by Brian Pretti CFA, Contrary Investor. May 25, 2007
Liquidity Is A Coward
With the near vertical movement in the equity market since last summer, the mainstream media these days is filled with commentary and debate related to stock prices, valuations, potential price targets, etc. You get the picture. But I think it’s very important not to forget what's happening in the world of fixed income. As I've maintained for a good while now, it’s the credit cycle that's the important driver of economic and financial market outcomes, hence, the fixed income markets demand ongoing attention. Moreover, probably the three strongest, or most popular, rationales for investment in domestic equities right now is liquidity, private equity demand, and ongoing M&A. Of course at their headwaters, each of these rationales for equity investment find their origins in the credit or fixed income markets.
What are the important items to watch as potential markers of change as we fly over the fixed income landscape? Near term it’s inter and intra market yield and credit spreads. Also very important is to keep an eye on the credit rating agencies, who I believe will ultimately be forced to lower ratings for many a CDO vehicle over the next six to twelve months due to realized losses in the land of mortgage credits. When this ultimately occurs, the mark to market process will not be fun by any means and will more than likely cause an institutional investor or two to start asking pointed questions. But we're not quite there yet.
As is common knowledge, the use of leverage in fixed income investing today dwarfs anything we've ever seen before. The level of interest rate derivative contracts outstanding these days is simply testimony to this simple fact. So perhaps the important question becomes, when we ultimately hit an extreme in credit spread contraction and begin to see widening in yield and credit spreads again, how will the role of modern day leverage in the investment process play out? It certainly has the potential to exacerbate the hard part of the cycle, if you will, and the final level of yield and credit spread widening if heavily levered fixed income investors everywhere were to potentially rush for the exit door at once. But since we're not there yet, no one really has a handle on the fallout or speed involved in what will be this cyclical eventuality; an eventuality I believe institutional investors, at least in private, accept as inevitable, but hope they will sidestep prior to the masses rushing for the exit door. This will eventually be quite the important test for the highly levered financial markets of the moment. Just ask yourself, with the magnitude of leverage seen in the investment world of today (especially in fixed income), will spread widening and yield curve change be completely orderly, allowing all investors time to adjust seamlessly when it ultimately occurs? Don't count on it.
The reason I bring this up is that it’s becoming more a good bet that any major financial market problems ahead have a very good chance of emanating from the credit markets. The credit markets are the locus of real economy and financial market support, and have been for a good while now. You know that the term "liquidity" is thrown around today as an underlying bullish rationale for so many things. Equity prices, bond prices, as well as yield and credit spreads, commodity prices, etc., all beneficiaries of liquidity, right? But in days gone by, "liquidity" had a much different meaning. In the world of yesterday, liquidity was actual cash. As a very quick divergence and example of perhaps a truer picture of the relationship between real liquidity and financial asset values, have a look at the chart below. This is M2 (money supply) as a percentage of total equity market value as of year-end 2006. This doesn't exactly scream existing liquidity is plentiful, now does it?
How can this relationship above exist without many in the investment community being a good bit more concerned than not about lack of liquidity? Easy. Unfortunately, the implied, whether understood or not, definition of liquidity in the current cycle is access to additional credit, not availability of existing cash assets. Think about it. Private equity funds have access to massive liquidity (borrowed money to lever up acquisition targets). Hedge funds are the beneficiaries of institutional liquidity (levering at some multiple of invested capital). Fed repo activity is providing massive liquidity to the financial markets (lending to support levered investment speculation). We're sure you've heard all of these characterizations so often cavalierly thrown around the financial markets as of late. But, the key point to remember is that the "liquidity," per se, being referred to in these statements is borrowed money. Additional credit, not necessarily existing cash. What the term liquidity sure as heck means in my mind in the current environment is level of access to borrow-able funds, not actual cash. So when we hear the comment, "the financial markets are awash in liquidity," we can translate that to mean the markets are floating on a sea of borrowed money, or credit. No?
