That Was The Weak That Worked: Part II

By Grant Williams

January 6, 2014

Quantitative Easing
the introduction of new money into the money supply by a central bank

Financial Repression
any of the measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere

1. the act or process of recovering from a shock or a setback
2. restoration to a former or better condition

Payment Shock
the risk that a loan's scheduled future periodic payments may increase substantially

Last week, in Part I of "That Was The Weak That Worked," we reviewed the equity markets in an attempt to see how equity investors managed to scamper through 2013 with the friskiness of puppies when all about them lay doubt and potential disaster.

We found the answer in quantitative easing of course.

This week we will take a look at how the bond market managed to navigate the same 12-month period and see what can be learned about 2013 in order to forecast for 2014.

Let's begin by considering the subject of logical fallacies — an endeavor rendered more obsolete with each passing day.

(Deus Diapente): The study of logical fallacies is useful in learning how to think instead of what to think. In learning how to deconstruct an argument, you learn how to efficiently construct your own thoughts, ideas, and arguments. You learn how to find fallacies in your own line of reasoning before they're even presented, which is a valuable methodology for learning how to think. Which is a lot more honest, liberating, and possibly more objective than simply regurgitating what society, teachers, parents, preachers, friends, or politicians tell us...

"Learning how to think instead of what to think"?

The very idea is enough to send many into an Austen-like swoon, and yet within this relatively simple construct lies a principle that, if it were applied to today's markets, would have every rational investor rushing headlong into the hills.

Allow me to demonstrate using everyone's favourite logical structure: the syllogism.

A syllogism is classified as a point-by-point outline of a deductive or inductive argument. Syllogisms normally contain two premises followed by a conclusion:

Premise 1Miley Cyrus is the most talented musician of her generation.

Premise 2: The most talented musician of every generation achieves legendary status.

Conclusion: Miley Cyrus is a legend.


The conclusion, from a purely logical standpoint, holds water. The problem comes when either of the first two premises is not accepted by the person to which they are proposed.

At that point, the argument starts to fall apart.

The common term for this kind of flawed argument is a "non sequitur," which literally means "it does not follow."

So let's apply the syllogistic approach to the concept of quantitative easing and see how we go:

Premise 1: Central banks have been printing money like lunatics.

Premise 2: Their printing of money hasn't had any ill effects.

Conclusion: Printing money doesn't have any ill effects.

Right then. There's our syllogism

Do you want to go first, or shall I?

Oh... ok.

The rest, as they say (whoever "they" are), is history.

The effect on the Fed's balance sheet is plain to see:

Source: Bloomberg

That's a very steady, predictable line; and markets, as we have discussed, LOVE steady and predictable. The consistency of this curve underpinned the strength in equity markets this year, as I demonstrated last week. But in Bondville? Well, that's another story...

Below is a chart I've used before that has been helpfully updated by Goldman Sachs (courtesy of Barry Ritholtz). It shows the coupon on the US 10-year Treasury going back to 1790 and highlighting every peak, trough, and major catalyst along the way.

My advice is to bookmark it for 2014.


The only thing that ISN'T included on the chart is the average coupon over the last 224 years, which is a hair below 6%.

But the world is a very different place now than it was in 1790, obviously, and so it may seem unfair to take an average that goes back quite so far in time. So truncate the same chart to the period between 1962 and 2013 in the hope that a 50-year window is more palatable to grapple with. The beauty of that window is that it encapsulates both the high and the low prints for the entire 224-year span.

What do we find when we zoom in for our close-up (next page)? Well, we find that the average rate over the last 50 years was ... wait for it ... 6.58%.

OK, so as we attempt to disprove our original syllogism, we have established that somewhere between 6 and 6.5% is probably a fairly representative rate for the US to be paying to borrow 10-year money from the rest of the world. Now, let's head back to the dictionary:

(Free Dictionary): Regression toward the mean

Noun1. The relation between selected values of x and observed values of y (from which the most probable value of y can be predicted for any value of x).

Put in a slightly less mathematical way:

(Wikipedia): In finance, the term mean reversion has a different meaning. Jeremy Siegel uses it to describe a financial time series in which "returns can be very unstable in the short run but very stable in the long run."

More quantitatively, it is one in which the standard deviation of average annual returns declines faster than the inverse of the holding period, implying that the process is not a random walk, but that periods of lower returns are systematically followed by compensating periods of higher returns.

