(ELD) Archives - Page 2 of 2 - Mad Hedge Fund Trader

Tag Archive for: (ELD)

The 1% and the Bond Market

With the bond market confounding forecasters and prognosticators once again, I thought I?d delve into one of the more mysterious reasons why the bond market keeps going from strength to strength.

To a man, hedge fund traders expected bond prices to take a dive in 2014 and 2015 and for yields to soar. Isn?t that what?s supposed to happen in recovering economies?

Instead, we got the opposite, and yields have plunged, from 3.05% for the ten-year Treasury to as low as 2.80% this week.

There are many important lessons to be learned here. This is not your father?s bond market.

The internal dynamics of the fixed income markets have changed so much in the last three decades that it has become unrecognizable to long term practitioners, like myself.

A big factor has been the takeover of the bond market by the 1%, the richest segment of the US population and, indeed, the global economy. As wealth concentrates at the top, its character changes.

Let me stop here and tell you that the ultra rich are different from you and me, and not just because they have more money.

I have learned this after nearly half-century-long relationships with the planet?s wealthiest families, including the Rockefellers, Rothschilds, DuPonts, Morgans, and Pritzkers, first as important contacts of mine at The Economist, then as clients of mine at Morgan Stanley, then as investors in my hedge fund, and now as subscribers to The Diary of a Mad Hedge Fund Trader.

The wealthier families become the more conservative they get in their investment choices. Their goal shifts from capital appreciation to asset protection.

They lose interest in return on capital and become obsessed with return of capital. This is how the rich stay rich, sometimes for centuries. I have even noticed this among my newly minted billionaire hedge fund buddies.

What this means for the bond market is that they never sell. When they buy a 30-year Treasury bond, it is with the expectation of keeping it for the full 30 years until maturity.

That way they can avoid capital gains taxes and only have to pay taxes on the coupon interest. When they die, spouses get the step up in the cost basis, and then the wealth passes from one generation to the next. Taxes are never paid.

Back in the 1980s, when wealth was more evenly distributed, the top 1% only accounted for 1% of Treasury bond ownership. Today, that figure is closer to 25%.

Add this to the 50% of our national debt that is owned by foreign investors, primarily central banks, who also tend to hold paper for its full life. Central banks don?t pay taxes either.

China and Japan are the biggest holders with around $1 trillion each. This means that 75% or more of bonds are owned by investors who won?t sell. What does that mean for the rest of us? Bond prices that never go down.

With bonds very close to 30-year highs, keeping your bonds has been the right thing to do. I can?t tell you how many investment advisors I know who have distilled their practices down to managing fixed income instruments only.

This involves the entire coupon clipping space, including municipal bonds (MUB), corporates (LQD), junk (JNK), and even emerging market debt (ELD).

This is driven by customer demand, the 1%ers, not from any great insights or epiphanies they achieved on their own.

Of course, there is a certain amount of "driving with your eyes firmly fixed on the rear view mirror" going on here. Maybe the rich will finally sell their bonds once prices fall hard, stay down and then go down some more.

Inflation rearing its ugly head might also do the trick since it is always bad for bond prices as it reduces the purchasing power of money. Selling is certainly what they were doing in the early eighties, when the ten-year yield hit 12%.

Again, the rear view mirror effect, when bond were called ?certificates of wealth confiscation.?

There are other matters to consider with the 1% owning so much of the bond market and keeping it there.

This money is not getting invested in new start ups and creating jobs. It is money that is not being used to engender new economic growth. One of the fantasies of the last election was the claim that the 1% were creating so many jobs. They weren?t, not as long as their money was parked in a risk free bond market.

Instead, it is just stagnating. This is one reason why economic growth is so flaccid this decade and will remain so. This is fine for the 1%, but not so good for the rest of us.

The bottom line here is that while bonds are overbought and due for a pullback, they are not by any means going to crash. We could be living in the 2.60%-3.50% range for the 30-year for quite some time, maybe for years.

That is if the new Federal Reserve governor and my friend, ultra dove Janet Yellen, has anything to say about it. She has only just started and could be with us for another eight years.

Personally, I don?t foresee any appreciable rise in interest rates until we get well into the 2020s, when real inflation finally returns from the dead.

That is when bonds will become the asset class you don?t want to know, whether you?re in the 1% or not.

Bonds Will Stay Up Until Inflation Returns from the Dead

The Game Changer in India

Diary, Newsletter

So far in 2015 the Indian stock market has handily beaten that of the US, by 10.6% compared to 5.3%.

?The India election result is the biggest development to affect emerging markets over the last 30 years.? That is what retired chairman of Goldman Sachs Asset Management and originator of the ?BRIC? term, Jim O?Neal, told me last week.

