Bonds – Page 4 – The Aleph Blog

The Crisis at the Tipping Point

Posted on 9 August 20179 August 2017 by David Merkel

Photo Credit: Fabio Tinelli Roncalli || Alas, there were so many signs that the avalanche was coming…

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Ten years ago, things were mostly quiet. ?The crisis was staring us in the face, with a little more than a year before the effects of growing leverage and sloppy credit underwriting would hit in full. ?But when there is a boom, almost no one wants to spoil the party. ?Yes a few bears and financial writers may do so, but they get ignored by the broader media, the politicians, the regulators, the bulls, etc.

It’s not as if there weren’t some hints before this. ?There were losses from subprime mortgages at HSBC. ?New Century was bankrupt. ?Two hedge funds at Bear Stearns, filled with some of the worst exposures to CDOs and subprime lending were wiped out.

And, for those watching the subprime lending markets the losses had been rising since late 2006. ?I was following it for a firm that was considering doing the “big short” but could not figure out an effective way to do it in a way consistent with the culture and personnel of the firm. ?We had discussions with a number of investment banks, and it seemed obvious that those on the short side of the trade would eventually win. ?I even wrote an article on it at RealMoney in November 2006, but it is lost in the bowels of theStreet.com’s file system.

Some of the building blocks of the crisis were evident then:

European banks in search of any AAA-rated structured product bonds that had spreads over LIBOR. ?They were even engaged in a variety of leverage schemes including leveraged AAA CMBS, and CPDOs. ?When you don’t have to put up any capital against AAA assets, it is astounding the lengths that market players will go through to create and swallow such assets. ?The European bank yield hogs were a main facilitator of the crisis that was to come, followed by the investment banks, and bullish mortgage hedge funds. ?As Gary Gorton would later point out, real disasters happen when safe assets fail.
Speculation was rampant almost everywhere. (not just subprime)
Regulators were unwilling to clamp down on bad underwriting, and they had the power to do so, but were unwilling, as banks could choose their regulators, and the Fed didn’t care, and may have actively inhibited scrutiny.
Not only were subprime loans low in credit quality, but they had a second embedded risk in them, as they had a reset date where the interest rate would rise dramatically, that made the loans far shorter than the houses that they financed, meaning that the loans would disproportionately default near their reset dates.
The illiquidity of the securitized Subprime Residential Mortgage ABS highlighted the slowness of pricing signals, as matrix pricing was slow to pick up the decay in value, given the sparseness of trades.
By August 2007, it was obvious that residential real estate prices were falling across the US. ?(I flagged the peak at RealMoney in October 2005, but this also is lost…)
Amid all of this, the “big short” was not a sure thing as those that entered into it had to feed the trade before it succeeded. ?For many, if the crisis had delayed one more year, many taking on the “big short” would have lost.
A variety of levered market-neutral equity hedge funds were running into trouble in August 2007 as they all pursued similar Value plus Momentum strategies, and as some fund liquidated, a self reinforcing panic ensued.
Fannie and Freddie were too levered, and could not survive a continued fall in housing prices. ?Same for AIG, and most investment banks.
Jumbo lending, Alt-A lending and traditional mortgage lending had the same problems as subprime, just in a smaller way — but there was so much more of them.
Oh, and don’t forget hidden leverage at the banks through ABCP conduits that were off balance sheet.
Dare we mention the Fed inverting the yield curve?

So by the time that BNP Paribas announced that three of their funds that bought?Subprime Residential Mortgage ABS had pricing issues, and briefly closed off redemptions, and Countrywide announced that it had to “shore up its funding,” there were many things in play that would eventually lead to the crisis that happened.

Some of us saw it in part, and hoped that things would be better. ?Fewer of us saw a lot of it, and took modest actions for protection. ?I was in that bucket; I never thought it would be as large as it turned out. ?Almost no one saw the whole thing coming, and those that did could not dream of the response of the central banks that would take much of the losses out of the pockets of savers, leaving bad lending institutions intact.

All in all, the crisis had a lot of red lights flashing in advance of its occurrence. ?Though many things have been repaired, there are a lot of people whose lives were practically ruined by their own greed, and the greed of others. ?It’s a sad story, but one that will hopefully make us more careful in the future when private leverage rises, creating an asset bubble.

But if I know mankind, the lesson will not be learned.

PS — this is what I wrote one decade ago. ?You can see what I knew at the time — a lot of the above, but could not see how bad it would be.

