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Monday, December 05, 2005
Secrets
Investors Insight Publishing
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Whether short term rates are high today is one of the louder debates among economists. And why are long rates so low? Will an inverted yield curve mean what it has for the past 40 years, i.e., a slowdown and/or a recession?
This week's letter is a recent essay by Bill Gross, the Managing Director of Pimco, also known as the Bond King. Gross sits on top of the largest pile of bonds in the world. He thinks short term rates are high and nearing a peak for this cycle and that the economy will begin to slow down next year. He includes the main points, sent to their investment committee, which Pimco is looking at when viewing the bond market.
Will he be correct in his assessment of rates? When someone as large as Pimco offers their view of the market, we should keep an eye on them and that is why this was picked for Outside the Box.
- John Mauldin
Secrets
By Bill Gross
December 2005 - Investment Outlook
"The secret to success is to know something nobody else knows."
- Aristotle Onassis
Golf is an eternal conflict between elation and despair. My favorite
response to Sue's perfunctory "How'd you shoot?" upon returning home
after a decent Saturday afternoon's round is a rousing "I think I
found the secret!" Inevitably the next weekend's retort is a
hopeless "I think I lost it." Secrets come and go in golf faster
than an episode of Desperate Housewives. You can find one and lose
it again between the 13th and 14th holes. And even if you've
rediscovered the magic, it doesn't help to have a bunch of secrets
stored in your head just as you're about to start your backswing.
The brain can't handle "straight left arm, head down, swing to one
o'clock, full follow-through" all at the same time. "Just hit it"
seems to work the best but then that's not much of a secret. And if
hitting the ball is an enigma, just try putting it. National TV
appearances, keynote speeches before a thousand people - nothing
compares to the pressure of making a five-foot putt for par. I
push'em, I pull'em, I leave'em short. They say every shot in golf
makes someone in your foursome happy. If so, I'm a philanthropic
hacker the likes of which has rarely been seen. I put smiles on
everyone's face but mine and money in their pockets on the 19th hole
to boot. Secret? The secret to golf is like the secret to quitting
smoking: don't start.
The biggest secret during the past few years in the bond market has
been why intermediate and long-term interest rates have remained so
low in the face of a 300 basis point uplift from the Federal
Reserve. Departing Chairman Greenspan has called it a "conundrum"
while incoming Chairman Bernanke sought to provide answers via his
"global savings glut" speech in early 2005. PIMCO, to be fair, teed
off on the conundrum long before Bernanke pulled the cover off his
driver, elaborating as far back as our 2003 Secular Forum on the
lack of global aggregate demand and the dampening effect it would
have on global growth. We did not, however, draw the logical
extension from declining G-7 investment spending/reserve recycling
to a flattening yield curve and stationary long-term rates. Too bad.
What is clear to us now, however, as well as to a growing list of
other investment managers, economists, and even Federal Reserve
Board researchers is that interest rates have been lowered for a
number of logical reasons that are likely to persist for some time:
- Economic globalization has led to the prioritization of export
supply over domestic demand as Asian and OPEC countries have adopted
a mercantilistic model emphasizing reserve accumulation and the
recycling of those reserves into global bond markets.
- U.S. and Euroland corporations are accelerating the global
savings glut by conserving cash flow instead of investing it. With
China offering huge returns on investment relative to G-7 economies,
it's hard to blame them.
- Asset/liability trends stressing long-end maturities as well as
reduced risk premiums due to central bank transparency may have
added a marginal although difficult to measure compression to the
longer end of global curves.
This challenge to answer Greenspan's conundrum has been a productive
one if only from the standpoint of the amount of research and
brainpower applied to the question. It's as if a Nobel Prize were at
stake with some papers emphasizing corporate savings, others
stressing ALM trends/risk premiums, and perhaps a majority siding
with Bernanke and his global savings glut thesis. None of them seem
willing to acknowledge the totality of factors as if to suggest that
the secret - the philosopher's stone of the bond market - is theirs
alone. I suspect not, but an astute investor has only to recognize
that all of the above cited factors have a probable longevity that
exceeds a normal business cycle, and will therefore keep yields low
for some years to come. Globalization, demographics and central bank
transparency are difficult trends to reverse and will likely be
compressing yields in 2010 much like they have in 2005. That is why
discretionary bond investors like PIMCO are comfortable in investing
clients' money at a 4½% 10-year Treasury rate instead of waiting for
6% which may have been a more "normal" yield during the investment
frenzy of the dot-com years or the less than "transparent" central
bank policy years of the 1980s.
