Writer’s Block, Low Interest Rates and Baby Boomers

With the Euro Crisis continuing to dominate financial markets I have struggled to find a topic to write about other than the crisis. However, there is one area of the market where something very peculiar is happening—interest rates.

It is no secret that since 2007/08 interest rates on everything from CDs to AAA rated government debt, and even mortgages, have been low and steadily declining. This is largely due to central banks trying to stimulate growth through cheap capital by setting short-term rates at or near 0% and lowering long-term rates through quantitative easing.

However, over the last several months, nominal interest rates (or the interest rate before accounting for inflation) on bonds issued by Germany, Finland, Denmark, Switzerland, the Netherlands and Austria have all gone negative. Negative nominal rates mean that investors are literally paying the issuing country to hold their money:

“Germany sold two-year bonds at a negative yield for the first time on record on Wednesday, as the borrowing costs of Europe’s more creditworthy nations were driven even lower by investors seeking safety.” Source: Financial Times

Figure 1: Negative nominal rates on the 2-Year Swiss Bond; source: Bloomberg  

Negative yields are nothing new. Whenever the rate of inflation is greater than the interest rate on a bond or CD, the “real” rate of return on that bond is negative. For example, if you own a bond that pays an annual coupon of 2.5% and the annual rate of inflation is 3.0%, then the real rate is -0.5%—every year the value of the payment received is less than the amount that inflation has eroded. However, what is new is that for the first time ever nominal rates across multiple countries and maturities are negative.

So why would any rational investor pay a country to lock in a guaranteed loss? It doesn’t make sense, unless…

1. Investors are more concerned about the return (preservation) of their capital than the return on their capital and are therefore willing to accept extremely low rates to “guarantee” that their cash is for the most part protected.
2. Investors are using safe-haven bonds as a hedge and are counting on bond appreciation as rates go down to offset losses in other areas of their portfolio.
3. Investors expect deflation in the future, where the future value of cash is greater (i.e. buys more goods and services) than its current value. 

All of the above are possibilities:

• Greek and Spanish investors are in a situation where they are uncertain of which currency their cash will be valued in the future should their country exit the EZ. For example, if Greece goes back to the drachma, then Greeks should be willing to pay to ensure that their cash stays in Euros rather than being converted into a significantly devalued “new” Drachma.
• Other investors may be using the negative correlation to equities historically associated with bonds from AAA-rated “safe-haven” counties as a way to hedge risky assets in their portfolio. As rates decline in times of market stress, the price of their bond holdings increase (as bond yields go down, bond prices go up). By not holding the bond until it reaches maturity these investor can trade in and out of their position and lock in profits as their bond holdings appreciate.
• Finally, others may be worried that the world is entering a prolonged period of stagnant global growth similar to what Japan has experienced over the last several decades, and therefore are betting on deflation and prolonged low rates. 

Record setting low nominal yields are likely the result of a combination of the above depending on who the investor is and where he/she is domiciled. As long there is uncertainty over the EUR and global growth the trend should remain in place (particularly if Japanese-style deflation turns out to be the correct thesis). However, in theory, at some point investors, particularly income-sensitive investors such-as pension funds, retirees and banks/insurance companies, that rely on income from their investments to survive, will shift out of low yielding safe haven bonds into higher yielding securities like dividend paying stocks, such-as utilities and telecoms, and high-yield bonds.

This is particularly true given that over the next decade or so Baby Boomers will be retiring at an accelerating pace. In what may be one of the Boomers’ last rebellions against the status quo, they may stray from tradition, which would have them switching from equities to bonds as they enter retirement, and instead do the opposite in search of return and yield that offers the regular payments required to live without a steady paycheck. 

Figure 2: Investors are shifting out of equity funds into bond funds. We will be watching for this trend to reverse and for interest rates to rise as a signal that investors are reversing their conservative stance. Source: Morningstar 

Bottom Line: While very low to negative nominal rates work for a short period of time as a strategy for parking money, it is not an effective long-term strategy for many investors unless there is outright deflation. Furthermore, if/when rates increase, investors will be in for a rude awakening as their bond holdings decrease in value (interest rates up --> bond prices down). As a result, we are watching fund flows (see figure 2 above) as well as interest rates for signs that investors are tiring of playing it safe and are willing to accept more risk in order to meet their income and return objectives.

