Market Comment May 29th, 2013

K E S S L E R K E S S L E R I N V E S T M E N T A D V I S O R S , I N C . & C O M P A N Y I N V E S T M E N T S , I N C .

What has happened to long-term U.S. Treasury yields and why they wont stay up here for long
What happened
US Treasury yields have risen sharply in the last four weeks with 10yr yields higher by about 50 basis points (fig.1). We are the first to admit that we didnt see this coming, but other than the secular and political interest rate bears, no one else did either. more than expected yet Building permits were less than expected. For the whole picture, it helps to consider indicators that combine individual data for the month into a single number. All of these show a slowing, not improving economy. The Chicago Fed National Activity Index showed a decrease in aggregate activity, the coincident indicators index (correlates well with real GDP growth) grew at just an annualized rate of 1.2%, and our Kessler Interest Rate Economic Indicator modeled after the Chicago Fed National Activity index is showing a decrease as well. Then of course, there is Ben Bernanke who made the slightest hint to the possibility that a tapering of purchases could begin in the next few meetings if the economics warranted. It wasnt so much what he said on its face, but just that the markets hadnt imagined this possibility was even entertained by him until that moment. But trying to position a trade based on the impact of the Fed quickly becomes a reflexive exercise going no place because the Treasury market finds a way to reflect macroeconomics despite them. The history of the Fed shows that economics always trumps their effects. This isnt to say that at any given moment, the Fed may have interest rates at a different level than they otherwise would be, but it isnt useful to use this as a reason to buy or sell because a change in their buying could just as easily mean that the economy will be weaker and thus rates would fall as that they would cause rates to rise. Regardless, yields have risen dramatically and we are not trying to dismiss it. The price is the price, however; it is important for us to express our thoughts for where we think yields are

fig.1 UST Yields so far in 2013

10yr UST Yields
2.2% 2.1% 2.0% 1.9% 1.8% 1.7% 1.6%

01/01/2013 05/29/2013

+0.54%

Jan

Feb

Mar

Apr

May

Data Source: Bloomberg

Direct causation is hard to find. While the economic data has improved in places, the prices have moved much more than the facts1! For just about every good piece of data, there was an equal piece of bad news. For instance, where the jobs report showed an unemployment rate improving to 7.5% from 7.6%, the broader underemployment rate (U6) that includes those that would like to work but havent looked for a job in the last 4 weeks, worsened to 13.9% from 13.8%. Durable goods orders came in better than expected, yet Industrial production came in worse than expected. New home sales were
1 This

phrase is borrowed from David Ader and Ian Lyngen at CRT Capital

Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013

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ultimately going, especially when there is virtually no one out there to make this case. We also realize that the market never trades based on what the economy looks like now, but rather where it thinks it will be. And so, what this recent yield back-up boils down to is that the market is expecting that there is self-sustaining, above trend, GDP growth coming. It isnt often that prices become this divorced from fundamentals. Expecting selfsustaining above trend growth is hoping, not the result of a careful analysis. We continue to think that no matter how forceful this back-up has been, or where it ultimately peaks, we will see new low yields in the Treasury market before this cycle is over. Here is why.

leading indicator. The market hopes that higher consumer confidence will translate into higher consumer spending but that is far from guaranteed (fig.3).

fig.3 Consumer confidence is not a good predictor of the future

Conference Board Consumer Confidence
01/1999 05/2013

160 140 120 100 80 60 40 20 0

Confidence peaks when stocks do, not a good predictor of future consumer behavior.

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

In the short-run: 1. The macro ingredients arent nearly there for the Fed to tighten policy and create a major sell-off in bonds like 1994 or 1999. It is useful to look at the state of the economy before major previous Fed tightening episodes (fig.2).

