For the first time in 17 years, the US treasury will issue a new security, a Floating Rate Note. This will become a program of quarterly auctions.  Why are they doing this?

1. How does one get longer term funding at low interest rates? How does one attract investors to longer maturity assets with little or no duration?
2. How will the US government keep debt service manageable over time despite longer dated liabilities?

1. • The answer to 1 above is to issue Floating Rate Notes.

1. • The answer to 2 above is to maintain short term interest rates at close to zero for longer. Given that the first issues will be 2 year maturities and coupons will be benchmarked to the 13 week T bill rate, I expect that the US Fed will not be raising interest rates till 2016 at the earliest.

http://www.bloomberg.com/news/2014-01-23/u-s-treasury-to-offer-15-billion-in-first-floating-rate-notes.html

On a side note, I expect the long bond (that’s the 30 year US treasury) to outperform. While I don’t like duration in general I don’t think the 10 year will fare as badly as the consensus believes. The 30 year, however, is under-issued, and demand from insurance companies and other real money investors with long term liabilities will keep it well supported. I expect the USD curve will form a hump at the 10 year. I’d be a buyer of the 30 year UST.

On another side note:Time to buy some GLD US. Time to buy some equity volatility. Some cracks are beginning to show.

QE Taper, for real?

• The Fed is reducing UST purchases from 45 billion USD to 40 billion USD per month, a 11.1% reduction. It is reducing Agency MBS purchases from 40 billion USD to 35 billion USD, a -12.5% reduction.
• US treasury issuance is shrinking at roughly 18% YOY due to an increase in tax receipts as the US economy recovers. Agency MBS issuance is also slowing, by about 30% YOY as banks underwriting standards have tightened and asset quality has improved to the extent that banks are willing to retain mortgages on balance sheet.
• This implies that despite spending fewer dollars on buying bonds, the US Fed is buying up an increasing proportion of new issuance. This is hardly tapering.

Short term interest rates, low for how long? The market expects rates to be kept low till 2015. Its possible that rates may be kept low for even longer. Why?

• Its possible that all that bond buying by the Fed was to maintain a respectable bid to cover ratio at auction, and not to reflate the economy. Why? Surely the Fed would understand that banks lend out of capital and not liquidity and all the LSAPs would do is liquefy the financial system, not provide it with capital.
• Treasury relied on the Fed to keep yields low so that it could refinance itself cheaply.
• The Fed balance sheet, at 4 trillion USD has reached critical limits making general prices potentially unstable. The Fed needed to find a less risky means of refinancing Treasury.
• This month, Jan 2014, will see the inaugural issue of Treasury FRNs (floating rate notes). Treasury needs to fund itself longer than the T Bills market. It intends to issue 2 and 3 year paper. It understands that investors will only provide longer term financing if they do not have to take on duration risk. FRNs are ideal for both lender and borrower.
• This provides the Fed with a cheaper and less risky way of suppressing Treasury’s interest expense. The Fed only needs to keep short rates floored at zero.
• The risk to this strategy is that whereas fixed rate debt can be inflated away, floating rate debt becomes more expensive under inflation as rates react to inflation expectations.
• Under the above thesis, interest rates will be kept low for another 3 years or more. Unless inflation perks up.

What about long rates?

• Inflation expectations are one of the important determinants of UST yields. US inflation numbers are low. The headline number is 1.2%, down from 1.8% a year ago. Core inflation, which excludes volatile and transitory items such as food and energy are at 1.7%, down from 1.9% a year ago. Considering that shelter is a large item in the CPI, and US housing and mortgage rates are rising, we should expect to see much slower inflation in the larger cash flow items (that is ex owner equivalent rent, which is not a cash flow item.) CPI ex shelter has fallen from 1.4% a year ago, to 1.0% today. Again, a 4% 10 year UST yield is not a foregone conclusion.
• However, given that the US Fed is a large buyer of treasuries, the eventual withdrawal of QE is likely to steepen the term structure.
• Take note of the US trade balance which has been recovering quite steadily. US manufacturing is rebounding, an ageing population is consuming more services and less goods, more production is being re-shored and shale gas and fracking technology is reducing reliance on energy imports mean that the US will export less USD, less exported USD will mean less demand for US treasuries, implying a steepening of the term structure.

