[What follows is a thought piece I spent two weeks writing and sent around to some colleagues on Sunday October 18th. It has been modified slightly to take some associate's names out. TILB believes the outcome of rising rates would be unusually horrible for risk assets and, frankly, our society in general.]
“Are you getting it? Armageddon it! Ooh, really getting it? Yes, Armageddon
it!”- Def Leppard
We have spent a great deal of time reflecting on the lessons learned over the past two years. As I've contemplated those lessons and considered
Hatch's recent point that after this recent risk-rally, it appears that market participants' behavior is seemingly unchanged, I began thinking about what we should do to prepare/adjust for the risks that remain in the world (assuming any do). I have many views about this but want to address one in particular.
Humans have a fairly well defined collective “nature” and we are all challenged to deal with our own tendencies within our nature. We have a tendency to self deceive – particularly in situations where we’ve already put ourselves out to the world as having taken a view. Among other things, we have a desire to be right, a desire to be liked, we anchor to the past – especially the recent past – and we act emotionally and generally as a herd. I suffer from all of these, especially self deception.
It's part of life.
Hopefully I have some advantage in dealing with my own tendencies simply by acknowledging them, being aware of them, and realizing that self-deception doesn’t help with my even greater desire to be right. When I frame something through those combined lenses, it helps me stop deceiving so that I can get on the side of “right”.
That’s me. But collectively it’s not possible for man to suppress its aggregate nature and so we muddle along doomed to commit the same mistakes over and over again. The mistakes may not be identical on the surface but they’re identical at their core. This reality was reinforced by Seth Klarman at a conference I saw him speak at back in 2004 or 2005 when he fielded the question (paraphrasing), "do you worry that with the rise of hedge funds and everyone looking for inefficiencies that you're not going to find fat pitches anymore; that the market has become more efficient?" with the following response, "I'm not worried that human nature has changed."
Exactly.
So what is it about human nature pre-2007 that led to the “crisis”. This doesn’t need to address the true “core” problems that I see of fiat money, fractional reserve banking, and unintended consequences of certain policy and regulatory actions. Instead, let’s look at the nature of the foundation those skewed incentives created and how those building blocks were set to crumble in the first place.
In summary, we had a lack of respect for risk, perhaps engrained from 25 years of a generally painless experience for capital (recency bias) where the speedbumps that were approached seemed to be flattened out by the all-seeing, all-knowing Federal Reserve. Howard Marks said that, "the fear of loss is to capitalism as fear of hell is to Catholicism." Collectively, our balance between fear and greed was eroded by this apparent government-gilded safety net and the scales tipped out of whack. This manifested itself in a variety of ways including too much leverage, too little diligence, too much faith in government, too much moral hazard, prices that appreciated too far above the associated intrinsic worth of the assets they represented, too much illiquidity, etc.
I think back on 2006 and remember having conversations over and over where smart investment managers told us that “spreads were too narrow” in the credit world. In fact, despite our repeated asking,
we could find almost nobody who would admit to buying at then prevailing prices. This lack of opportunity caused these managers to hold cash or, more often, drift out of their competency in credit analysis into other areas like public equities, LBOs, etc. We spent a little time trying to figure out who was actually buying these assets but frankly did not do a thorough job. What bothered me about this was that I felt like this was a consensus view and my strong preference is to be contrarian.
I have been noodling on the paradox of what it means for me to agree with the consensus - perhaps it is possible that a consensus view point can actually be contrarian? My conclusion is it can. When very large unnatural forces impact the market, an artificial, "unseen" consensus may be created that opposes the traditional "seen" consensus, allowing the seen consensus to actually be contrarian.
I refer to the unnatural forces creating the artificial, unseen consensus as "dumb money". It is dumb in the sense that is not invested with risk-adjusted return generation as its north star; it serves some master other than unfettered economics, be it regulatory or political. In that regard, it is mindless and dumb.
As I mentioned, the view that credit spreads were too tight was a consensus view. However, a thorough research job would have shown us that there was, in effect, an enormous regulatory bid. It was a bid from ABS in the form of CDOs, CMBS, CLOs, RMBS, etc. This was and remains purely a regulatory game where assets that do not have the most attractive properties from a regulatory capital standpoint (e.g., sub-prime no doc mortgages, 2nd lien small cap bank lending to an LBO company, BBB tranches of other ABS) are pooled and re-crafted to rate very well from a regulatory standpoint. Generally 75-85% of these pools of unattractive regulatory assets receive an attractive regulatory treatment (A rated or better) and the balance of the assets are held by unregulated owners that are willing to take low- or un-rated risk.