Source: Bloomberg

What that also means is that periods of lower rates are systematically followed by compensating periods of higher rates, which isn't great news as we continue to move inexorably higher from the lowest print in history.

Just because there HAVEN'T been any ill effects from QE doesn't prove there WON'T be. There goes our syllogism. Sorry.

As you can see from the downward-sloping trendline above, we have reached a somewhat crucial juncture.

Back in May, when Ben Bernanke provoked the Taper Tantrum, rates on the US 10-year Treasury were at their all-time lows of 1.6255%. Since then, almost imperceptibly, rates have climbed higher ... and higher ... and higher still, to the point where they have almost doubled since Ben let the cat out of the bag on that fateful day in May:

Source: Bloomberg

Ah yes, I hear you say, but it's not as though 3% is a steep interest rate for a country carrying a $14 trillion deficit to pay to finance its debt — and you're right. The problem comes with that whole regression to the mean thing — and more specifically, the tendency for these moves in interest rates to overshoot.

Back in late April, before the first taper trial balloon was floated, Bloomberg had this warning for bond investors:

(Bloomberg): If rates rise, the market value of government bonds in particular — and all bonds in general — could be hurt significantly. For example, if the federal funds rate rises to 3%, a longer-term Treasury bond might lose as much as a third of its market value.

For every 1% increase in interest rates, expect the 10-year U.S. Treasury bond to lose 8.96% in price.

Historically, the 10-year Treasury bond returned a long-term average real rate of return and yield of 4.4%, according to Don Riley, chief investment officer of the Wiley Group. If the 10-year yield rose from 1.66% today to 4.4%, the price of that bond would fall 21 percent.

If and when interest rates rise again, are bond owners going to keep 10-year or 30-year Treasury bonds in their portfolios until those bonds mature? Very likely not. Who would want a 1.5% or 2.5% return for a decade?

And in October, after the last-minute pullback from the edge that all but shredded whatever credibility the Fed had left, the FT weighed in with some alarming statistics from our old friends the IMF:

(FT): Monetary tightening in the US threatens to expose financial excesses and vulnerabilities that could wipe trillions of dollars off bond markets, the International Monetary Fund warned on Wednesday.

If the Federal Reserve's likely move to start scaling back its asset purchases or fallout from a possible US failure to lift its ceiling on public debt raise long-term interest rates by 1 percentage point, the IMF's Global Financial Stability Report (GFSR) estimates that the market losses on bond portfolios could reach $2.3tn.

Well, since May, when all this taper nonsense began, rates have made sizable moves in the wrong direction, all the way along the curve:


... and in the two holiday-affected weeks since the Fed's "Taper Lite" announcement, they've shown no signs of stopping:

Source: Bloomberg

With the Fed now slowing their purchasing of Treasuries, the spectre of the loss of a free backstop has sent investors barreling back into high-yield debt as a means to supplement their loss of interest income and capital losses on government bond portfolios; and that move has given us one of those charts you just have to love for the glaring disconnect that seems not to matter to anybody:

                                                     Source: Sober Look

Clearly, something is amiss here, but why worry about it nowjust chase the yield. There will always be a greater fool to sell your position to, and if things get really sticky the Fed will probably ride to the rescue.



Meanwhile, it probably makes senseseeing as the Fed is buying $40 bn in Treasuries and $35 bn of MBS every month in order to stabilize the market and keep rates down and the housing market "recovery" bubbling away — to take a look at what effect, if any, these rising rates are having on the aforementioned "recovery." To do that I'll enlist the help of my great friend Greg Weldon, whose chart work really is second to none.

(Greg has again kindly offered a free trial of his work to Things That Make You Go Hmmm... readers. You can sign up HERE. Personally, I think Greg's work is utterly invaluable to anyone trying to navigate these treacherous markets.)

Housing starts are strong; that's undeniable, though a lot of that is preemptive confidence.

Source: Greg Weldon

But housing starts aren't the whole story, I'm afraid. Existing home sales have faltered at a crucial technical level and turned down sharply:

Source: Greg Weldon

Pending home sales have turned negative YoY:

Source: Bloomberg

... and perhaps most alarmingly, the MBA's weekly mortgage applications data has fallen off a cliff: down 66% from its highs to a new 13-year lowyes, way worse than in the depths of 2008–9:

Source: Bloomberg

Overlaying a couple of these metrics gives us one of those wonderfully divergent charts that people never seem to pay any attention to until the divergence once again turns into convergence:

Source: Zerohedge

Why the change in direction for the housing "recovery"?