Indeed, the stunning news has sent long term country specialists scampering. In my long term strategy lectures I have been titillating listeners for years with predictions that India was about to become the next China.

With half the per capita income of the Middle Kingdom, India was lacking the infrastructure needed to compete in the global marketplace. All that was needed was the trigger.

This is the trigger.

With a new party taking control of the government for the first time in 50 years, the way is now clear to carry out desperately needed sweeping political and economic reforms. At the top of the list is a clean sweep of corruption, long endemic to the subcontinent. I once spent four months traveling around India on the Indian railway system, and the demand for ?bakshish? was ever present.

A reviving and reborn India has massive implications for the global economy, which could see growth accelerate as much at 0.50% a year for the next 30 years. This will be great news for stocks everywhere. It will help offset flagging demand for commodities from China, like coal (KOL), iron ore (BHP), and the base metals (CU).

Demand for oil (USO) grows, as energy starved India is one of the world?s largest importers.

A strengthening Rupee, higher standards of living, and relaxed import duties should give a much needed boost for gold (GLD). India has always been the world?s largest buyer.

The world?s largest democracy certainly delivers the most unusual of elections, a blend of practices from today?.and a thousand years ago. It was carried out over five weeks, and a stunning 541 million voted, out of an eligible 815 million, a turnout of 66.4%. That is far higher than elections seen here in the United States.

Of the 552 members in the Lok Sabha, the lower house (or their House of Representatives), a specific number of seats are reserved for scheduled castes, scheduled tribes, and women. Gee, I wonder which one of these I would fit in?

Important issues during the campaign included rising prices, the economy, security, and infrastructure such as roads, electricity and water. About 14% of voters cited corruption as the main issue.

Some 12 political parties ran candidates. The winner was Hindu Nationalist Narendra Modi of the Bharatiya Janata Party (BJP), who led a diverse collection of lesser parties to take an overwhelming majority. For more details on this fascinating election, please click here at http://www.ndtv.com/elections.

It is still early days for the Bombay stock market, which has already rocketed by a stunning 20% since the election results became obvious last week.

This could be the beginning of a ten-bagger move over coming decades. Managers are hurriedly pawing through stacks of research on the subcontinent they have been ignoring for the past four years, the last time emerging markets peaked.

In the meantime, the action has spilled over into other emerging markets (EEM), their currencies (CEW), and their bonds (ELD), which have all punched through to new highs for the year.

I?ll be knocking out research o specific names when I find them. Until then, use any dip to pick up the Indian ETF?s (INP), (PIN), and (EPI).

Why Are Bond Yields So Low?

Newsletter

Investors around the world have been confused, befuddled and surprised by the persistent, ultra low level of long term interest rates in the United States.

At today?s close, the 30 year Treasury bond yielded a parsimonious 2.01%, the ten year, 2.62%, and the five year only 1.51%. The ten-year was threatening its all time low yield of 1.37% only two weeks ago, a return as rare as a dodo bird, last seen in August, 2012.

What?s more, yields across the entire fixed income spectrum have been plumbing new lows. Corporate bonds (LQD) have been fetching only 3.29%, tax-free municipal bonds (MUB) 2.89%, and junk (JNK) a pittance at 5.96%.

Spreads over Treasuries are approaching new all time lows. The spread for junk over of ten year Treasuries is now below an amazing 3.00%, a heady number not seen since the 2007 bubble top. ?Covenant light? in borrower terms is making a big comeback.

Are investors being rewarded for taking on the debt of companies that are on the edge of bankruptcy, a tiny 3.3% premium? I think not.

It is a global trend.

German bunds are now paying holders 0.35%, and JGB?s are at an eye popping 0.30%. The worst quality southern European paper has delivered the biggest rallies this year. Portuguese government paper is paying only 2.40%, and is rapidly closing in on US government yields.

Yikes!

These numbers indicate that there is a massive global capital glut. There is too much money chasing too few low risk investments everywhere. Has the world suddenly become risk averse? Is inflation gone forever? Will deflation become a permanent aspect of our investing lives? Does the reach for yield know no bounds?

It wasn?t supposed to be like this.

Almost to a man, hedge fund managers everywhere were unloading debt instruments in January. They were looking for a year of rising interest rates (TLT), accelerating stock prices (QQQ), falling commodities (DBA), and dying emerging markets (EEM). Surging capital inflows were supposed to prompt the dollar (UUP) to take off like a rocket.

It all ended up being almost a perfect mirror image portfolio of what actually transpired since then. As a result, almost all mutual funds are down so far in 2014. Many hedge fund managers are tearing their hair out, suffering their worst year in recent memory.

What is wrong with this picture?