When you think about this, it is a fascinating reality: buyers had all kinds of incentives that had little to do with the quality or price of what they were buying and a lot to do with interference in markets by regulators and government that drove buyers toward assets for unnatural reasons. In essence, they were price insensitive and it led to unsustainable outcomes.
So we learned a lesson: Follow the Dumb Money. It leads you to the excess (and perhaps to opportunities for shorting).
So Where is the Dumb Money Today?All of the above was a preamble to establish the case that human nature is fundamental, it causes recurring problems, and the problems are identifiable if we’re willing to hunt down the Dumb Money’s most recent activities. We saw in the recent credit bubble a regulatory Incentive Caused Bias that led buyers to overpay for high ratings and over-trust ratings agencies. Where is Dumb Money today?
It has bothered me for some time that the "seen" consensus view point seems to believe higher rates and more inflation are inevitable. It bothers me because I completely agree with it. I operate more comfortably in a contrarian circle and yet here I find myself rubbing shoulders with the masses. Perhaps it's simply another form of self-deception but I believe we are witnessing a volume of Dumb Money buying ("unseen" consensus) that registers near the right tail on an all time scale. And
the Dumb Money ring master is us - the US taxpayer - via our body politic and our printing press operations at the Federal Reserve.
One of the causes of truly great inflations is that in the early stages of rapid money-printing, the price of a typical consumer's basket of goods doesn't immediately respond one for one with monetary creation. The economist Murray Rothbard was a student of past inflations. He refers to that phase of apparent central bank induced nirvana of rapid money-printing and stable prices as a "heady wine" for those operating the printing presses*. It reinforces the logic and encourages a continuation of the practice and, by the time the inevitable result is obvious, it is too late and often too politically difficult to cease, much less unwind. Today we have a Chairman of the Fed that has all but promised to continue debasing the currency by interfering with the Treasury and Agency markets ("quantitative easing" or QE) and is in the process of fulfilling a nearly $2 trillion execution of his QE thesis. Two. Trillion. And I doubt he'll be able to stop there.
Today, I believe the Dumb Money is in sovereign debt, specifically US Treasury Bonds.Similar to when AAA CLO tranches were issued at par paying 20 bps over LIBOR, Ten Year U.S. Treasuries today are priced to yield 3.3% - not exactly a glorious return, even if inflation is subdued. A while back, Jim Grant coined the term “return free risk” to describe Treasuries at these levels. I believe that return free risk extends well beyond simple Treasury Bonds but before we get to that, let’s talk about why these are the home for today’s Dumb Money buyers.
In a world of global trade imbalances, a dollar-based reserve currency, deleveraging and defaults, Treasuries hold a special place. Combined with unusually favorable capital treatment at regulated institutions, the artificially steep yield curve created by the Fed has given banks a taxpayer gift to put a bid on longer bonds. Near term deflationary fears have a foot on the head of the short end. Foreign central banks – flush with IOUs from the Fed (“dollars” exported by our trade imbalance) – have to buy Treasuries or other dollar denominated assets every single day. Capital raised by banks must find a home and when those banks either lack quality borrowers or are uncomfortable lending precious capital out (or both) they buy Treasuries. Scared by the run on commercial paper last year, money market funds have shifted toward Treasuries. Capital market participants have shifted away from risk assets and toward Treasuries. Etc., etc., ad nauseum.
Most importantly, the Fed itself has announced that it will purchase hundreds of billions of Treasuries and even more of Agencies (the sellers of which then take the
newly printed dollars from the Fed and themselves buy Treasuries).
In summary, there are a slew of buyers for U.S. government issued debt (including, confusingly, the government itself) and in the current environment of fear of “risk” assets, “risk free” assets have caught a hell of a bid. Most of these buyers are buying for reasons that have nothing to do with absolute value. They are mindless, Dumb Money buyers.