As we stated in our last commentary: “Everyone knows that Greece is in trouble. What is unknown is how individuals and banks in more economically significant countries will react to Greece’s eventual exit.” Now we can add everyone knows that Spain is in trouble, and it appears that we are getting a better idea of how investors are preparing for a possible Greek or Spanish exit—they are parking cash in traditional safe havens despite the costs.

Until there is more clarity on how Europe is going to resolve the Euro crisis, we continue to maintain our conservative stance, which underperformed in the first quarter of the year as markets ignored Europe’s troubles, but is now outperforming as market uncertainty rises once again. This means we are:

• Avoiding European markets 
• Fully invested in safe-haven fixed income assets like US treasuries, as well bonds that will benefit from further quantitative easing like mortgage REITs 
• Underweight equities by investing in ‘safer’ large, dividend paying US equities, while shorting more risky emerging market equities, which will be negatively impacted by slowing global growth 
• Underweight commodities that will be negatively impacted by slowing global growth (energy and materials) 
• Short EUR versus long USD, and at the same time long Gold as a hedge against rapid appreciation of the EUR in the event that the US Fed eases further or the EUR crisis is quickly resolved 
• Adjusting risk exposure as needed by going long or short volatility products like VXX--long volatility protects against sharp moves downward while short volatility increases exposure

To learn more about bonds read “Everything You Need to Know About Bonds” by PIMCO.

“Angela, we’re going to need a bigger hose…”

“Policy makers don’t understand that they are not in control. It’s not that speculators are in control, either, but rather that fundamentals actually matter.” – interview with Colm O’Shea, “Hedge Fund Market Wizards”, Jack D. Schwager, 2012

With recent elections across Europe going to anti-austerity/anti-bailout parties and Greek bank runs, individuals—who largely have been silent throughout the crisis (aside from the occasional protest or riot in Greece)—are reacting to the deteriorating fundamentals of the Euro Zone and are forcing change one vote and one (large) ATM withdrawal at a time.

The entrance of individuals as active players in the European crisis is a sign that the crisis has entered a new and critical stage. To date central bankers and politicians have been able to prevent flare ups from turning into full blown wildfire through policies and rhetoric that bought time, but did nothing to address the true structural issues associated with the Euro. However, over the last several weeks, European citizens’ actions at polling stations and ATMs have reignited the crisis and reversed nearly all of the stabilization policies put in place over the last 6-12 months.

As a result, the Euro is trading near its 2010 low (see Figure 1) and the odds that a country (Greece) will leave the Euro before the end of 2013 have increased significantly (see Figure 1): 

Figure 1 – The Euro is down over 7% from its recent local maximum at the end of February. Source: http://www.barchart.com 

Figure 2 – According to intrade.com there is a 57.6% chance that a country currently using the Euro will announce intention to drop it before midnight ET 31 Dec 2013. Source: http://www.intrade.com/ 

But, a Greek exit from the Euro in and of itself does not need to be a catastrophe for the entire Euro Zone and signal an end to the Euro. In theory investors have had more than enough time to prepare for Greece’s exit — most private investors (including European banks) have already realized significant losses on their Greek debt holdings due to the private sector debt swap earlier in the year.  This means that the direct financial impact of a Greek exit on European banks should be relatively contained because they have already taken the hit.

Policy makers now need to shift their focus to policies that actually address the true structural flaws in the EZ — i.e. that a one size fits all monetary policy for the whole EZ does not work without greater fiscal unity and economic burden sharing across strong and weak countries — and that mitigates the growing threat of contagion and bank runs, which have already started in Greece and to a lesser extent in Spain:

According to the Financial Times, “Shares in Bankia, the Spanish bank which was part-nationalised last week, plunged by over a quarter on Thursday morning, after a report that customers had withdrawn €1bn from the bank over the past week.”

Specifically, the threat of bank runs could be significantly reduced by providing some sort of assurance that bank deposits are not only insured against bank failure but also guaranteed against adverse currency conversion should the banks' home country abandon the Euro for a weaker currency.