Redacted Version of the June 2017 FOMC Statement

Posted on 14 June 2017 by David Merkel

Comments

Labor conditions are reasonably good. GDP might be improving.
The yield curve is flattening, with long rates falling.
Stocks and gold fall. Bonds rose this morning and remain up.
I think the Fed is too optimistic about the economy. I also think that they won?t get far into letting securities mature before they stop reinvestment.
Interesting that they dropped the statement about following global financial conditions.

Why Social Security Should not be Invested in the Stock Market

Posted on 13 June 2017 by David Merkel

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Stocks always return more than Treasury Bonds. ?So why doesn’t Social Security invest the trust funds in stocks rather than Treasury bonds?

The first reason is simple. ?The government wanted Social Security to be free from accusations of favoritism. ?Why should public businesses have access to government capital, when private capital doesn’t have that same advantage? ?The second reason is also simple: do we want the government to be an owner of a large percentage of the businesses of the country? ?Do you want the government to have even more influence on businesses than activist investors do?

The third reason is complex. ?Do you want to mess up the stock market? ?A large dedicated buyer would drive the market up to levels where future returns would be very low, much lower than at present. ?Very marginal businesses would go public to take advantage of the dumb capital.

Far from earning more money for Social Security, the investment would put in the top of the market. ?There would be a generational top where the brightest investors would leave the market,, ?Future returns would be low.

Not that anyone significant is suggesting it at present, but it is wiser to keep governments out of business management. ?Don’t reach for false gains in investment performance if the price is government involvement in the details of business.

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One more note: all of the benefits of Social Security are based off of labor earnings, not capital earnings. ?Most taxes are collected from labor income. ?That’s why Treasury bonds make sense — it is a neutral asset that is similar to those who receive the benefits. ?Treasury bonds are as broad-based as those who receive benefits.

The Biggest Problems For Investors Today

Posted on 10 June 2017 by David Merkel

What could be more a propos to investing than a bubble spinner? — What could be more ? propos to investing than a bubble spinner?

A letter from a “reader” that looked like he sent it to a lot of people:

Hello my name is XXX,
After looking through your website I have really been enjoying your content.
I am also involved in the investing space and wanted to ask a quick question.
I was curious as to what you think the biggest problems are for investors today?
For example do they not have enough investment choices? Do they just not have enough knowledge? Really anything that you have noticed.
I would love to hear your perspective on this. I really appreciate the help. If you have any questions feel free to ask. Thanks.

This was entitled “Love what your doing, my question will only take 2 minutes.” ?I wrote back:

This is not a 2 minute question.

That said, it’s a decent question. ?Here are my thoughts:

The biggest problem for investors is low future returns. ?Bonds have low rates of returns, and equities have high valuations. ?You’ll see more about equity valuations in my next post.
The second largest problem is investment monoculture — there is a handful of large cap growth stocks that dominate the major indexes, and there is a self-reinforcing cycle of cash flow going on now that is forcing their prices well above what can be justified in the long run.
Third is inadequate ability to diversify. ?This is largely a function of the two problems listed before, and benchmarking and indexing, which has been correlating the markets more and more. ?I’m not talking about short-term correlations — diversification applies of the time horizon of the assets, which is long.
Fourth is bad government and central bank policy. ?The growth in government debt is the growth in unproductive capital, which drives the first problem.
Fifth, too many people are relying on investments to fund their future spending — that also exacerbates the first problem.

That’s all — if you can think of more, leave your suggestion in the comments.

PS — my apology to those I tweeted to on Friday about a post on equity valuations. ?That will appear Saturday night. ?Thanks.

Four Simple Investment Strategies That Work

Posted on 30 March 2017 by David Merkel

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This will be a short post, though I want to toss this question out to readers: what investment strategies do you know of that are simple, and work on average over the long-term?

Here are four (together with posts of mine on the topic):

1) Indexing

Index Investing is not Inherently Socialistic

Why Indexes are Capitalization-Weighted

Why do Value Investors Like to Index?

On Bond Investing, ETFs, Indexes, and the Current Market Environment

2) Buy-and-Hold

Buy-and-Hold Can?t Die

Buy-and-Hold Can?t Die, Redux

Buy and Hold Will Return?? 2/15/2009 (what a time to write this)

Patience and a Little Courage

Risk vs Return ? The Dirty Secret

3) The Permanent Portfolio

The Permanent Portfolio

Can the ?Permanent Portfolio? Work Today?