Data Source: Conference Board

3. Inflation continues to fall. The core PCE deflator is running at 1.1% (yoy%) and is expected to drop to 1.0% this Friday, 05/31/2013 (fig.4).

fig.2 Economics now compared to prior tightening environments

Economics that led the Fed to tighten

fig.4 Inflation is lower now than its postcrisis trough

PCE Core Inflation (yoy%)
01/2005 04/2013
2.6% 2.4% 2.2% 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

1994 set-up 1999 set-up

Data Date: 12/31/1993 12/31/1998

Now
4/30/2013

Output Gap/Surplus Non-farm payrolls (prior 12 month avg) Unemployment Rate Real Retail Sales YoY Core Inflation (PCE)

-1.7% 321k 6.5% 5.6% 2.1%

2.5% 251k 4.4% 5.2% 1.5%

-5.6% 173k* 7.5% 2.6% 1.1%

*note: population has grown by 20% since 1994, and 14% since 1999

Quite a bit different now than then.

Data Source: Bloomberg

Post crisis low: 1.2%

2. Higher consumer confidence was cited as a major reason for the large bond sell-off this Tuesday (05/28/2013). This indicator is not a

Data Source: Bureau of Economic Analysis

Core inflation: 1.1%

Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013

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2014

Why we think they wont stay up here for long

4. Commodities are not confirming the risk-on sentiment, and for one important case, is suggesting the opposite (fig.5).

5. Positive sentiment exploded with the housing news released in May, but it is important to look at these charts nominally. Because they have fallen so much, high growth rates represent small nominal gains (fig.6).

fig.5 Commodities have been decreasing which is not consistent with a risk-on bull market
CRB commodity index
500 450 400

fig.6 Large percentages in housing numbers are misleading

U.S. New Home Sales (annual rate, thousands)
01/1960 04/2013
1,600k

01/2005 05/29/2013

1,200k

350 300 250 200 150 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Data Sources: Thompson/Reuters, Jefferies

This indicator has improved by 68.2%! from the trough, but the percentage is nearly meaningless when the value has fallen so much.

-11.4%

800k

400k

New Home Sales are toiling at levels from the 1960s

0k 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Data Source: U.S. Census Bureau

...and a main ingredient for homes has been falling dramatically

6/1/2012 05/29/2013
$420

Lumber Futures Contract (price per 1k board feet)

$380

$340

6. Europe is in recession. So far, the U.S. has been able to ignore it because it hasnt shown up in a measurable way. But, it would be a stretch to expect that this won't have some drag on U.S. growth when Europe represents nearly a quarter of global GDP (23%). The new Treasury Secretary, Jacob Lew, has been harping on this and just yesterday, the OECD cut their 2013 global growth forecast (fig.7).

$300

$260

31.6%

$220 6/1/2012

9/1/2012

12/1/2012

3/1/2013

6/1/2013

Note: Lumber futures are not a heavily traded contract and the reasons for this price drop may eventually relate to reasons endemic to the industry in addition to macroeconomic reasoning.
Data Source: Chicago Mercantile Exchange

Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013

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fig.7 23% of the worlds economy is contracting

European Real GDP (yoy%)
6% 4%

01/1996 03/2013

EXPANSION
2% 0% 1996 -2% -4% -6%
Data Source: Eurostat

Great Depression and Japans lost decades are that deleveraging will become structural (i.e. Pimcos New Normal theory), last a very long time (10yrs or more), and likely overshoot to an underleveraged position. For the U.S. consumer to reduce their debt to 90% of disposable income (a reasonable level chosen for an example), they will pay down a further $1.8 trillion of debt. If this were spread over the next five years, it is a drag on GDP averaging about 2% per year (fig.9).
2012 2014

1998

2000

2002

2004

2006

2008

2010

Europe represents an even bigger percent of world GDP than the US, 23.1%. This will eventually exert a drag on the U.S.