On the surface individuals moving their money to ‘safer places’ like Britain, Switzerland, and Germany does not seem as bad as an entire country defaulting; however, bank runs can be incredibly insidious 

Figure 3 – 'Gross' anatomy of a EZ bank run. 

because once they start they are difficult to stop. This problem is further magnified in Europe where most banks hold a significant portion of their assets in their home country’s debt. When the bank is forced to sell assets in order to raise cash to meet withdrawals, they have to sell their country's bonds, which further destabilizes the country’s credit and in turn the bank’s (see Figure 3).

Without currency conversion protection, bank runs will become the most significant challenge that the EZ has faced since the crisis began.

Bottom Line: Everyone knows that Greece is in trouble. What is unknown is how individuals and banks in more economically significant countries will react to Greece’s eventual exit and to devaluation threats from currency conversion.  To date European policy makers have been putting out flare-ups with buckets and a garden hose on a country by country basis, but have done little address the threat of a widespread wildfire.

Consequently, despite the temptation to buy into the rally in the first half of the year, we largely maintained our conservative stance. This conservative, slightly bearish stance means that our portfolios underperformed as the markets moved higher earlier in the year; however is now providing the protection that we desire as the crisis once again is front and center in investors’ minds and as contagion risks rise. This means we are:

• Avoiding everything European (equities, bonds, EUR, bank accounts, insurance, etc.) 
• Fully invested in safe-haven Fixed Income assets like US treasuries and other relatively safe bonds 
• Underweight Equities by investing in ‘safer’ large, dividend paying US equities, while shorting more risky emerging market equities, which will be negatively impacted by slowing global growth 
• Underweight Commodities that will be negatively impacted by slowing global growth (energy and materials) and that are inversely correlated to the strengthening US Dollar (gold) 
• Short EUR versus long USD 

Policy makers' actions and elections results (Greece is holding more in June) over the next several weeks will guide our positioning.  If we see signs that policy makers are addressing bank run concerns, or a renewed coordinated program by central banks around the world then we will selectively increase exposure. Until then, despite possible market moves higher, uncertainty remains too high for us to move significantly away from our conservative positioning.

Pessimism Exhaustion

I am going to keep this month’s note short given that I am sure you are exhausted of hearing me go on about the European Crisis which has produced more back and forth moaning and groaning than a Williams/Sharapova match. 

Unfortunately despite recent headlines claiming the 2nd Greek bailout is done, the tragedy is not over. Digging a little deeper into the new requirements imposed on Greece:

“European creditor countries are demanding 38 specific changes in Greek tax, spending and wage policies by the end of this month and have laid out extra reforms that amount to micromanaging the country’s government for two years” – "Athens told to change spending and taxes”, Financial Times

It is difficult to envision how a country that couldn’t meet its original significantly less painful targets (over a span of two years!), will successfully meet these draconian, completely eviscerating, new demands in a few short weeks. However, according to Angela Merkel, these demands (and high private sector participation in the Greek bond swap which as we pointed out last month is far from certain) must be met in order to receive the new aid.

And yet, despite these long odds, markets have rallied like its 1999, ignoring the difficult road ahead for Greece and Europe. This leaves me, along with many other managers that have not fully bought into the recent rally, in the unenviable position of having to decide to: (1) chase the market higher, ignoring inherent risks and warning signals coming out of Europe, or (2) wait for the market to come back in as it is repriced to the real risks associated with the Greek bailout.

While not an easy decision given the swiftness of the rally, we are not chasing this market higher for several reasons:

1. We do not feel the Greek solution is a done deal. 
2. Crude and gas prices are surging due to worries in Iran; if sustained these higher prices could negatively affect global growth. 
3. Finally, the rally has been on extremely light volume—a sign that big investors do not have conviction in the current move (see chart below)

As evidence for point 3:

“Last January (2011) the average number of stocks traded on the NYSE per day was 891mm shares vs 661mm for this January (a 26% drop YoY!) and this is down an incredible 59% from January 2008.” 