Permanent Asset Allocation

4) Bond Ladders

On Bond Ladders

I chose these because they are simple. ?Average people without a lot of training could do them. ?There are other things that work, but aren’t necessarily simple, like value investing, momentum investing, low volatility investing, and a few other things that I will think of after I hit the “Publish” button.

That said, most people don’t need to work on investing. ?They need to work on cash management, and I have written a small fleet of articles there. ?Managing cash is simple, but it takes self-control, and that is what most people lack in their financial lives.

But for those that have gotten their cash under control, with a full buffer fund, the above strategies will help, and they aren’t hard.

Final note: I realize valuations are high now, so buy-and-hold is not as attractive as at other times. ?I realize that interest rates are low, so bond ladders aren’t so great, seemingly. ?Indexing may be overused. ?Most?of the elements of the Permanent Portfolio look unappealing.

But what’s the alternative, and simple enough for average people to do? ?My answer is simple. ?If they can buy and hold, these strategies will pay off over time, and far better than those that panic when things get bad. ?There are few regularities in the markets more reliable than this.

The Permanent Portfolio

Posted on 19 March 2017 by David Merkel

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I will admit, when I first read about the Permanent Portfolio in the late-80s, I was somewhat skeptical, but not totally dismissive.? Here is the classic Permanent Portfolio, equal proportions of:

S&P 500 stocks
The longest Treasury Bonds
Spot Gold
Money market funds

Think about Inflation, how do these assets do?

S&P 500 stocks ? mediocre to pretty good
The longest Treasury Bonds ? craters
Spot Gold ? soars
Money market funds ? keeps value, earns income

Think about Deflation, how do these assets do?

S&P 500 stocks ? pretty poor to pretty good
The longest Treasury Bonds ? soars
Spot Gold ? craters
Money market funds ? makes a modest amount, loses nothing

Long bonds and gold are volatile, but they are definitely negatively correlated in the long run.? The Permanent Portfolio concept attempts to balance the effects of inflation and deflation, and capture returns from the overshooting that these four asset classes do.

What did I do?

I got the returns data from 12/31/69 to 9/30/2011 on gold, T-bonds, T-bills, and stocks.? I created a hypothetical portfolio that started with 25% in each, rebalancing to 25% in each whenever an asset got to be more than 27.5% or less than 22.5% of the portfolio.? This was the only rebalancing strategy that I tested.? I did not do multiple tests and pick the best one, because that would induce more hindsight bias, where I torture the data to make it confess what I want.

I used a 10% band around 25% ( 22.5%-27.5%) figuring that it would rebalance the portfolio with moderate frequency.? Over the 566 months of the study, it rebalanced 102?times. ?At the top of this article is a graphical summary of the results.

The smooth-ish gold line in the middle is the Permanent Portfolio.? Frankly, I was surprised at how well it did.? It did so well, that I decided to ask, what if we drop out the T-bills in order to leverage the idea.? It improves the returns by 1%, but kicks up the 12-month drawdown by 7%.? Probably not a good tradeoff, but pretty amazing that it beats stocks with lower than bond drawdowns. ?That’s the light brown line.

Results	S&P TR	Bond TR	T-bill TR	Gold TR	PP TR	PP TR levered
Annualized Return	10.40%	8.38%	4.77%	7.82%	8.80%	9.93%
Max 12-mo drawdown	-43.32%	-22.66%	0.02%	-35.07%	-7.65%	-14.75%

Now the above calculations assume no fees.? If you decide to implement it using SPY, TLT, SHY and GLD, (or something similar) there will be some modest level of fees, and commission costs.

?What Could Go Wrong

Now, what could go wrong with an analysis like this?? The first point is that the history could be unusual, and not be indicative of the future.? What was unusual about the period 1970-2017?

Went off the gold standard; individual holding of gold legalized.
High level of gold appreciation was historically abnormal.
Deregulation of money markets allowed greater volatility in short-term rates.
ZIRP crushed money market rates.
Federal Reserve micro-management of short-term rates led to undue certainty in the markets over the efficacy of monetary policy ? ?The Great Moderation.?
Volcker era interest rates were abnormal, but necessary to squeeze out inflation.
Low long Treasury rates today are abnormal, partially due to fear, and abnormal Fed policy.
Thus it would be unusual to see a lot more performance out of long Treasuries. The stellar returns of the past can?t be repeated.
Three hard falls in the stock market 1973-4, 2000-2, 2007-9, each with a comeback.
By the end of the period, profit margins for stocks were abnormally high, and overvaluations are significant.