Well, unsurprisingly, as the rate on the 10-year has spiked since May, so have mortgage rates:

Source: Bloomberg

And if we step back and take a broader look at that chart, taking in the last 15 years, we see just how broken things really are:

Source: Bloomberg

As you can see, the housing boom that was fostered by Alan Greenspan's low-interest-rate binge was born of rates around 6%. That level was low enough to generate the biggest US housing boom in history. Yet today's "recovery" in the housing market is being choked off by rates a shade above 4%. And in places such as Brooklyn a staggering 70% of homes are being bought for cash. The skew caused by that phenomenon has led to the bifurcation of the market.

(NYT): A handful of large private equity and real estate investment firms, including the Blackstone Group and Colony Capital, have bought billions of dollars' worth of single-family homes in some of the areas most affected by the housing collapse.

The goal for these Wall Street investors is not to buy and flip the properties for a quick profit à la real estate bubble of the early 2000s. Instead, they are hunting for steady, dividend-like returns they believe can be earned by renting out the homes.

Where these investors see opportunity, however, their critics see opportunists.... Those arguments may hold up in places like Phoenix or Las Vegas, which were overbuilt during the boom and struggled when the housing market collapsed. But prices have soared in parts of the market that weathered the housing storm, like Brooklyn, increasingly frustrating the dreams of first-time home buyers, analysts say.

The median price of a home in Brooklyn climbed nearly 12 percent in just the past year to hit a 10-year record, according to a recent report released by the real estate brokerage firm Douglas Elliman. Prices for highly desirable one-family brownstones in Brooklyn have leapt almost 40 percent in the last year to a median price of $1.6 million.

Some real estate agents say investors, more often than not, have been at the forefront of buying activity.

"I'd say by the spring, maybe 70 percent of the sales we were seeing were to hedge funds, investors and others taking advantage of what was happening in Brooklyn" ...

So here's the Fed's own little prisoners' dilemma:

By purchasing a trillion dollars of Treasuries and MBS they have managed to avoid the bankruptcy of several major investment banks pick the moribund housing market off the floor and generate some interest in one of the major drivers of any "recovery." However, now that things are looking better (optically, at least), they need to cut back on the stimulus that has created the optimism. Their policy is leading to higher rates, which in turn are already starting to affect the nascent housing recovery.


So ... does the Fed cooperate and taper the taper in order to stifle the rate increase — or does it defect, continue to tighten, and watch the housing market tumble again?

Tough choice, particularly as they know that the second they backtrack on the taper, the last vestiges of credFedibility go ...


Remember that Bloomberg article we looked at a few pages ago? I'll refresh your memory to save you going back to it (and even throw in a little emphasis of my own for good measure):

(Bloomberg): If rates rise, the market value of government bonds in particular — and all bonds in general — could be hurt significantly. For example, if the federal funds rate rises to 3%, a longer-term Treasury bond might lose as much as a third of its market value.

For every 1% increase in interest rates, expect the 10-year U.S. Treasury bond to lose 8.96% in price.


2013 has been loudly trumpeted as the year gold saw its first down year in 13. The headlines trumpeting the end of the gold bull market have been ubiquitous and unbelievably celebratory, for some bizarre reason.

(Gold will get a year-end review all of its own of courseshortly):

"Gold Notches Biggest Annual Loss in Three Decades"

"Gold's First Down Year Since 2000"

"Gold Set for First Annual Loss in 13 Years"

Those three are just by way of a sample.

What you WON'T find, unless you go looking in the weeds, is coverage of a similar fact markedly less gloated over:

(Bloomberg): Bond investors worldwide who were stung by their first annual losses since 1999 are bracing for more declines as the Federal Reserve pulls back on stimulus that's supported fixed-income markets for five years.

Debt globally fell 0.4 percent in 2013 as losses of 3.4% in U.S. Treasuries offset the 1.2% gain in corporate debt that was led by a 7% return in high yield, according to Bank of America Merrill Lynch index data

Europe's recovery from a sovereign debt crisis led to a 57% rally in Greek bonds and a 12% surge for those of Ireland.

Yields in the six major government bond markets from the U.S. to Germany and Japan are forecast to rise next year with world economic growth poised to accelerate to 2.8% in 2014 from 1.98% this year, according to Bloomberg surveys of economists.

Now hold on just a cotton-pickin' minute.

