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March 2, 2005
Like A Lead Balloon
By Brady Willett

What Is And What Should Never Be

Contrary Investor recently published an excellent overview of the U.S. consumer price index (CPI). Not only does this report show how the disparity between actual home prices and the ‘cost of housing’ component of CPI is understating inflation, but it also discusses why the U.S. government and Federal Reserve Board benefit from an understated CPI. Although the CPI issue has been covered before, few reports are as readable.

If the Contrary Investor commentary had been clipped by three paragraphs there would be no need for criticism. However, the temptation to push the ‘rigged CPI’ theme further than required was, unfortunately, too strong:

“This brings us to what we believe is one last important issue.  And an extremely important issue it is.  What about the trillions and trillions of dollars sitting apparently quite complacently in the US bond markets at the moment?  Are the majority of current US bond holders complete idiots?  Can they not do the simple calculations presented above?”

At first, the idea that ‘US bond holders are complete idiots’ makes perfect sense. After all, if CPI is vastly understating inflation bond holders should not be happy about receiving ‘negative real rates of return’. Nevertheless, remember that Contrary Investor focuses solely on home prices to propose that inflationary pressures are understated (instead of say commodity prices).  Accordingly, after further investigation some logical contradictions emerge: if U.S. interest rates (and mortgage rates) are artificially low would this not mean that housing prices/activity are/is artificially high?  And if home prices are artificially high could it not also be the case that bond holders are astutely aware that the inflationary threat from escalating housing prices (which is not covered in full in CPI) is overstated?

Confusing I know.  And while the above questions are not put forward in an attempt to paint an intelligent face on the average bond holder – the majority of U.S. Treasury purchases are being made with no consideration to housing prices but by foreign central banks with the goal of currency tinkering - to even suggest that a rigged CPI is responsible for bond holders acting irrationally is absurd.

Realizing the limitations of their CPI/interest rate theory, the Contrary Investor article in question reiterates the pessimistic party line when it comes to explaining the interest rate

“For now, unprecedented systemic liquidity creation and resulting leverage has skewed the connection between the fixed income markets and the underlying reality of inflationary pressures in the real economy.”

What is the end result of the fixed income market underestimating inflationary pressures?  A falling bond market of course: “At some point, the markets will reflect economic reality.”

The Song Remains The Same

The interest rate ‘conundrum’ highlighted by Contrary Investor is being explored elsewhere, and similar ends - albeit with a different emphasis on the means – are being forecasted. For example, in Bill Gross’s latest he repeats his ‘artificially low’ theme unrelentingly: 

“...the frenzy to capture carry has been the inevitable result, producing artificially low yields out the curve, artificially low spreads, and artificially low volatility…

As if to offer proof that his macro predictions have recently gone astray for completely capricious reasons, Mr. Gross points out that the interest rate ‘guessing game’ is being ‘complicated by buyers who have non-interest rate concerns’.  We will have to wait and see if the term ‘non-interest rate concerns’ ends up being presumptuous or prescient, but it is nonetheless amusing (put into context Gross is arguing that that crazy Asian central banks are responsible for taking logic out of the bond market).

Along with C.I. and Gross there are – quite literally - countless other sources offering color on why long-term U.S. interest rates are not reflecting ‘reality’.  For a taste:
Fekete blames the yen carry-trade, BCA and others point to pension asset allocation switches, Puplava blames the overly transparent Fed, and - bordering on the ridiculous - Hutchison suggests that Satan may be to blame

Why The Blame Game?

When the U.S. stock markets rallied to unthinkable heights during the 1990s market bears – at least those that were not fired or mocked into a den of hibernation – played the blame game. To be sure, in an effort to explain why stock prices were ridiculously high bears and/or value investors blamed the Fed, Wall Street, Corporate America, and the SEC/FASB. If the truth be told, gullible/naive investors who believed the Fed, Wall Street, Corporate America, and the SEC/FASB were looking out for their best interests were to blame for the stock market bubble, but I digress. Not surprisingly few paid attention to the bears until the stock markets peaked in early 2000 and the crash began.

In similar fashion, today’s curve bears – or those that blame the Fed, hedge funds, pensions funds, and the actions of foreign central bankers for creating an interest rate conundrum by riding carry trades to the top off a cliff – are largely ignored by the mainstream. The blame game is a defensive mechanism: under attack from investors, clients, and the media the first response from someone like Roach is to fight back.  Only when, and if the collapse of the carry transpires will the curve bears be vindicated.

If the blame game continues long enough Gross, Roach, Grant, Fleck, Puplava and others will ostracized further, which – ironically – would provide strong anecdotal evidence that their dire predictions are drawing closer. 