But maybe the way to view the abnormalities of the period as being ?tests? of the strategy.? If it can survive this many tests, perhaps it can survive the unknown tests of the future.

Other risks, however unlikely, include:

Holding gold could be made illegal again.
The T-bills and T-bonds have only one creditor, the US Government. Are there scenarios where they might default for political reasons?? I think in most scenarios bondholders get paid, but who can tell?
Stock markets can close for protracted periods of time; in principle, public corporations could be made illegal, as they are statutory creations.
The US as a society could become less creative & productive, leading to malaise in its markets. Think of how promising Argentina was 100 years ago.

But if risks this severe happen, almost no investment strategy will be any good.? If the US isn?t a desirable place to live, what other area of the world would be?? And how difficult would it be to transfer assets there?

Summary

The Permanent Portfolio strategy is about as promising as any that I have seen for preserving the value of assets through a wide number of macroeconomic scenarios.? The volatility is low enough that almost anyone could maintain it.? Finally, it?s pretty simple.? Makes me want to consider what sort of product could be made out of this.

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Back to the Present

I delayed on posting this for a while — the original work was done five years ago. ?In that time, there has been a decent amount of digital ink spilled on the Permanent Portfolio idea of Harry Browne’s. ?I have two pieces written:?Permanent Asset Allocation, and?Can the ?Permanent Portfolio? Work Today?

Part of the recent doubt on the concept has come from three sources:

Zero Interest rate policy [ZIRP] since late 2008, (6.8%/yr PP return)
The fall in Gold since late 2012 (2.7%/yr PP return), and
The fall in T-bonds in since mid-2016 (-4.7%?annualized PP return).

Out of 46 calendar years, the strategy makes money in 41 of them, and loses money in 5 with the losses being small: 1.0% (2008), 1.9% (1994), 2.2% (2013), 3.6% (2015), and 4.5% (1981). ?I don’t know about what other people think, but there might be a market for a strategy that loses ~2.6% 11% of the time, and makes 9%+?89% of the time.

Here’s the thing, though — just because it succeeded in the past does not mean it will in the future. ?There is a decent theory behind the Permanent Portfolio, but can it survive highly priced bonds and stocks? ?My guess is yes.

Scenarios: 1) inflation runs, and the Fed falls behind the curve — cash and gold do well, bonds tank, and stocks muddle. ?2) Growth stalls, and so does the Fed: bonds rally, cash and stocks muddle, and gold follows the course of inflation. 3) Growth runs, and the Fed swarms with hawks. Cash does well, and the rest muddle.

It’s hard, almost impossible to make them all do badly at the same time. ?They react differently to?changes in the macro-economy.

Upshot

There are a lot of modified permanent portfolio ideas out there, most of which have done worse than the pure strategy. ?This permanent portfolio strategy?would be relatively pure. ?I’m toying with the idea of a lower minimum ($25,000) separate account that would hold four funds and rebalance as stated above, with fees of 0.2% over the ETF fees. ?To minimize taxes, high cost tax lots would be sold first. ?My question is would there be interest for something like this? ?I would be using a better set of ETFs than the ones that I listed above.

I write this, knowing that I was disappointed when I started out with my equity management. ?Many indicated interest; few carried through. ?Small accounts and a low fee structure do not add up to a scalable model unless two things happen: 1) enough accounts want it, and 2) all reporting services are provided by Interactive Brokers.

Closing

Besides, anyone could do the rebalancing strategy. ?It’s not rocket science. ?There are enough decent ETFs to use. ?Would anyone truly want to pay 0.2%/yr on assets to have someone select the funds and do the rebalancing for him? ?I wouldn’t.

Redacted Version of the March 2017 FOMC Statement

Posted on 15 March 2017 by David Merkel

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Comments

2% inflation arrives, and the FOMC tightens another notch.
They are probably behind the curve.
The economy is growing well now, and in general, those who want to work can find work.
The change of the FOMC?s view is that inflation is higher. Equities and bonds rise. Commodity prices rise and the dollar weakens.
The FOMC says that any future change to policy is contingent on almost everything.