Bonds have had THEIR OWN first down year in 14 years DESPITE the world's major central banks having supplemented the natural forces of supply and demand to the tune of a combined $4.7 trillion over the past five years and around $1.5 trillion this year alone, and that's not as newsworthy as the decline of gold?


You can be sure we'll get back to THAT little lapse in logic in Part III.

But for now, let's stay with bonds and look at the annual returns this past 12 months for various sectors of the largest pool of capital on the face of the planet:

2013 Return
US Treasuries
High Yield
Global Asset-Backed
Leveraged Loans
Spain (Sovereign)
Greek (Sovereign)
Italy (Sovereign)
Ireland (Sovereign)
Data Source: BAML

US Treasuries fell 3.4% in a year when the Federal Reserve monetized purchased over half a trillion dollars' worth. The other component of QE, mortgage securities, fell 1.5%.

Meanwhile, the Greek, Irish, Italian, and Spanish sovereign debt that litters bank balance sheets was all up double-digit percentages. (Italy, you ask? Oh, 8% is near enoughcut me some slack.) Meanwhile, the junk bonds that hedge funds and banks piled into in 2011 and 2012 were up 13%... Do I need to spell it out any further?

The big losers are the public and the big winners are the smart money. Again.

Surely this isn't a surprise to anybody. It's called smart money for a reason, and trusting your finances to the same group of hopeless academics government-appointed officials with little or no real-world experience who thought subprime was "contained" and that low rates for a coupla years in the early 2000s were a great idea, is a gameplan guaranteed to turn out poorly.

I wonder what would happen if the Fed entrusted their $85 bn a month to the smart money? Think it would rush into Treasuries and MBS?

Me neither.

2014 is going to be a bumpy ride for bond markets, folks. Count on it.

Government debt is at levels that only governments themselves would pay, at exactly the time when they are trying to lean more heavily on the private sector to take up the slackgood luck with that.

High-yield bonds will have significant gains that the holders will all be looking to lock in at once should we see markets wobble; and as for corporate issuance, well, the frenzied attempts to issue debt at current rates should tell you all you need to know:

(WSJ): Highly rated companies sold a record $1.111 trillion of bonds in the U.S. in 2013, even as the debt offered the worst returns in five years.

This year's issuance volume is based on preliminary figures supplied by data provider Dealogic.

This year's issuance surpasses the previous record set in 2012, when investment-grade companies sold $1.053 trillion of bonds. Dealogic's data goes back to 1995.

Despite the rise in yields, interest rates remain at relatively low levels, a situation that has encouraged companies to keep borrowing.

While holding investment-grade debt was a money-losing strategy in 2013, the bonds outperformed other kinds of debt....

The demand for high-grade corporate bonds this year was highlighted by two mammoth deals: Apple Inc. (AAPL -1.41%) sold $17 billion in April, which at the time was the largest corporate bond ever sold. But it was beat several months later by Verizon Communications Inc. (VZ -0.28%), which sold $49 billion of debt in September.

Interest rates, bond markets, and the housing market are inextricably intertwined. They always have been and always will be. Period.

You cannot monkey around with one piece of that eternal triangle and expect the others not to be affected at some point, and just because nothing bad has happened definitely does NOT mean it won't.

It will.

2013 may well have been The Weak That Worked, but the odds on that continuing for another 12 months are very short indeed.

And so, as we wrap up this week, let's revisit the idea of logical fallacies and throw a couple more that the guardians of the global economy are relying on into the ring for good measure:

The Taper Syllogism

Premise 1: The Fed tapered its monthly asset purchases.

Premise 2: The taper had no major negative effect on markets.

Conclusion: Tapering has no negative effect on markets.

The Housing Bubble Syllogism

Premise 1: The government has all the data on the housing market.

Premise 2: The government sees no bubble in the data.

Conclusion: There is no housing bubble.

The Interest Rate Syllogism

Premise 1: The Fed sets interest rates.

Premise 2: The Fed has promised low rates of zero to 0.25 percent "... at least as long as the unemployment rate remains above 6.5 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."

Interest rates will stay at zero to 0.25% and zero to 0.25 percent will be appropriate "... at least as long as the unemployment rate remains above 6.5 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."

The Inflation Syllogism

Premise 1: The world's central banks have printed ~$4.7 trillion.

Premise 2: There is no noticeable problem with (official) inflation numbers.

Conclusion: Printing money doesn't cause inflation.

Your assignment: Discuss.