April 8, 2015

Doug Kass shorting Bonds

This piece is committed to expanding on my original bond short thesis.  

Financial markets are cyclical. While bull and bear markets are inevitable, the timing of an inflection point is often not easy to diagnose. Most often predicting a non-consensus trend change is not a popular view. Indeed, taking an outlier position (like shorting the bond market) can often even be business or portfolio destructive. So an appropriate weighting becomes an important ingredient to any variant strategy, if you want to live and tell the tale!

Bonds have been rising in price and yields have been moving lower in price since 1981. "Like the snowball rolling down the side of a snow-covered hill" (The Temptations, "It's Growing") investors in fixed income have developed muscle memory and have grown inured to the bull market in bonds.  But we shouldn't lose sight that, while a long-running investment trend tends to gather force and its persistence and duration leads more people to think that it will never end, in its later stages, a trend is inherently risky and, ultimately, unstable.   

This is the second time I have aggressively employed a short bond strategy. Back in 2012-2013, I called shorting bonds as (potentially) the "Trade of the Decade" and chronicled my analysis in a lecture I gave at the Kellogg School of Management at Northwestern University and in a talk I gave in Omaha, Neb., at the Value Investing Congress. 

As the rate of global economic growth began to decelerate, my expectations for economic growth were consistently revised lower. By 2013, my growth expectations were well below consensus  and I abandoned my view of higher interest rates.  An important factor in my changed view were the weakening prospects for growth in China, Japan, and, especially in the eurozone (where I expected bold monetary efforts aimed at materially lowering sovereign debt yields). Both of these observations and conclusions were outliers at the time and differed from consensus views. Indeed, in late 2013, I underscored that bond equivalent areas of the market -- particularly closed-end municipal bond funds -- represented the most attractive segments of the U.S. stock market (and the asset class performed mightily).   

Let's now return to my current view of shorting bonds.

In Monday's analysis on Real Money Pro, I made the outlandish claim that "if history rhymes, I can see U.S. Bond yields rising without any material upside revision in economic expectations."

Yesterday, I even suggested that the yield on the 10-year U.S. note is discounting U.S. real GDP growth of only +1.2% -- truly an audacious and out of mainstream statement.

What rate of U.S. real GDP growth is being discounted in current yields?

Consider my calculations.

Over the last six decades, the yield on the 10-year U.S. note has averaged about 6%, basically in line with the nominal GDP growth in our country (Nominal GDP = Real GDP plus The Rate of Inflation). 

Domestic and global GDP growth has been slowing for some time relative to consensus expectations, in part due to structural headwinds. Let's assume the secular rate of economic growth has been permanently impaired -- and that growth will be somewhat slower in the future than in the past. Besides, efforts on the part of the ECB (and others) are turning interest rates into a negative yield ground and expanding yield differentials. For example, German 10-year Bunds yield an astonishing 173 basis points below U.S. 10-year yields.

I have been expecting this relationship since late 2012 -- and it has occurred in spades. This policy serves as a gravitational pull taking down interest rates worldwide in a flat, network and interconnected world.

I am presuming that these two major variables -- slowing global economic growth and the institution of ever lower (and even negative) interest rates by monetary authorities -- will serve to shift the relationship between the yield on the U.S. 10-year note and nominal GDP from 1.0x (as has existed in the last 60 years) to about only 0.7x. This seems to be a conservative and realistic assumption in calculating what rate of domestic economic growth the U.S. bond market is discounting.

Assuming the 0.7x (above) figure is reasonable, and given the current 10-year U.S. note yield of 1.89%, in order to calculate the rate of U.S. growth being discounted in the 10-year we need only one more input: the current core rate of inflation. Former Federal Reserve Governor Kevin Warsh appeared on CNBC's Squawk Box this week. In his appearance, Warsh stated that core U.S. inflation (as measured by the Fed) in the U.S. approximates +1.5%. Let's go to the tape.

Here is my equation to calculate what is the rate of growth in U.S. real GDP that is being discounted in the bond market:

The 10 Year US Note Yield = A Theoretical Multiplier x Nominal GDP (Real GDP(X) + Core Inflation)

In mathematical terms:

1.89%= 0.7 x ((X) + (+1.5%))

The solution (what rate of GDP growth is being discounted):


With the U.S. bond market (as measured by the 10-year note yield) discounting only +1.20% U.S. Real GDP growth, I am  of the view that owning any U.S. note or bond is like picking up nickels in front of a steamroller.

Besides being statistically (and even absurdly overpriced), bonds may be vulnerable to two fundamental events over the next few years that could make shorting them an outstanding investment and more than just a trade:

1. There could be an unscripted burst of prosperity, in which the U.S. actually gets its economic "mojo" back and returns to 3%+ Real GDP growth.

2. Market participants could Lose Their Faith in the world's Central Bankers. I call this the "Ah Ha" Moment.

Bond holders around the world may now be holding "certificates of confiscation" -- as they were known in the 1970s and early 1980s. At that point in history (1981), with bond prices continuing their uninterrupted decline, investors gave up on the asset class -- just at a time when they shouldn't have. Today, the movie is in reverse: bond investors have grown far too comfortable with the 34-year bull market move and have embraced the "safety" of the asset class.

But, safety is a tricky investment concept. Safe assets are often the assets that most investors view as hopelessly risky. Unsafe assets are often the assets that investors view as having no risk -- like bonds -- as my previous muscle memory metaphor applies.

In summary, I am of the view (and this was expressed in my 15 Surprises for 2015) that the three-decade Bull Market in bonds will end this year and that the bond market is currently discounting U.S. Real GDP growth of only +1.2%. It is even possible that we are now about to enter a period that resembles 1946 to 1981, when bond prices tumbled and interest rates persistently rose. Though I think the previous 35-year rise in rates will be more subtle in the next few decades, the difference could be this time compared to the first decade of the rate rise (1946 to 1956) -- when rates only rose by 100 basis points -- that the initial movement will be more. I suggest this to be the case because dealers no longer carry large inventory of corporate debt -- a residue of legislation that followed The Great Decession (Dodd, Frank) -- so air pockets might occur if many try to get out at the same time.

Here is my basic thesis in shorting US bonds, as expressed a few days ago.