Everyone Needs Good Advice

Posted on 18 February 201719 February 2017 by David Merkel

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I am a fiduciary in my work that I do for my clients. I am also the largest investor in my own strategies, promising to keep a minimum of 80% of my liquid net worth in my strategies, and 50% of my total net worth in them (including my house, etc.).

I believe in eating my own cooking. ?I also believe in treating my clients well. ?I’ve treated part of this in an earlier post called?It?s Their Money, where I describe how I try to give exiting clients a pleasant time on the way out. ?For existing clients, I will also help them with situations where others are managing the money at no charge, no payment from another party, and no request that I manage any of those assets. ?I do that because I want them to be treated well by me, and I know that getting good advice is hard. ?As I wrote in a prior article?The Problem of Small Accounts:

We all want financial advice.? Good advice.? And we want it for free.? That?s why we come to the Aleph Blog, where advice is regularly dispensed, and at no cost.

But? I can?t be personal, and give you advice that is tailored to your situation.? And in my writing here, much as I try to be highly honest, I am not acting as a fiduciary, even though I still make my writings hold to such a standard.

Ugh.? Here?s the problem.? Good advice costs money.? Really good advice costs a lot of money, and is worth it, if you have enough money to spread the cost over.

But when you have a small account, you have a problem in getting advice.? There is no way for someone who is fiduciary (like me) to make money addressing your concerns.? That is why I have a high minimum for investing: $100,000.? With that, I can spend time on clients, even helping them with assets from which I make no money.

What extra things have I done for clients over time? ?I have:

Analyzed asset allocations.
Analyzed the performance of other managers.
Advised on changing jobs, negotiating salary, etc.
Explained the good and bad points of certain insurance companies and their policies, and suggested alternatives.
Analyzed chunky assets that they own elsewhere, aiding them in whether they keep, sell, or sell part of the asset.
Analyzed a variety of funky and normal investment strategies.
Advised on buying a building, and future business plans.
Told a client he was better off reinvesting the slack funds in his business that needed?financing, rather than borrow and invest the funds with me.
Told a client to stop sending me money, and pay down his mortgage. ?(He has since resumed sending money, but he is now debt-free.)

I take the fiduciary side of this seriously, and will?tell clients that want to put a?lot of their money in my stock?strategy that they need less risk, and should put funds in my bond strategy, where I earn less.

I’ve got a lot already. ?I don’t need to feather my nest at the expense of the best interests of my clients.

Over the last six years, around half of my clients have availed themselves of this help. ?If you’ve read Aleph Blog for awhile, you know that I have analyzed a wide number of things. ?Helping my clients also sharpens me for understanding the market as a whole, because issues come into focus when the situation of a family makes them concrete.

So informally, I am more than an “investments only” RIA [Registered Investment Advisor], but I only earn money off of my investment fees, and no other way. ?Personally, I think that other “investments only” RIAs would mutually benefit their clients if they did this as well — it would help them understand the struggles that they go through, and inform their view of the economy.

Thus I say to my competitors: do you want to justify your fees? ?This is a way to do it; perhaps you should consider it.

Postscript

Having some people in an “investment only” shop that understand the basic questions that most clients face also has some crossover advantages when it comes to understanding financial companies, and different places that institutional money gets managed. ?It gives you a better idea of the investment ecosystem that you live and work in.

Two Questions on Returns

Posted on 14 February 2017 by David Merkel

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I recently received two sets of questions from readers. Here we go:

David,

I am a one-time financial professional now running a modest ?home office? operation in the GHI?area.? I have been reading your blog posts for a couple years now, and genuinely appreciate your efforts to bring accessible, thoughtful, and modestly stated insights to a space too often lacking all three characteristics.? If I didn?t enjoy your financial posts so much, I?d request that you bring your approach to the political arena ? but that?s a different discussion altogether?

I am writing today with two questions about your work on the elegant market valuation approach you?ve credited to @Jesse_Livermore.?? I apologize in advance for any naivety evidenced by my lack of statistical background?

I noticed that you constructed a ?homemade? total return index ? perhaps to get you data back to the 1950s.? Do you see any issue using SPXTR index (I see data back to 1986)?? The 10yr return r-squared appears to be above .91 vs. investor allocation variable since that date.