While the inflationary 1970s taught investors that fixed income securities could be “certificates of confiscation”, Greenspan and Bernanke’s Great Moderation brought us a slightly different lesson: From Oct. 1, 1982 through Sept. 30, 2009 (which is three generations, in Wall Street measurements), the Merrill Lynch 7-10 Year U.S. Treasury Bond Index returned 10.0% p.a. Over the last 1, 5 and 10 year periods, it earned 8.0%, 5.7% p.a. and 6.8% p.a., respectively. Stocks as measured by the S&P 500 did not manage to differentiate themselves, besting bonds over the 28 year period by just over 1% per annum, but trailing massively over the 1, 5 and 10 year timeframes.
As such, we have generations of Wall Streeters that have grown to appreciate and believe in the risk free return of U.S. Treasury Bonds, adding stickiness to their bid and reinforcing the mantra of “risk free” (another recent mantra, “home prices never decline nationally”). We have trade partners that are addicted to American IOUs ("dollars"), we have banks and insurance companies that are junkies for any regulatorily blessed capital rebuilding efforts and are now riding the yield curve dragon hoping to catch that old high, we have scared Boomers trying to preserve their precious retirement, we have a Fed that is encouraging the buying of Treasuries and that has itself become the global marginal buyer of Treasuries and Agencies. For the time being, the freshly printed money that is funding the Fed's purchases has not multiplied and filtered out to society, at least on a scale that has frightened the average American. We are in Rothbard's "heady wine" phase and so the process continues. As the merry-go-round spins, non-value oriented buying pressure is unnaturally manipulating prices, keeping them artificially high and yields artificially low.
The Dumb Money is in U.S. Treasury Bonds. They provide virtually no return and a ton of risk. They are, indeed, return free risk.
But, by definition, either this buying cycle will end voluntarily or a special dose of inflation will take hold. And when either of those occurs, what happens to rates?
Unlike other asset classes, U.S. Treasury Bonds denominated in dollars hold a special place in the world. They are considered the global Risk Free Return and are the benchmark for virtually every other asset class on Earth. Even to this day, despite the debacle of the past few years, homebuyers make their purchase decisions not on the economic return a house can generate, but on monthly payment affordability. That affordability is directly tied to Treasury yields and thus, homeowners are effectively short rates (or long long-duration bonds). Commercial real estate, when cap rates are in the 6-8% range as they are today, are attractive only if Treasury yields stay low. Today's price to earnings multiples of 17x or 18x (vs. historical averages of 15x) are implicit bets on low rates, all else being equal. Discount rates and WACC calculations for most people actually embed the 10 Year U.S. Treasury Bond into their calculation. Yield curve junkies are betting on stable or flattening curve-structure. How would floating rate borrowers perform in a rising rate environment, many of whom are skirting bankruptcy now on the backs of a sub 1.0% LIBOR?
And what about the U.S. Federal Budget? The average maturity on the Treasury’s debt is 50 months or so, meaning that the bulk of our issued debt has a four and a quarter year maturity or less, reflecting the U.S. Treasury’s attempt to take advantage of the most attractive end of the yield curve. Despite lower average rates, for the fiscal year-to-date through August (a September FYE), interest expense for the Treasury was $367 billion, eating up 20% of receipts.
We have built an entire world around the foundation of low rates. This is the thread that ties. The Singularity. This is the risk that could cause every asset in our portfolio to get face-punched, as diversity vanishes into the ether and the singularity saddles up.
If debasement activities continue much longer, inflationary expectations will take hold and rates will rise. They must to offset the losses created by monetary inflation, otherwise lenders will not lend and the government will not be able to finance itself. So rates will rise. Perhaps by a lot.
Imagine yourself in a world where instead of a 2s/10s yield curve of 0.9%/3.3%, we were in a world of 3%/6% or 6%/10%. What does that world look like? I’ll take a crack:
- Corporate profits suffer as financing costs skyrocket and customers pull back;
- P/Es contract massively and stocks get re-rated downward;
- Spreads widen on credit securities and absolute rates obviously back-up, leading to a severe decline in the value of credit securities;
- Homeowners get obliterated;
- Corporate borrowers get obliterated;
- Commercial real estate gets obliterated;
- This leads to giant holes in bank balance sheets;
- The annual Federal deficit gaps wider by nearly two-thirds of $1 trillion on U.S. Treasury interest alone (5% of GDP). That incremental deficit is the size of the entire deficit we suffered under Bush2 when we already thought the deficit size was unsustainable. Interest expense alone could theoretically consume nearly half of all Federal tax receipts. How do you ever recover from that?
