Wednesday, June 12, 2013

It's The Economy Stupid: OMG...2.25% 10yr notes are going to choke growth

From the fertile mind of David Zervos...

-----Original Message-----
Sent: Wednesday, June 12, 2013 9:03 AM
To: John Broussard
Subject: OMG...2.25% 10yr notes are going to choke growth

A number of folks are opining on how higher long term interest rates will choke off the US recovery. The thinking goes along standard partial equilibrium lines as follows - higher mortgage rates crush the housing recovery, higher government bond yields create bigger deficits, higher corporate funding rates stop business investment and expansion, and higher municipal funding rates put further pressure on already strapped state and local governments. This dreaded 2.25 percent 10yr destroys all the best laid plans of our central bankers.......PULLLEASE!

If I said to anyone pre-2008 that a 2.25 or even a 3 percent 10yr yield would be associated with "choking off" an economic recovery, I would have been laughed out of the room. The reality is that long term yields have overshot to the downside as too many folks believed Fed policy would NOT work to generate a recovery. More specifically market expectations for low growth, deflation and a failure of QE policies conspired with general post-crisis risk aversion in the equity space to send folks flocking to fixed income. And rather than accept 0 nominal rates in the front end, folks reached for yield by taking too much duration, credit, structure and most importantly liquidity risk.

This was a very foolish trade. And I suppose this reach for yield likely crested right about the time investors gobbled up Rwandan 10yrs with a 6 handle coupon. Right now, the post crisis move to fixed income is failing. Portfolio rebalancing must take place in the wake of this mistaken allocation - and the process will create excessive volatility as losses build. From emerging markets to high yield to Agency mortgage structured product to levered 10yr notes, the fixed income markets have extended too much. And managers who face redemptions will quickly realize that they have sold liquidity risk too cheap. The bid/offer for 10m Rwandas is a mile wide, and it ain't narrowing anytime soon. There is a shortage of liquidity for enhanced yield product with emerging markets at the center of that shortage. Its going to be a messy time for those who decided to take large outright duration and/or spread duration enhancements - especially those in EM.

But importantly, this fixed income positioning problem will NOT get in the way of one simple fact - the FOMC will continue with uber-easy policies until a reflationary recovery takes FIRM hold in the US. A few blow-ups in EM did not disturb a US bull market back in the 90s, and a few more in coming years won't disturb one now. Those who sell their equity positions because of dislocations in global fixed income markets will be full of regret.

The likely path ahead is that the FOMC will stay too easy for too long - just like they have in the past. This will further work to undermine the value of durated assets as higher inflation risk premiums work their way into long term fixed income markets. But for those who fund short - like most SMEs and banks - this move to a higher, steeper yield curve will be just fine. NIMs will widen and corporate confidence will rise. In fact, we should all be welcoming a higher 10yr yield as a sign of successful FOMC policies. They are reflating hard assets and deflating the value of long term debt. They are repairing the tattered balance sheets from the crisis. QE is working.

As Warren Buffet said a few months back - "I feel sorry for those folks invested in US Treasuries". I do too. We have remained steadfast in the view that long term bonds (even ones with spread enhancement) will generate significant negative real returns over the long run. It appears that more folks are coming to that realization. And the ability of managers to get out of illiquid yield enhanced duration positions is limited. Strap in for a wild ride in fixed income, but don't lose faith in the reflationary recovery. A lot of folks need to move out of global fixed income and into developed market risk assets over the coming quarters/years. Those who are already there will be welcoming the newcomers with open arms - and loads of capital gains in their back pockets. Good luck trading.

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