The most current Fed/FRED data is from Q32016.? It appears that the Q42016 data will be released early March (including perhaps ?re-available? data sets for each of required components http://research.stlouisfed.org/fred2/graph/?g=qis ).? While I appreciate that the metric is not necessarily intended as a short-term market timing device, I am curious whether you have any interim device(s) you use to estimate data ? especially as the latest data approaches 6 months in age & the market has moved significantly?

I appreciate your thoughts & especially your continued posts?

JJJ

These questions are about the Estimating Future Stock Returns posts. ?On question 1, I am pulling the data from Shiller’s data. ?I don’t have a better data feed, but that should be the S&P 500 data, or pretty near it. ?It goes all the way back to the start of the Z.1 series, and I would rather keep things consistent, then try to fuse two similar series.

As for question 2, Making adjustments for time elapsed from the end of the quarter is important, because the estimate is stale by 70-165 days or so. ?I treat it like a 10-year zero coupon bond and look at the return since the end of the quarter. ?I could be more exact than this, adjusting for the exact period?and dividends, but the surprise from the unknown change in investor behavior which is larger than any of the adjustment simplifications. ?I take the return since the end of the last reported quarter and divide by ten, and subtract it from my ten year return estimate. ?Simple, understandable, and usable, particularly when the adjustment only has to wait for 3 more months to be refreshed.

PS — don’t suggest that I write on politics. ?I annoy too many people with my comments on that already. 😉

Now for the next question:

I have a quick question. If an investor told you they wanted a 3% real return (i.e., return after inflation) on their investments, do you consider that conservative? Average? Aggressive? I was looking at some data and it seems on the conservative side.

EEE

Perhaps this should go in the “dirty secrets” bin. ?Many analyses get done using real return?statistics. ?I think those are bogus, because inflation and investment returns are weakly related when it comes to risk assets like stocks and any other investment with business risk, even in the long run. ?Cash and high-quality bonds are different. ?So are precious metals and commodities as a whole. ?Individual commodities that are not precious metals have returns that are weakly related to inflation. ?Their returns depend more on their individual pricing cycle than on inflation.

I’m happier projecting inflation and real bond returns, and after that, projecting the nominal returns using my models. ?I typically do scenarios rather than simulation?models because the simulations are too opaque, and I am skeptical that the historical relationships of the past are all that useful without careful handling.

Let’s answer this question to a first approximation, though. ?Start with the 10-year breakeven inflation rate which is around 2.0%. ?Add to that a 10-year average life modification of the Barclays’ Aggregate, which I estimate would yield about 3.0%. ?Then go the the stock model, which at 9/30/16 projected 6.37%/yr returns. ?The market is up 7.4% since then in price terms. ?Divide by ten and subtract, and we now project 5.6%/year returns.

So, stocks forecast 3.6% “real” returns, and bonds 1.0%/year returns over the next 10 years. ?To earn a 3% real return, you would have to invest 77% in stocks and 23% in 10-year high-quality bonds. ?That’s aggressive, but potentially achievable. ?The 3% real return is a point estimate — there is a lot of noise around it. ?Inflation can change sharply upward, or there could be a market panic near the end of the 10-year period. ?You might also need the money in the midst of a drawdown. ?There are many ways that a base scenario could go wrong.

You might say that using stocks and bonds only is too simple. ?I do that because I don’t trust return most risk and return estimates for more complex models, especially the correlation matrices. ?I know of three organizations that I think have good models — T. Rowe Price, Research Affiliates, and GMO. ?They look at asset returns like I do — asking what the non-speculative returns would be off of the underlying assets and starting there. ?I.e. if you bought and held them w/reinvestment of their cash flows, how much would the return be after ten years?

Earning 3% real returns is possible,?and not that absurd, but it is a little on the high side unless you like holding?77% in stocks and 23% in 10-year high-quality bonds, and can bear with the volatility.

That’s all for now.

Yield = Poison (3)

Posted on 7 February 2017 by David Merkel

Photo Credit: Brent Moore || Watch the piggies run after scarce yield!

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If you do remember the first time I wrote about yield being poison,?you are unusual, because it was the first real post at Aleph Blog. ?A very small post — kinda cute, I think when I look at it from almost ten years ago… and prescient for its time, because a lot of risky bonds were about to lose value (in 19 months), aside from the highest quality bonds.

I decided to write this article this night because I decided to run my bond momentum model — low and behold, it yelled at me that everyone is grabbing for yield through credit risk, predominantly corporate and emerging markets, with a special love for bank debt closed end funds.