As such, the Federal Reserve faces a Faustian bargain with a choice between letting nature take its course and walking away (allowing the deflation and liquidation phase of the cycle that the market demands) or to monetize aggressively. What do you think the Fed will do in that scenario? Abandon the Treasury and allow her to default? Monetizing is the Occam’s Razor outcome, despite the problematic result of reinforcing the higher rate regime. Bernanke has said again and again that he will not late the “mistakes” of the past recur. He has already and will continue to use freshly printed money to fill the money supply vacuum left by damaged, deleveraging banks. The government may struggle to find enough buyers to take on the new supply of debt the deficit would demand, forcing Bernanke to either let the Treasury deal with its own problems or to monetize the debt.
He will monetize.
As dollar holders rationally begin to question the value of their currency and the sustainability of its purchasing power, commodity prices will rise to reflect a weak dollar and the velocity of money will accelerate as demand for money diminishes**. Interest rates will rip, financial assets will face valuation headwinds, levered entities that need to refinance, sell or deal with floating rate obligations will spiral toward bankruptcy. The singular thread that ties virtually all asset classes is low rates. We need to be prepared for the pain that will occur when higher rates aggressively yank that thread and unravel the world.
Worst of all, this is a self feeding cycle that will persist as long as deficits grow as a percentage of output or the government continues to monetize debt. If nobody steps in to break the cycle (e.g., Volker), at some point utter devastation results.
I will go out on a limb and state that if rates rise too much and the monetization cycle loses control, a number of non-investment risks that can be difficult to mitigate may arise. These include the erosion of the dollar’s reserve currency status, cessation of tax-exempt status for not-for-profits, overtly confiscatory behavior by governments, much higher tax rates, a challenged system of fractional reserve banking, and the potential for civil unrest. Some of these are unavoidable and difficult to mitigate. But we should try.
How Can We Prepare?
As we consider preparing for the more pure investment ramifications of this outcome, the vast majority of preparations should not be around profiting, but instead should be built around preservation of purchasing power and asset protection/defense. From a macro standpoint, printing new money shifts a portion of every existing dollar's purchasing power to the hands of the person holding the newly printed dollar (the government and banks). This means the government will likely steal more and more of society's purchasing power through this particularly unconstitutional tax. Simply treading water from a purchasing power standpoint will take yeoman's work because we'll be fighting this backdoor wealth confiscation headwind. What are some steps we can take?
- Aggressively shift our equity exposure into high quality, unlevered, low capex businesses. Businesses with global or purely foreign operations may be preferred
- Immediately diversify a meaningful portion to non-U.S. domiciled custody, outside the grasp of our government if true tail risk arises (the new country’s stability must be considered as well). This is low cost, super high value insurance for a magnitude 10 Earthquake on the Richter scale. Seems like a no-brainer.
- On the margin, move our asset allocation toward cash and move “cash” toward select commodities and select foreign currencies as our "new cash". Don't be tricked into believing that just because our "new cash" seems to move everyday relative to the dollar means they have a special risk. Prices constantly move relative to the dollar for everything which means the dollar intrinsically holds the same risk. It just so happens that oil is quoted in dollars rather than dollars being quoted in oil. But the fundamental relative risk is the same, particularly if the dollar’s reserve currency status dissipates. Within commodities, focus on fixed or diminishing resources such as precious metals and energy resources, (maybe agricultural land).
- Avoid all Treasuries and, if we must hold some, keep it all in TIPS even beyond implied inflation levels where we might normally sell (recognizing that we are reliant on the CPI calculation, which is dangerous).
- Prepare for a distressed cycle - huge opportunity.
- Short long-duration Treasuries, perhaps through long-dated, well out of the money puts. Do it in a size that moves the needle and is perhaps surprisingly far out of the money. Long-dated is key. The issue is they are expensive today.
- Short a basket of credit spreads that are too tight, perhaps some sovereigns too - the U.S. isn't the only country going down this road.
- Economic unions like the Euro bloc could be blasted apart as different countries desire massively different monetary and fiscal policy actions.
- Raise the cost of our money yet further - we should be increasingly selective with investing "new cash". The implication of this is that perhaps we need to prune our portfolio and exposure even further and build our new cash exposure.
Where Are We Now?