And this is exactly why I circle back and suggest that what happens in the credit markets will be quite important as we move ahead. This is why watching credit spreads will be quite the important tell for the financial markets as a whole; credit spreads that may be impacted by in place investment leverage of the moment unlike any circumstance we've ever seen in modern day financial market history. Anything that happens to disrupt the current level of "access to liquidity," or borrowed funds, changes the game and impacts both real economic and financial market outcomes. What's happening, or not happening anymore to be more correct, in the land of sub prime mortgage credit availability is a direct example. Ultimately a self-reinforcing cycle in terms of mortgage credit availability? We'll see. If the credit spread between Moody's Baa debt and Treasuries were to expand meaningfully, would the private equity world feel it? You bet. Likewise, conceptually stripped of significant access to borrowed funds, would the above chart worry a few more folks? Just remember, liquidity is ultimately a coward. There's always too much when it's least needed and it's nowhere to be found when needed the most. At least that's what financial market and economic history has taught us.
Although I guarantee this will mean little to nothing to your trading activities on a daily or monthly basis directly ahead, I thought it appropriate to take one big step back and have a long term look at what are some of the great long cycle dynamics of the bond bull market we have lived through over the past quarter century-plus. Why? If we can understand some of the very important infrastructural supports to the bond market, only then can we look for signs of change and perhaps an ultimate end to the bond bull market of a lifetime. I hope this is simply important in terms of garnering further perspective on the credit cycle of really a generation we have been dealing with, and a cycle that has underpinned the US economy and financial markets for some time now. The real economy and financial market sun and moon rise and set to the rhythm of the credit cycle. Without belaboring the point, the credit cycle is the key.
Let's start with an update of a chart I've used repeatedly in the past. Very simple stuff. We're looking at the year over year rate of change in nominal GDP (the black bars) set against the 10 year Treasury yield from 1960 to present. What is more than noticeable is that from roughly 1960 to 1980, nominal GDP growth was running ahead of the nominal ten year Treasury yield. In other words, the financial markets were constantly catching up to the reality of GDP growth -- nominal GDP growth at the time that was being stoked by ever increasing inflationary pressures. If we looked at the Fed Funds rate as opposed to the 10 year UST yield, we'd see the same thing in terms of pattern as is seen below. The Fed was in continual catch up mode throughout the period. Like long bond investors, the Fed was in a state of almost continually chasing the reality of GDP and inflationary growth. And in this financial foot race, if you will, inflationary pressures were both born and ultimately exacerbated.
With a change of thinking and a bit of dogged determination at the Fed under the Volcker regime, in the early 1980's we entered a period where the bond market, and the Fed, via the Funds rate also, had learned its lesson of the prior two decades. No longer would bond vigilante's chase inflationary pressures, but would rather choose to lead from the inflation containment watchtower by keeping the yield on long dated interest rates above that of the ongoing change in nominal GDP growth. This is exactly what we are looking at below.
Another way of looking at the relationship between the two data points above is what you see below. In the next chart I've simply plotted the difference between the year over year rate of change in nominal GDP growth and the corresponding period nominal ten-year Treasury yield. This method of presenting the same data paints a much clearer view of again what has been a big support to defining and driving the long term bull market in bonds we have so enjoyed for the past 25+ years. And what seems clear from this viewpoint is perhaps what will ultimately come to be seen as bookends on the bond bull market of a lifetime. Only time will tell whether the second bookend is the real thing. As is detailed in the chart, the bull market in long dated bonds began back in the late 1970's/early 1980's at exactly the time that ten year Treasury yields rose above the year over year rate of change in nominal GDP growth. And from that time until late 2002, except for occasional temporary bursts and retreats throughout this period, Treasury yields remained above GDP growth. But again, that changed in the fourth quarter of 2002, at which time once again the rate of change in GDP growth has remained above Treasury yields. Certainly with the recent weakness in 1Q 2007 GDP, we're retreated a bit toward the zero differential line, but we'll see what happens ahead.