Over The Hills But Not Far Away

“A flat or inverted curve stymies the business of lending and borrowing. It's ice on the wings of the U.S. financial economy.” James Grant

If the Fed continues to push up short term interest rates mathematics say that either long-term interest rates must rise or the yield curve will invert (recession warning). Given that rising long-term interest rates would threaten to pop a U.S. economy recovery that is being supported largely by the U.S. housing bubble, and that a flatter curve would stifle financial market activity that is being supported primarily by leveraged carry trades, one would think that so long as the Fed is tightening the macro outlook reeks of uncertainty.  But this couldn’t be further from the truth -- instead of being afraid market participants are fighting the Fed; credit spreads have narrowed further in 2005, stocks have remained sturdy, and there has been a mad – as insane –
rush of capital into hedge funds

The counterintuitive reaction in the markets to Fed tightening is why curve bears are prophesizing that the unwinding of ‘the carry’ will not go smoothly. By ‘not go smoothly’ this is not to say that a flattening curve will not only spark earnings woes in financial stocks – a moderate decline in earnings does not necessarily mean the unwind is proceeding chaotically - but that some leveraged market participant(s) will collapse and/or trigger a chaotic unwind of theirs and other carry trades. The danger under such a scenario is that long-term U.S. interest rates will not simply rise, but spike uncontrollably higher.

Mr. Gross and others have been selling the ‘collapse’ outlook for some time, and the odds of such a scenario – according to curve bears – only continued to increase. 

“And for those institutional foreign bond holders, and the "hedgies" domiciled in the Caymans, there’s no doubt too that a higher and higher short rate reduces and in some cases eliminates "carry," leading to collapsed positions and ultimately higher yields further out on the curve.” Gross

Incidentally, whether or not some ‘leveraged participants’ (i.e. hedge funds) are near the brink is a matter of curve speculation. To be sure, Greenspan has long been against regulating hedge funds (and the OTC market for that matter), and – even as hedge funds expand to service a wider clientele – he has maintained his stance that hedge fund are secluded investment vehicles for institutional types only.  As such, thanks largely to Greenspan a thorough investigation of hedge funds is impossible at this time.

“Institutional investors have accounted for a growing share of hedge fund investments, and they can and should protect their own interests rather than rely on the limited regulatory protections…” 
Greenspan. Aug 2004

How Mr. Greenspan kept a straight face while belting out ‘their own interests’ is unknown. Regardless, in light of previous statements what is clear is that Alan offers as much intellectual contradiction when it comes to the hedge fund regulation issue as he is does with

“Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own.”
Greenspan. Oct 1998
Suffice to say, with liquidity aplenty ‘the seizing up of markets’ seems like distant nightmare not likely to come to pass anytime soon…and yet the Fed keeps tightening.

Good Times Bad Times

Those that have been successful in plotting the bond market’s path in the past – Bill Gross included – are currently confronted by logic defying developments that “are as rare as Ahi tuna that never hits the grill.”  With this in mind, and contrary to the conclusions of Contrary Investor, the reality isn’t that ‘markets will reflect economic reality’, but that the financial markets are prone to bouts of excessive optimism and pessimism that push the envelope of what is historical precedent.  

The value investor has profited in recent years from owning gold to hedge against a dollar decline, by purchasing equities when traditional valuation measures are attractive and business prospects are understood, and by holding cash. With the exception of cash – which has (depending on which cash) underperformed during the U.S. stock market bounce - the value investor is still well served by deploying the same type of strategy today. In fact, the only BIG question the value investor needs to ask is whether or not an end to the carry will send gold (which is a future inflation indicator) into a death spin.

What determines success for the value investor is whether or not they remain stubborn enough to remember that the immediate path of any financial market is largely unpredictable; that while history often rhymes a bet on an exact repeat is simply that. 

Clichés aside, the plight of the curve bears is a reminder that seemingly logical investment choices are not always the correct and profitable choice in the short term.  Accordingly, instead of trying to play the curve, the value orientated long-term investor should only acquire positions that stand to profit in both good and bad economic and financial market times.

Babe I’m Gonna Leave You

Obviously the above value investing notes are the required caveat before drawing out some final speculations on the of carry disintegration theme. To reiterate the sentiment of the caveat, unless the investor remains grounded they run the risk of turning their risky macro speculations into win/lose investment choices. 

With that warning out of the way, the CRB index hit a 24-year high this week, the U.S. housing market is showing signs of
slowing down, according to CSFB risk appetite is in the euphoria zone, and the Fed is promising to raise interest rates.  Making perfect sense out of all of these things is impossible, and is not really required.  Rather, what is required is the basic knowledge that current trends in interest rates, commodity prices, rigged inflation reports, and asset prices (the housing example will suffice) can not continue indefinitely -- unless you believe in miracles something or someone related to the curve is inevitably in for a rude awakening. 

Along with all of the fantastic financial market occurrences today, the trillion plus dollar hedge fund market is growing wildly, and - if history indeed rhymes - is likely to continue growing at a phenomenal rate until the next LTCM arrives. Quite frankly, it will take an increase in long-term U.S. interest rates or some type of type of financial crisis for investor intrigue in hedge funds to go down like a lead balloon. But make no mistake, when hedge fund excitement starts to wane the nightmare of market seizure could quickly come into view.

In summary, the U.S. Federal Reserve Board will continue raising interest rates until, as Puplava puts it, ‘something breaks in either the financial markets or the economy’. If, after this inevitable break, risk appetite craters like a Lead Zeppelin the nightmare that is market seizure will quickly arise, and those investors that attempted to defy logic will be exposed as the ‘complete idiots’ they are.  Only after all of this will the curve bears switch their focus and begin attacking the soft landing voices as being overly optimistic.

The U.S. economic and stock market recovery was the best that money could buy, but signals from New York to Tokyo are now flashing a warning: money is going to continue getting tighter.  With apologies to Led-Zeppelin, Dancing Days are not here to stay.


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