Future Fed Chairman Bernanke has treaded mildly with this
semi-permanent thesis for lower U.S. and indeed global bond yields
by analyzing a rather esoteric and initially somewhat confusing
indicator shown below in Chart 1.
The graph displays a history of the one-year real Treasury rate nine
years forward into the future. Such yields can always be
interpolated from existing yield curves although the extent to which
they represent expectations as opposed to say a reduced risk
premium, is difficult to measure. Nonetheless, in March of this year
Bernanke went so far as to point out that the market expectation of
the future one-year nominal short-term rate has declined during the
past few years by as much as 1¼ percentage points, and that
was before the additional decline of 50 basis points seen over the
past six months. The global savings glut was his primary
explanation, hinting that the change had longevity.
PIMCO analysis has gone even further, at least in terms of the
conundrum's magnitude. We would suggest the U.S. and indeed many
global bond markets have experienced a reduction in forward nominal
and real short-term interest rates of as much as 200 basis points
due to the aggregate global trends discussed in preceding
paragraphs, and that these yields are likely to represent the norm
for years to come. If true, that means in terms of current monetary
policy that the Fed is much tighter than standard analysis would
presume. Today's short rate of 4% is really equivalent to 6% in my
view, a rate that was only 50 basis points shy of the cyclical
tightening peak of 6½% in 2000. I find it a little perplexing
to listen to economists expounding on the still stimulative level of
today's short-term and indeed long-term yields in the U.S. As seen
below in Chart 2, the current recovery has been only average
relative to the past 20 years or so in terms of GDP growth (and
below average in terms of employment) despite massive Fed and fiscal
stimulation over the past few years beginning in 2001. Now after 300
basis points and 17 months of tightening - which by the way is
typical of prior bear cycles as well - it should only be logical to
expect a slower economy in 2006, an end to Fed tightening, and the
beginning of an easing cycle late in the year. While yields may not
fall much on the longer end of the curve unless ALM trends
accelerate, one- to five-year rates could decline by as much as 100
basis points over the next 12 months. This scenario is at risk of
course should exporters such as China decide to invest their surplus
funds within their own borders instead of in global bond markets - a
possibility that at the moment appears years away.
How best to prepare for this expected transition to lower yields?
Well, despite skeptics who are suspicious of ulterior motives, we at
PIMCO keep very few secrets. I like to think of us as the Ohio State
Buckeyes of yesteryear, boasting a well advertised "three yards and
a cloud of dust" and daring the opposition to stop us. So, printed
below is a duplicate copy of a firm-wide memo just several weeks
old.
Whether or not such a portfolio will be successful in 2006 depends
not so much on what Aristotle Onassis would claim as knowing
something "nobody else knows" but on knowing something that the
investment markets, economists, and a future Fed Chairman alike are
slowly but surely coming to believe and by weighting strategy
significantly in that direction. Short-term interest rates are high,
not low, and by this time next year central banks the world around
will be initiating easing cycles that favor front-ends of yields
curves, longer than average duration portfolios and a high quality
emphasis within the context of a slowing U.S. and global economy
with contained inflation. Hopefully this forecast will in no way
resemble my erratic golf game, because once you find even a well
publicized secret in the bond market you'd better not lose it - or
lose with it. Birdies are our objective and bogies are unacceptable
as we try to stay atop the leaderboard. Hopefully the five-foot
putts will be few and far between. Fore! I think we've found the
secret.
Conclusion
Your always watching the yield curve analyst,
John Mauldin
JohnMauldin@InvestorsInsight.com
www.2000wave.com
December 5, 2005
Copyright 2005 John Mauldin. All Rights Reserved.
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John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273.
Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above.
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