CONTRACTION

fig.9 The US consumer still has a high amount of debt

Ratio of Household Debt to Personal Disposable Income
140%

01/1960 03/2013

7. China is slowing down and remains a real downside risk (fig.8).

130% 120% 110%

fig.8 China is slowing and the risk of a sharp slowdown is ever present
Chinese Manufacturing Purchasing Managers Index (PMI)
60

100% 90% 80% 70% 60% 50% 1960 1970 1980 1990 2000 2010 2020

01/2005 05/2013

55

Data Sources: Bureau of Economic Analysis, Federal Reserve

50

EXPANSION CONTRACTION The latest data point (an estimate published by HSBC) showing contraction was cited as a reason for the Nikkeis sudden 7% drop on May 23, 2013
2005 2007 2009 2011 2013

45

40

As an aside, this is a helpful explanation for why the Fed has been so aggressive, but they cannot control consumer behavior or demographics, they can only try to offset them. 2. Weve written about the Output Gap many times before but it is still relevant and wide. By the Congressional Budget Offices estimate of the economys potential, the economy is operating more than 5% below its potential. This is important for estimating when demand will equal supply to create inflationary pressures in the economy as well as for when it would make sense for the Fed to tighten policy (fig.10).

35
Data Sources: China Federation of Logistics and Purchasing, HSBC

In the long-run: 1. There is no indication that the consumer is finished deleveraging. While there is no way to know when this turns around, unless this time is different, the experiences from the

Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013

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fig.10 The output gap is not closing with ongoing 2%-type GDP growth
U.S. Real GDP (2005 dollars) actual and potential
gro wt h

fig.11 The often used mirror chart to suggest an end to the bull market in Treasuries
10yr UST Yields
18% 16% 14% 12% 10% 8%

01/2007 01/2022
$17tn $16tn $15tn $14tn $13tn $12tn
TH OE ER

Actual Real GDP $2005 dollars (BEA)

O DT LA IN F

NP TIO

RE

T AL T IC

ES HR

L HO

E UR SS h wt gro % 3 th wi w th

wit h

Potential Real GDP $2005 Dollars (CBO)

01/1950 05/2013

4%

w i th

ro %g

The implication is that yields will begin climbing in a mirror-like fashion from this point.

2.1
2007 2008 2009 2010

th row %g

r... o fa

6% 4% 2%

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

0%

Data Source: Bureau of Economic Analysis, Congressional Budget Office

Data Source: Bloomberg

3. Many commentators point out the mirror-like symmetry of US Treasury yields round trip from 2% to 16% to 2% with roughly 32 years on each side. The implication is that going forward should look like putting up a mirror to the last 32 years. What is rarely brought out is that US Treasury yields did not make their trough of 1.55% until 16 years after the 1929 stock market peak and if the recent 0.44% 10yr JGB yield proves to be a cycle low, this is 23 years past the Nikkeis stock market peak. But also, the high rates of the 70s and 80s were a one time anomaly in the entire history of interest rates (fig.11 and fig.12). Consider this quote from Sidney Homer and Richard Syllas highly regarded A History of Interest Rates,

..yet extending the chart back to 1920 shows it was anything but mirror-like prior to 1950.
10yr UST Yields
18% 16% 14% 12% 10% 8% 6% 4% 2% 0%

01/1920 05/2013

Anomaly not found anywhere else in interest rate history.

10yr UST yields stayed below 3% for 18 years.

...recent peak yields were far above the highest prime long-term rates reported in the United States since 1800, in England since 1700, or in Holland since 1600. In other words, since modern capital markets came into existence, there have never been such high long-term rates as we had all over the world a quarter century ago.

Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013

1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Data Source: Bloomberg

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fig.12 Past experiences of interest rates after major credit crises show that they take decades to work out. We think that the Bernanke Fed has accelerated this process but not by as much as is commonly thought. 10yr Government bond rates calibrated to the beginnings of deleveraging cycles
JAPANESE LOST DECADES 10yr JGB starting 12/1989 THE GREAT DEPRESSION 10yr UST starting 08/1929 NOW 10yr UST starting 10/2007
n

9% 8% 7% 6% 5% 4% 3% 2% 1%

I s o t c om me m thi on n g ly lik exp e t ec his te w i d th ll h at ap pe

Now

0% 00yrs

05yrs

10yrs

15yrs

.. like.whe th i n so si m s m et ore hing like ly

20yrs

25yrs

Data Source: Bloomberg

We cannot know if this yield backup has run its course but from our perspective, it isnt a question of if, but when yields resume their downward trend. As always, we look forward to the time when economics deem a shift from being fundamentally long to fundamentally short interest rates, but we do not see this yet.

Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013

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