Food for thought…

There has emerged a clear consensus about the outlook for US asset markets. While I am with the consensus for now, it is good practice to have an eye on the alternative view. With the tapering of QE, it has become established wisdom that equities will outperform bonds. Of course, there are many types of bonds; there are government bonds, municipal bonds, investment grade corporate bonds and high yield bonds. Bank debt, or loans are another debt instrument to consider in the analysis. The consensus view is the following:

1. The US economy is sufficiently strong that QE can be moderated.
2. The positive prognosis for the US economy implies the same for US corporate financial performance.
3. The Fed has announced a moderation in its large scale asset purchases from 85 billion USD a month to 75 billion USD a month, the reduction to be split equally between its agency MBS and US treasury programs.
4. The reduction in Fed purchases of US treasuries will lift yields at the mid and long end of the USD term structure.
5. The impact on bonds with any significant duration follows from the above. The relative preference for equities over bonds also follows.

The above consensus relies on some assumptions and interpretations that deserve closer inspection.

1. The US economy may be sufficiently strong that QE can be moderated. On the other hand, the Fed might be slowing LSAPs for other reasons. It could, for example, regard the size of its balance sheet as a risk to price stability. The Fed has never run a balance sheet of this size before and any pick up in demand or the velocity of money could spark of a rise in nominal output that real output might not be able to keep pace with – inflation. The Fed might have realized that interbank unsecured lending has shrunk and that lending has moved to the secured market – the repo market, and that its LSAPs are reducing the stock of available collateral for use in repo.
2. The US economy is growing, but its long term trend rate is no longer the 4% it experienced pre 2008, and closer to 2%. The market expects growth to average 3% in 2014, but this would be above the new trend rate. Corporate earnings growth and profit margins at the same time are at a cyclical high. In the last quarter US corporate earnings saw more downward revisions and the current quarter is likely to see further moderation of earnings growth expectations. This will make current valuations, which are not cheap, harder to sustain.
3. The Fed may have tapered its notional purchases but compared with a year ago, it is buying up an increasing proportion of new issue US treasuries. US treasury issuance is shrinking by about 18% YOY and Agency MBS issuance is shrinking by about 33% YOY. A 5 billion reduction in UST and MBS purchases amounts to a 12.5% reduction. It is not trivial nor a forgone conclusion that the 10 year UST yield is on a one way ride to 4%.
4. One of the important determinants of UST yields is inflation expectations. US inflation numbers are low. The headline number is 1.2%, down from 1.8% a year ago. Core inflation, which excludes volatile and transitory items such as food and energy are at 1.7%, down from 1.9% a year ago. Considering that shelter is a large item in the CPI, and US housing and mortgage rates are rising, we should expect to see much slower inflation in the larger cash flow items (that is ex owner equivalent rent, which is not a cash flow item.) CPI ex shelter has fallen from 1.4% a year ago, to 1.0% today. Again, a 4% 10 year UST yield is not a foregone conclusion.

I am with the consensus on this one. However, whenever we have a strong consensus, we should be mindful of the alternative view and be particularly watchful for the signs that the consensus is wrong. One of the obvious indicators is price action itself. That’s why traders have a cut loss policy. At the same time we will be watching corporate profitability and economic numbers seeking signs of weakness, while remaining overweight in equities and underweight in duration.

Complacency

We began 2012 utterly dejected. Apart from the US, most regions from Europe to Asia to Latin America faced slowing growth. That said central bank pump priming managed to sustain global equity markets and 2012 turned out to be a good year for risk assets despite some mid year volatility. We began 2013 optimistic on the back of momentum in risk assets. As 2013 unfolded in became clear that the US real economy was actually improving and this helped to dampen volatility as the US equity market climbed steadily. In the latter half of 2013, the European economy began to signs of recovery driving their equity markets higher. Emerging markets fared less with slowing growth and rising inflation. Signs that the US Fed might slow down its large scale asset purchases added fuel to the fire and drove volatility there. Japan continued to confound the skeptics adding real economic progress to the improved sentiment. And even China appeared to recover from its apparent risk of a hard landing. Taken together, there is little to fear in the world of investing today. This is a thing to fear.