Interest rates like these are hinting that the global economy is about to endure a serious nose dive, possibly even re-entering recession territory?or it isn?t.

To understand why not, we have to delve into deep structural issues, which are changing the nature of the debt markets beyond all recognition. This is not your father?s bond market.

I?ll start with what I call the ?1% effect.?

Rich people are different than you and I. Once they finally make their billions, they quickly evolve from being risk takers into wealth preservers. They don?t invest in start-ups, take fliers on stock tips, invest in the flavor of the day, or create jobs. In fact, many abandon shares completely, retreating to the safety of coupon clipping.

The problem for the rest of us is that this capital stagnates. It goes into the bond market where it stays forever. These people never sell, thus avoiding capital gains taxes and capturing a future step up in the cost basis whenever a spouse dies. Only the interest payments are taxable and that at a lowly 20% rate.

This is the lesson I learned from servicing generations of Rothschild?s, Du Ponts, Rockefellers, and Getty. Extremely wealthy families stay that way by becoming extremely conservative investors. Those that don?t, you?ve never heard of, because they all eventually went broke.

This didn?t used to mean much before 1980, back when the wealthy only owned 10% of the bond market, except to financial historians and private wealth specialists, of which I am one. Now they own a whopping 23%, and their behavior affects everyone.

Who has bee the largest buyer of Treasury bonds for the last 30 years? Foreign central banks and other governmental entities, which count them among their country?s foreign exchange reserves. They own 36% of our national debt, with China in the lead at 8% (the Bush tax cut that was borrowed), and Japan close behind with 7% (the Reagan tax cut that was borrowed). These days they purchase about 50% of every Treasury auction.

They never sell either, unless there is some kind of foreign exchange or balance of payments crisis, which is rare. If anything, these holdings are still growing.

Who else has been soaking up bonds, deaf to repeated cries that prices are about to plunge? The Federal Reserve, which thanks to QE1, 2, and 3, now owns 22% of our $17 trillion debt. Both the former Federal Reserve governor Ben Bernanke, and the present one, Janet Yellen, have made clear they have no plans to sell these bonds. They will run them to maturity instead, minimizing the market impact.

An assortment of other government entities possess a further 29% of US government bonds, first and foremost the Social Security Administration, with a 16% holding. And they ain?t selling either, baby.

So what you have here is the overwhelming majority of Treasury bond owners with no intention to sell. Only hedge funds have been selling this year, and they have already done so, in spades.

Which sets up a frightening possibility for them, now that we are at the very bottom of the past year?s range in yields. What happens if bond yields fall further? It will set off the mother of all short covering squeezes and could take ten-year yield down to match the 2012, 2.38% low.

Fasten your seat belts, batten the hatches, and down the Dramamine!

There are a few other reasons why rates will stay at subterranean levels for some time. If hyper accelerating technology keeps cutting costs for the rest of the century, deflation basically never goes away (click here?for ?Peeking into the Future with Ray Kurzweil?).

Hyper accelerating corporate profits will also create a global cash glut, further levitating bond prices. Companies are becoming so profitable they are throwing off more cash then they can reasonably use or pay out.

This is why these gigantic corporate cash hoards are piling up in Europe in tax free jurisdictions, now over $2 trillion. Is the US heading for Japanese style yields, or 0.39% for 10 year Treasuries?

If so, bonds are a steal here at 2.55%. If we really do enter a period of long term -2% a year deflation, that means the purchasing power of a dollar increases by 35% every decade in real terms.

The threat of a second Cold War is keeping the flight to safety bid alive, and keeping the bull market for bonds percolating. This could put a floor under bond prices for another decade, and Vladimir Putin?s current presidential run could last all the way under 2014.

All of this is why I?m out of the bond market for now, and will remain so for a while.

**Why Are They So Low?**

Throwing in the Towel on the Bond Market

Diary, Free Research, Newsletter

Here are the long-winded, feeble bunch of excuses I promised you.

I have broken every rule in my trading book hanging on to my position in the (TBT) for the past four months. I ignored my own stop losses. I listened to the morons on TV saying interest rates were about to spike up. I took the pile of charts that were telling me there was no bottom in sight, and deliberately lost them behind the radiator.

I even listened to the Fed signaling me with an emergency flare gun that they would raise rates in June.

As a result, I have been punished. Not too severely though, for I did follow one cardinal rule: I kept the position small. I did not double, triple and quadruple up, as many in the hedge fund industry have done.

As a result, I am merely suffering a thrashing in the woodshed, the kind my grandfather used to give me when he caught me shooting out the lights with my .22 rifle on our ranch in Indio, California. This is not a beheading, nor even a water boarding, and not a scintilla of an existential threat.