I get the idea — short rates are going to rise because the Fed is tightening and inflation is rising globally, and there is no credit risk anymore because economic growth is accelerating globally — it’s not just a US/Trump thing. ?I just have a harder time playing the game because we are in the wrong phase of the credit cycle — profit growth is nonexistent, and debts are growing.

I have a few other concerns as well. ?Even if encouraging exports and discouraging imports aids the US economy for a while (though I doubt it — more jobs rely on exports than are lost by imports, what if there is retaliation?) there is a corresponding opposite impact on the capital account — less reinvestment in the US. ?We could see higher yields…

Charles Gave:THE END OF THE DOLLAR STANDARD https://t.co/WZxUWX15SN I have wondered the same: Won’t Trump’s policies undo USD standard? $$

? David Merkel (@AlephBlog) February 4, 2017

That said, I would be more bearish on the US Dollar if it had some real competition. ?All of the major currencies have issues. ?Gold, anyone? ?Low short rates and rising inflation are the ideal for gold. ?Watch the real cost of carry go more negative, and you get paid (sort of) for holding gold.

If growth and inflation?persist globally (consider some of the work @soberlook has ?been doing at The WSJ Daily Shot — a new favorite of mine, even his posts are?too big) then almost no bonds except the shortest bonds will be any good in the intermediate-term — back to the ’70s phrase “certificates of confiscation.” ?One other effect that could go this way — if the portion of Dodd-Frank affecting bank leverage is repealed, the banks will have a much greater ability to lend overnight, which would be inflationary. ?Of course, they could just pay special dividends, but most corporations lean toward growing the business, unless they are disciplined capital allocators.

As Trump Team Enters Office, Repealing Dodd-Frank Could Have Inflationary Risks https://t.co/RCMcV5ksdv I talk about excess bank capital $$

? David Merkel (@AlephBlog) January 13, 2017

But it is not assured that the current growth and inflation will persist. ?M2 Monetary velocity is still low, and the long end of the yield curve does not have yield enough priced in for additional growth and inflation. ?Either long bonds are a raving sell, or the long end is telling us we are facing a colossal fake-out in the midst of too much leverage globally.

Summary

I’m going to stay high quality and short for now, but I will be watching for the current trends to break. ?I may leg into some long Treasuries, and maybe some foreign bonds. ?Gold looks interesting, but I don’t think I am going there. ?I’m not making any big moves in the short run — safe and short feels pretty good for the?bond portfolios that I manage. ?I think it’s a time to preserve principal — there is more credit risk than the market is pricing in. ?It might take a year or two to get there, or it might be next month… I would simply say stay flexible and look for a time where you have better opportunities. ?There is no fat pitch at present for long only investors like me.

Postscript

To those playing with fire buying dividend paying common stocks, preferred stocks, MLPs, etc. for yield — if we hit a period where credit risk becomes obvious — all of your “yield plays” will behave like stocks in a poisoned sector. ?There could be significant dividend cuts. ?Dividends are not guaranteed like bonds — bonds must pay or it is bankruptcy. ?Managements avoid defaulting on their bonds and loans, but will not hesitate to cut or not pay dividends in a crisis — it is self-preservation, at least in the short-run. ?Even if they get replaced by angry shareholders, the management typically gets some sort of parachute if the company survives, and far less in bankruptcy.

One final note on this point — stocks that have a lot of yield buyers behave more like bonds. ?If bond yields rise above current stock earnings yields, the stock prices will fall to reprice the yield of the stock, even if there is no bankruptcy risk.

And, if you say you can hold on and enjoy the rising dividends of your high quality companies? ?Accidents happen, the same way they did to some people who bought houses in the middle of the last decade. ?Many could not ride out the crisis because of some life event. ?Make sure you have a margin of safety. ?In a really large crisis, the return on risk assets may look decent from ten years before to ten years after, but a lot of people get surprised by their need to draw on those assets at the wrong moment — bad events come in bunches, when the credit cycle goes bust. Be careful, and don’t reach for yield.