Source: ZeroHedge.com, Chart: Bloomberg  

With that said, there are reasons to be bullish including the unprecedented amount of liquidity from central banks and relatively strong US economic data.  As a result we have added some lower risk US equities positions over the last month or so in attempt to capture some of the rally; however, until Greece either (1) makes their March 20 payment or (2) defaults, we will maintain a neutral to slightly negative stance across all portfolios based on our hypothesis that the Greek solution will be more messy than the market is currently pricing in (i.e. CDS triggered, policy errors, and renewed loss in confidence in the EZ). We feel this positioning will protect our portfolios regardless of the outcome in Greece.

Bottom Line: Like a 4am drunk, happy and full of confidence one minute, angry and sloppy the next, global markets are not on firm footing. Should there be successful resolution in Europe, we will shift away from our defensive stance by increasing equities exposure in developed and developing markets. Until then we remain defensive, which means we have:

• nearly full allocations to fixed income skewed towards bonds that should perform better in a down market (treasuries and muni bonds) versus bonds that should rally along with risk (corporate, high yield and emerging market bonds) 
• hedged positions in equities (lower beta (lower risk) US equities versus higher beta emerging market equities and volatility) 
• partial allocations to commodities skewed slightly long 
• short EUR/USD

If You Can't Find The Fish At The Table

There is a saying in poker “if you can't find the fish at the table, then you're it.” And right now, when it comes to the Euro Crisis, no one thinks they are the fish. 

The amount of brinksmanship taking place in global financial markets has reached a fevered pitch more akin to the Word Series of Poker than the implementation of global economic policy. Depending on whom you listen to (or want to believe): 

1. the Euro crisis has been contained and financial markets are on the verge of a renewed bull market because of improving economic data and the amount of cash sitting on the sidelines, or 
2. Europe is staring into the abyss and heading for the next great depression because of the increasingly complicated financial trickery in Europe and the impending hard default of Greece

The reality, of course, is that both cannot be correct and odds are expectations will continue to oscillate wildly between the two outcomes over the next several months and quarters as the stresses in Europe eventually work themselves out. 

The most obvious place where this game is being played is in Greece where negotiations between the Greek government, the Troika (European Central Bank, European Union and International Monetary Fund), and European banks have been ongoing for months. Simply:

• Greece needs money for interest payments due in March so they have agreed to draconian austerity measures
• The Troika needs the EU to remain stable, so they have agreed to give Greece money even though Greece is a bottomless pit
• Banks do not want the EU crisis to deteriorate further, so they have agreed (in principal) to forgive a significant portion of Greece’s debt 

On the surface, this is THE main event—the stakes are high and all sides appear to be playing to win. 

However, in the last several months, a fourth player has shown up that no one has paid attention to who has the ability to significantly affect the outcome of the game. This player, small yet cutthroat, may be the real shark at the table. 

It appears that a handful of hedge funds have been buying Greek sovereign debt at distressed prices in amounts sufficient to influence the outcome of the restructuring negotiations. While their exact motive is unclear, it is likely they are attempting to engineer one of the following outcomes: 

1. These funds may simply want to force the hand of the Troika by blocking a Greek restructuring until new, more favorable terms are put in place for a quick profit (while the math is significantly more tricky, at the most basic level these funds probably paid around 20 to 30 cents for Greek bonds while they push for a restructured "new" price closer to 50 cents). 
2. The other, more insidious (albeit less likely), motive may be to exert enough pressure that Greece is forced into technical default. By buying CDS (insurance on bonds) that pay out when a country defaults, these funds may be gearing for a much larger win that pays off when Greece defaults (and contagion spreads to other periphery countries). 

Bottom line:  At the risk of remaining overly pessimistic for too long on Europe’s ability to contain the crisis we continue to maintain our negative positioning on the market.  We are prepared to adjust this stance once the details of Greece’s imminent restructuring are clear.

However, in our opinion, as it currently stands, the entrance of hedge funds into the Greek debt negotiations process significantly increases the likelihood that Greece and the Troika will make a policy mistake that will trigger a technical default and more importantly reduce investor appetite for other, more systemically important, European country bonds. 

Case in point, this morning there are rumors that “Greece Nears Deal With Creditors on Haircuts” that would pay only 32 cents on the euro for Greek bonds.  Forcing such a steep loss on all private investors, while good for Greece, may trigger credit default swap payments and at the same time inadvertently scare investors away from other high risk European countries like Portugal, Spain and Italy given the severity of the forced loss.