Still, a $14, 25% loss on a single position is no laughing matter. It?s about as welcome as a slap in the face with a wet mackerel. This is all proof that after 45 years in this business, I can still make the mistakes of a first year intern that was only hired for her good looks, shapely figure and loose morals.

If you told me that US GDP growth was 5%, unemployment was at a ten year low at 5.6%, and energy prices had just halved, I would have pegged the ten-year Treasury bond yield at 6.0%. The US economy created 2.9 million jobs in 2014, the most since 1999. Full employment is now almost a gimme.

Yet here we are at 2.00%.

You might as well take your traditional economic books and throw them in the trash. Apologies to John Maynard Keynes, John Kenneth Galbraith, and Paul Samuelson. It is yet another indication that this market has an insatiable need to teach an old dog new tricks.

After turning a blind eye to the writing on the wall, it?s time for me to read it out to you loud and clear.

The collapse of the German bond market is the big deal here. With the European economy in free fall, and doubts remaining about the ability of quantitative easing to work there under any circumstances, investors are assuming the future demand for money on the beleaguered continent will be zero.

German 10 year bond yields at 0.45% and still falling make 10 year US Treasuries at 2.00% appear the bargain of the century. Governments and hedge funds alike can buy US paper, sell short European paper against it, hedge out the currency risk, and lock in a risk free 1.55% a year for ten years. Sounds like a deal to me.

Multiply this by trillions of dollars and you can see what the problem is.

The other big deal here is the price of oil. I will reiterate my belief that if Texas tea stays down at the $40 handle, it is worth not just a 10% gain in stocks, but a double. The flipside is that interest rates stay far lower for longer than anyone expects, even including the Fed.

People just don?t understand how far reaching the impact of oil prices is. This heralds an entire new leg in the deflation story, one that could continue for years. It completely rules out any chance of a hike in interest rates this year. It is also fantastic news for the US bond market, and terrible for the (TBT).

If you want to add a third strike against continuing with a short bond position, look no further than the string US dollar. Investors around the world are pouring money into the greenback for a host of reasons. What do they do with the dollars when they get here? Buy bonds.

For more depth on why I totally missed the boat on bonds, please click here for ?10 Reasons Why I Am Wrong on Bonds?.

There are also opportunistic issues to consider here.

With implied volatilities on options sky high here, I can slap on almost any other options position and make back my 2.5% loss on the (TBT) in a couple of weeks. So there is no point in tying up 10% of my portfolio in a position that is dying a death of a thousand cuts.

Also, If you have been short the Euro (FXE), (EUO) and the Japanese yen (FXY), (YCS) after the past seven months, as I begged you to do, you have already more than made back the money.

The Run in Bonds is Over

Newsletter

This is a bet that the ten-year Treasury bonds, now trading at a 2.50% yield, don?t fall below 2.40% over the next 14 trading days. It has to make this move on top of an unbelievable decline in yields from 3.0% to 2.50% since September. And it has to do it quickly.

The Federal Reserve on Wednesday to consider whether they should raise rates, lower them, or leave them unchanged. Some traders are looking for hints of a taper that may arrive earlier than expected. I think there is zero chance of this. The futures markets for overnight money are trading at prices suggesting that this won?t occur until April or May of 2015! (No typo here). We could be setting up for a classic ?buy the rumor, sell the news? move here.

We are also blessed with a short calendar for the November 15 expiration, as November 1 falls on a Friday. This also takes us into the usual volatility sapping Thanksgiving holidays.

My standing view on bonds is that we will trade in a 2.40%-3.0% range for some time. Given that the ?Great Reallocation? trade may begin in earnest in 2014. We should take a run at the higher end of that range as we go into yearend.

Loss of 1.5% in fiscal drag from Washington next year could take US GDP growth up from a sluggish 2.0% to a more sporty 3.5%. This is not an environment where you want to own any kind of fixed income security.

You might also consider buying November call spreads on the double short Treasury bond ETF, the ProShares Ultra Short 20+ Treasury Fund (TBT), or just buying the (TBT) outright. Another run at the highs for the year from here is worth ten points.

While examining your own fixed income exposure, you might want to use the current strength in bonds to lighten up in other areas. Municipal bond prices (MUB) are now so high that the capital risk no longer justifies the tax savings. Get rid of them! The only successful muni bond strategy here is to die, and let your heirs sort out the wreckage. That way, your widow gets the step up in the cost basis.

Ditto for junk bonds (JNK), (HYG), which after the latest humongous rally, also see low yields no longer justifying the principal risk. The only bonds I like here are master limited partnerships (LINE), where double digit yields adequately pay you for your risk. I also like sovereign bonds (ELD), which will be supported by emerging market currencies appreciating against the US dollar.