May 2017	June 2017	Comments
Information received since the Federal Open Market Committee met in March indicates that the labor market has continued to strengthen even as growth in economic activity slowed.	Information received since the Federal Open Market Committee met in May indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.	Shades GDP up
Job gains were solid, on average, in recent months, and the unemployment rate declined.	Job gains have moderated but have been solid, on average, since the beginning of the year, and the unemployment rate has declined.	Shades labor conditions down
Household spending rose only modestly, but the fundamentals underpinning the continued growth of consumption remained solid.? Business fixed investment firmed.	Household spending has picked up in recent months, and business fixed investment has continued to expand.	Shades up household spending and business fixed investment
Inflation measured on a 12-month basis recently has been running close to the Committee’s 2 percent longer-run objective. Excluding energy and food, consumer prices declined in March and inflation continued to run somewhat below 2 percent.	On a 12-month basis, inflation has declined recently and, like the measure excluding food and energy prices, is running somewhat below 2 percent.	Shades inflation down.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.	Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.	No Change
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	No Change
The Committee views the slowing in growth during the first quarter as likely to be transitory and continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will stabilize around 2 percent over the medium term.	The Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.	Inflation down, growth up
Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.	Near term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.	Watches inflation closely, no longer looking at the rest of the world.
In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 3/4 to 1 percent.	In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1 to 1-1/4 percent.	Raises the Fed funds target range 1/4 percent.
The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.	The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.	No Change
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.	In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.	No Change
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	No Change
The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.	The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.	No Change
The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.	The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.	No Change
However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.	However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.	No Change
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction,	The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.	No Change
and it anticipates doing so until normalization of the level of the federal funds rate is well under way.	The Committee currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated.	I guess the low 1% region is what is considered the low end of a normal federal funds rate.
This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	This program, which would gradually reduce the Federal Reserve’s securities holdings by decreasing reinvestment of principal payments from those securities, is described in the accompanying addendum to the Committee’s Policy Normalization Principles and Plans.	Promises the slow end of QE, as they may start to let securities mature.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome H. Powell.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; and Jerome H. Powell.	All but one follow through on the idea that tightening is needed.
	Voting against the action was Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate.	Kashkari is a quirky guy.? Who knows?? Maybe he notes the flattening yield curve.

February 2017	March 2017	Comments
Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has continued to expand at a moderate pace.	Information received since the Federal Open Market Committee met in February indicates that the labor market has continued to strengthen and that economic activity has continued to expand at a moderate pace.	No real change.
Job gains remained solid and the unemployment rate stayed near its recent low.	Job gains remained solid and the unemployment rate was little changed in recent months.	No real change.
Household spending has continued to rise moderately while business fixed investment has remained soft.	Household spending has continued to rise moderately while business fixed investment appears to have firmed somewhat.	Shades up business fixed investment.
Measures of consumer and business sentiment have improved of late.		That sentence lasted for one statement.
Inflation increased in recent quarters but is still below the Committee’s 2 percent longer-run objective.	Inflation has increased in recent quarters, moving close to the Committee’s 2 percent longer-run objective; excluding energy and food prices, inflation was little changed and continued to run somewhat below 2 percent.	Shades their view of inflation up. Excluding two categories that have had high though variable inflation rates is bogus. Use a trimmed mean or the median.
Market-based measures of inflation compensation remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance.	Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.	No change. What would be a high number, pray tell?? TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.15%, unchanged from February.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy. But don?t blame the Fed, blame Congress.
The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will rise to 2 percent over the medium term.	The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will stabilize around 2 percent over the medium term.	No real change. CPI is at +2.8%, yoy.? Seems to be rising quickly.
Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.	Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.	No change.
In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1/2 to 3/4 percent.	In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 3/4 to 1 percent.	Kicks the Fed Funds rate up ?%.
The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.	The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.	Suggests that they are waiting to see 2% inflation for a while before making changes. They don?t get that policy direction, not position, is what makes policy accommodative or restrictive.? Think of monetary policy as a drug for which a tolerance gets built up.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.	In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.	No change.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	No change.? Gives the FOMC flexibility in decision-making, because they really don?t know what matters, and whether they can truly do anything with monetary policy.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.	The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.	Now that inflation is 2%, they have to decide how much they are willing to let it run before they tighten with vigor.
The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.	The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.	No change.? Says that they will go slowly, and react to new data.? Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	No change.? Says it will keep reinvesting maturing proceeds of treasury, agency debt and MBS, which blunts any tightening.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; Jerome H. Powell; and Daniel K. Tarullo.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Jerome H. Powell; and Daniel K. Tarullo.	Large agreement.
	Voting against the action was Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate.	Kashkari willing to be the lone dove amid rising inflation.? I wonder if he is thinking about systemic issues?