It is impossible to assess exactly where we are now and when this interest rate/inflation risk might manifest itself. We can’t know with certainty that rates will rise – Japan has defied this experience for twenty years (as an aside, Japan faces this risk as well, perhaps moreso). I have been saying for some time that I think Japan is the U.S.’s upside scenario. In any case, Japan has two advantages on us: 1) they began with a lower level of government debt as a percentage of GDP; and 2) they began with a much higher personal savings rate with which to internally finance newly issued debt (they also had a bigger bubble which meant the deflationary headwinds were bigger to begin with).
I think the U.S.’s peculiar situation is that, because we’ve acted much more aggressively faster, we have already begun to scare off the marginal central bank buyer. The Chinese have aggressively curtailed Treasury purchases. For instance, for the four months through July 2009, China only purchased $33.6 billion of Treasuries (and actually was a net seller during the months of June and July). The oil exporting nations have only added $3 billion to their aggregate $189 billion Treasury portfolios through July.
Stepping into their shoes has been the U.S. Federal Reserve. The left pocket (the U.S. Treasury) is issuing bonds and the right pocket (The U.S. Federal Reserve) is buying bonds with newly printed money. In March, the Fed authorized $300 billion of Treasury purchases, $200 billion of agency debt (Fan and Fred) and $1.25 trillion of agency MBS. In the last week of September alone, the Fed reported buying $5 billion of Treasuries, $3 billion of agency debt, and $39 billion of agency MBS. Its 29 week average for these purchases has been $35 billion per week. Since the late March authorization was put in place, the Fed has bought $291 billion of Treasuries (out of $300b authorized), $700 billion in MBS ($1.25T authorized), and $130 billion of agency debt ($200b authorized). This totals $1.1 trillion and the Treasury bond specific buying authorization is basically used up, though the agency capacity is still ample to last another several months. Of course, the Fed can expand its authority at any time.
The point is, we’ve had $1.1 trillion of money brought forth by the Fed and put into the world over the last six months. The run-rate of the Federal deficit is not shrinking – so how can the Fed stop? Who will step into their shoes?
Imagine what the world would look like if that $1.1 trillion did not exist today.
And so we watch.
But one thing we know is this rate of monetization cannot continue indefinitely without being hugely inflationary, which leads to rising rates. We also know that if the Fed were to suddenly stop, marginal buyers that can step into the Fed's shoes do not seem to exist at today's yields. So a cessation would also lead to rising rates. The Fed’s obvious hope is that they can restart the economy (despite worsening employment and default trends) so that someone can replace their buying or so that the government can cut spending / raise tax receipts and bring the deficit back to more manageable levels. They would then theoretically slowly but steadily unwind their QE, somehow without tipping the economy back into crisis mind you, and take the inflationary risk out of the room. I suppose anything is possible, but I am skeptical.
Further, it is quite possible that we actually suffer from continued deflation, which would seem to justify low nominal rates. The issue, of course, is that a) this is bad for risk assets in general in a society as levered as ours; and b) if we suffer continued deflation, the ensuing inflation will be even worse because it will provide Bernanke cover for even more aggressive debasement tactics. He's playing with fire in a dry forest, but he obviously believes nothing major will come of it.
When this heady wine phase passes and the hangover comes, I hope we are prepared. We have no excuse not to be. It is the most obvious risk in the world, but we have been numbed to it by three decades of apparent stability. The Dumb Money is trying as hard as it can to keep the music on and the party going. However, the more drinks we have, the less fun tomorrow morning will be.
It is time to prepare.
* Rothbard's more full quote is from his book The Mystery of Banking and it reads as follows: "Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new Santa Claus, a cornucopia, a magic elixir. They can increase the money supply to a fare-thee-well, finance their deficits and subsidize favored political groups with cheap credit, and prices will rise only by a little bit!
"It is human nature that when you see something work well, you do more of it. If, in its ceaseless quest for revenue, government sees a seemingly harmless method of raising funds without causing much inflation, it will grab on to it. It will continue to pump new money into the system, and, given a high or increasing demand for money, prices, at first, might rise by only a little."
** "Demand for money declining" may seem non-intuitive, but what we are really saying is that people who sell things demand more money for the same good or service or, described from the inverse, that consumers will prefer goods and services that can be purchased today to the risk of holding dollars for more expensive goods and services tomorrow.
