflation will be moderate or 1970’s severe in the years ahead — but since the largest debtor the world has ever known controls the money printing press, I feel very safe in ruling out deflation. If deflation were to take hold, the US government (and its debt) would be in terrible trouble. Inflation helps debtors, deflation hurts. It defies all common sense that “helicopter Ben” will be unable to do what every banana republic dictator does in his sleep. Deflation isn’t going to happen as long as the US government is a debtor and controls the money printing press.

    So yes, Treasuries are once again certificates of confiscation — except in some academic fantasy situation.

    I agree with you on EM equities more or less, but I worry that most EM economies (and specific industries) are not as capital intensive as they once were. They don’t need foreign investors as much, and where they do they prefer real money (not heavily indebted / levered fast money).

    IMHO — the best investments right now, in the US and outside, are not securitized. Again, both in the US and outside, the things entrepreneurs need most are leadership, guidance, mentoring, advice … not capital.

  • Greg says:

    BTW — in the 1930s, the US was still on the gold standard, and was still a massive net creditor.

    The gold standard limited the amount of money that could be printed (limited, not prevented)

    But inflation is a really bad thing when you are a net creditor. Hurling money from helicopters would have been a bad thing for a net creditor country.

    Today, inflation is still really bad if you are a net creditor — but if you are $12 trillion in debt on balance sheet, with another $50 trillion (at least) off balance sheet debt, than inflation is a wonderful thing. Deflation would be catastrophic, and any half-wit debtor would be printing money like crazy if he had the option.

    If deflation did take hold, it would make it impossible for the US government (or any large debtor) to stay in power. Dollar denominated debts would become worthless. Buying Treasuries if you see deflation coming makes no sense.

    I see the US government acting like every other spendthrift empire in decline: massive money printing, military intervention all over the globe to protect political elites’ private assets, and continued decline in the belief in government leadership

    “Plus ca change, plus ca meme chose’ in politics too