The risk of QE and its gradual withdrawal are significant. So far investors are pretty sanguine and some even interpret QE tapering as a sign of strength in the US economy and thus a positive development for equities, albeit less positive for fixed income. Depending on why US equities were bought up, there is a risk that the taper could be more damaging than expected. If for example, equities were bought as a claim on future production to hedge against future inflation, then higher discount rates further along the term structure could reprice equities making them more expensive than previously thought.

The other risk of QE is that we really don’t know what asset prices look like without it. Short rates are artificially low, but the arbitrary nature of the setting of short rates is something we have come to live with. That QE has been extended across the term structure means that the shape of the yield curve absent QE is also unknown, and the shape of the curve is a somewhat important factor in signaling economic growth and shaping asset pricing. Quite worryingly, we have come to rely on QE and embrace it as a reality in our investment strategy.

Like the consensus, we expect the world to be less globalized and that trade growth while positive will slow in the wake of the underground trade war that has been waged invisibly these last 5 years. However, there will be an impact on the leveraged shipping finance industry which is supported primarily by European banks. This could be another source of volatility in store for markets in the near future. A lot depends not only on the asset side of balance sheets but also on the liabilities. Some investments are simply not robust against rising interest rates.

The heavy issuance of debt in 2013 is also disturbing, almost like a last hurrah. As a rule of thumb, it is always good to be a reluctant lender, and thus to prefer securities companies are less willing to issue and to not prefer securities companies are more willing to issue. Overzealous lending is leading to a resurgence of covenant-lite issuance, now some 60% versus a mere 30% in 2007. Some companies have become, to an extent, passthru’s whereby their senior unsecured issuance is being used to fund dividends and payouts to other parts of the capital structure.

Pooling vehicles generally increase systemic risk. The rise of mutual funds and the return of CDOs and CLOs in the US add to instability in markets. The state of the art in risk management is backward looking. Any risk metric that aims to provide not only amplitude but timing of risk events must fail at one, or both. We believe that the estimation of timing of risk events is futile and advocate estimating the amplitude of risk events. We advocate a Gini Coefficient methodology for dealing with liability based risk.

A related risk is the large scale adoption of a small number of standardized risk models. Blackrock’s Alladin system stands out as an example. As more small, independent, boutique investment managers and traders outsource risk measurement to more standardized risk systems such as Alladin, investor behavior becomes more correlated and less independent. This violates the necessary conditions for convergence in many central limit theorems used in the same risk systems and could lead to highly leptokurtic markets.

Traditional investing is all about asset allocation based on macro economic outlook and then drilling down to security selection. That’s a bit too fuzzy for my liking. Investing capital should be a more disciplined activity since it puts that capital at risk. The risk should always be well compensated by the prospect of returns. Thus, unless there is a very good reason to invest, capital should not be invested. There is a real cost to not being invested, but this is a relatively more certain cost, being the difference between short term cash rates and inflation. The short term cash rate will depend on the investor’s level of access and short term risk appetite. Deposit rates, LIBOR, or overnight repo rates are good proxies. This cost of not being invested can also be thought of as an option premium paid to not have exposure. It is the option to invest in the current period.

An investment would require a clear and present rationale, an event or a catalyst to justify it. Valuation itself is not sufficient. It is an important factor. Most successful value investors don’t just buy value; they buy value with a catalyst in mind. Sometimes, these investors not only have a catalyst in mind but they are active catalysts themselves. Distressed debt investors are a classic example, where the debt of a distressed business is bought with a view to reorganizing the business and the liabilities of the company in order to unlock value. Merger arbitrage is another example where the takeover code, anti trust regulation and other regulatory legislation drive investments to their fruition or deal-break.

The disciplines of event driven and distressed investing should be applied to traditional investments as well. Tighter definitions of investment rationale should be demanded by investors when they are asked to place capital in harms way.