Hopefully without sounding over the top, I believe the following is perhaps THE most important chart I can possible think of for both the real economy and totality of the financial markets of the moment. We're looking at the 30-year US Treasury bond price since 1980. Talk about a very long term and consistent trading channel, I can think of none other a finer example. And what is nothing short of striking is the consistency in price channel tops and bottoms all along the way. As you'd guess, the monumental line of importance is the rising price bottoms trend line so well defined. A line we happen to be much nearer to than not at present. When this trend line is ultimately broken to the downside, we suggest it will be of critical importance to all financial market investors. Absolutely critical.
To perhaps help us gain insight into the character of cycles and long term price topping trends, indicated in the chart are points in recent years where we've experienced important bottoms in gold, oil and the CRB. And what I'm asking myself is whether what we are now watching is a slow motion and incredibly important topping process in the 30 year Treasury. Very importantly, it just so happens that the half-decade plus old bottoms in oil, gold and the CRB happen to roughly coincide with the breakout of rate of change in GDP growth above nominal ten year Treasury yields shown in the previous chart. Exactly like the long-term price tops and ultimate breakdowns in oil, gold and commodities in general occurred near the 1980 period that was the birth of the current bond bull. Hence the suggestion of a characterization of the bookends of the long cycle bond bull. Bookends not only for bonds, but also for oil, gold and commodities in general. As always, tops and bottoms of major long-term cycle importance can always be well identified...in hindsight. Probably few knew in 1980 that we had begun the bond bull market of a career. So too are we now perhaps near a major high in long dated bond prices, with a commensurate major low in yields already in place?
The chart above forces us to at least begin seriously thinking about this very question. Until the early part of this decade, the thirty-year Treasury bond price had consistently hit the top of the trading channel with each major bond price rally. But the price top in 2003 fell well short of the top of the long term trading channel. This is clearly how long term trends start to reverse. They first begin to lose momentum. Moreover, and quite importantly, since that time, we have now put in a perfect series of lower price highs on the long bond, yet still we see rising price lows as this relationship works itself into a wedge formation (breakouts from which can be quite the long term directional tell). Again, potentially a technical marker of very meaningful trend change. Remember, this is a trend that is playing out over a series of years, not weeks, months or quarters. Because of that, trend breaks or reversals can be very meaningful. Finally, as is drawn in the chart, just look at the longer-term loss of price momentum in the long bond as per the message of both RSI and MACD indicators. Again, exactly the technical character of longer term tops of secular importance.
To my always eager to learn something new eyes, unless the thirty year Treasury can begin a quite substantial rally to take prices above 2005 highs, risks are great that the quarter century plus bull market in long dated bonds is coming to a very important conclusion. At least this is the topping process that seems to be very clearly visible in the long-term chart. If we look back at the 1970's, it’s clear in hindsight that the disruption to global oil prices set in motion a rise in US domestic inflationary pressures that is not so dissimilar to what we are experiencing today. But what is different today is that simultaneously the Fed is actively promoting monetary reflation at the exact time real world commodity driven inflationary pressures are rising and rising fast, right alongside the growth in emerging economies. In my mind, nothing short of a melt down in the US economy is going to drive long dated Treasury prices meaningfully higher. A melt down being an economic outcome the Fed would respond to immediately that would most likely stoke further credit market expansion, currency weakness, and potentially softer long dated Treasury bond prices. The proverbial rock and hard place for long-term bonds? We'll just have to see.
And circling right back to the matter of ultimate importance, this would indeed have absolutely huge implications for the credit cycle so key to the US economy and financial markets of the moment. Again, this is a very long-term view of life. It will not provide meaningful information fodder for trade positioning at tomorrow's market open. If it may be approaching a time to bail on bonds, then the ramifications of this potential multi-decade trend break will ripple across the US economy and financial markets in very meaningful fashion and will cut right to the core of the in place credit cycle of the moment. We'll be watching and suggest you do also.
© 2007 Brian Pretti