Last of the Bond bulls

[GeorgeF]

Van Hoisington is the last important unapologetic bond bull(I know of). His reasoning for going long zero coupon tresuries are given on his web site. He also includes notes from a lecture he gave at the Grant's investor conference.

http://www.hoisingtonmgt.com/hoisington_economic_overview.htm

Grant's:
http://www.grantspub.com

[adios]

Wow! Thanks George. Excellent info and analysis IMO. Definitely food for thought. FWIW Capital Asset Pricing Model shows that there should not be a significant risk premium for stocks vs. long term treasuries i.e. for 20 year holding periods.

Here's something from the presentation that seems very logical to me regarding the risk premium for stocks vs. bonds:

These disparate returns for the different time periods demonstrate that stock and bond performances are significantly affected by three important considerations: the inflation rate; the dividend yield on stocks versus the yield on government bonds; and the P/E ratio on stocks.

Stock performance relative to bonds is enhanced
when inflation is high and reduced when inflation is low.
This is not surprising, since bonds lose value when infla-tion rises. Also, when inflation is accelerating rapidly, some firms will have such exceptional pricing power that they are able to use this environment to enhance profit margins.

Of course if a lower risk premium does exist for stocks than what is generally assumed (the article discusses what is generally assumed), stocks are MUCH more risky than what most people think.

I also found the portion of the presentation to the Grant's conference regarding the "The Productivity Illusion" to be very intersting as well. Have to think and study more about the case for deflation made in the presentation to comment on it as intellegently as possible. Haven't had time to give the Grants site info a close look but I do know that Grant is considered to be an interest rate guru.

Again thanks George.

[Wildbill]

I think the rather low VIX number should make it clear that risk for stocks isn't being taken seriously right now. Still I think it would be crazy to get excited about bonds at this point. When you start out with low rates and have to get to even lower rates to make a decent return, that just doesn't make much sense to me. Further I think people are underestimating inflation, namely in that the change in value of the dollar can't just be sopped up cleanly. At some point there will be some inflation pass through and if it hits at the time the economy is recovering it just portends more problems. I just don't get it with the Fed though, what kind of insurance do you need? I think they misjudge the psyche of the busines world. If interest rates are 1% now and 2.5% in say 6 months, just how much lending would that crimp??? My guess is next to none, maybe a little big in car sales and home sales, but not that much because long-term rates would be held down due to the clear message of the Fed fighting inflation. The problem is if it is 1% now and 1.25% in 6 months, but then 6.5% in two years because they didn't start taking away the punch bowl on time then we do have some problems. Inflation hurts too much to take it lightly and I think you could say that risk aversion is lacking in all sorts of ways in the thinking of investors and the Fed.

[Zeno]

I enjoyed your post. I do not know that much about long-term fed policy but one thing in your post struck me. I was thinking that the fed should start ratcheting up interests rates now or even a few months ago. A longer braking period would be a better policy to smooth potential economic "wave functions" further down the road. The more "knee jerk" reaction to money policy can have effects that exacerbate the inertia that gets pent up in economic systems, thus making for more exaggerated ups and downs. Am I just talking hooey, or is this something that everyone knows already, so the money boys that hold the purse strings are already considering it? You seem to imply that it is otherwise.

-Zeno

[adios]

The theory I read a lot is that the Fed would not mind some inflationary pressures since they know how to combat that. Furthermore the Fed absolutely doesn't want to deal with deflation since they can't and/or don't know how to fight that. That's the scuttlebut I've read a lot over the past several months FWIW.

I find it incredible that people are discussing all the pain inflicted recently. The friggen market's been up a lot so this year so I would think most are doing well year over year.

[Wildbill]

Fed doesn't really have a long-term policy I think, they are definitely more in the reactionary camp. Something has to give right now, either the government has to tone their spending way down, tax revenues have to go up, or the Fed has to raise rates. I think number 1 and 2 have less than zero chance to go through before late 2005 so you get the Fed on the clock as usual. What worries me about the Fed and everyone out there is they all act like exchange rates that are moving on nothing but the deficit right now and are completely out of anyone's control is something that is good. A modest reduction is good, but one that has no control and could bubble into something that drives up inflation quickly is not something good. Indirectly the Fed controls the rate because right now a lot of money that is leaving the country is just out to get yield, namely yield in Euro denominated assets. The ECB short term rate is 2%, the US is 1% and the Euro seems to be a one-way bet right now, is that not the easiest move you can make in the markets right now?

Problem we see is that everyone is sitting on the sideline and waiting for the other guy to do something. The election year is making it terribly dangerous as well, this expectation that the Fed will sit out of action for maybe 4-6 months scares me. Inflationary pressures will start hitting about summer of next year I suspect and if they do the dollar is in for even more trouble since so much of these foreign holdings in the US would be losing value quickly and they would have to be dumped. Politicians surely won't do anything then, if we have the Fed staying out that is a recipe for disaster. The Fed tacking on 1% is going to do so little to the economy, if someone thinks that kind of rate hike is going to send the economy back into recession they have lost their mind. The Fed raising to reach parity with the ECB and making it clear that they aren't afraid of deflation anymore would be the clear policy winner at the moment, but I just don't see it happening.

[mikelow]

Inflation--no one's worrying about it.

But the drop in the dollar (part of Bush's policies--maybe in the long run they think that will drive down the trade deficit) is really scary as there seems to be no bottom in sight. Look for an infaltionary pickup after Bush is reelected.

[adios]

"The Fed tacking on 1% is going to do so little to the economy, if someone thinks that kind of rate hike is going to send the economy back into recession they have lost their mind. The Fed raising to reach parity with the ECB and making it clear that they aren't afraid of deflation anymore would be the clear policy winner at the moment, but I just don't see it happening."

Good points. My impression is that the US markets would welcome such a move by the Fed and one of the reasons for the sell off in the stock market because of disappointment.

[adios]

The thing is that Greenie does have a history of doing thing gradually i.e. a quarter point at a time, sometimes a half point. The fact that the Fed is stating for the forseeable future means that if the Fed Funds rate is going to 3% or 4% it's a long way off given Greenie's past history. From what I can gather most feel that a 4% Fed Funds rate is neutral i.e. below 4% it's accomodative and above 4% it's restrictive. Given Greenie's past 4% seems like a long, long way off. Then again a lot of speculation that Greenie's out in 2005 and given his age that seems like it's probably true.

[adios]

Fed Sees Untapped Labor Resources Until Late 2005 (Update1) (http://quote.bloomberg.com/apps/news?pid=10000006&sid=a2TbgUfl2F7Y&refer=home)


Fed Sees Untapped Labor Resources Until Late 2005 (Update1)
Dec. 11 (Bloomberg) -- Members of the Federal Reserve's Open Market Committee cited lagging job creation as a central risk to the strengthening economy, minutes of their October meeting show.

``Members generally anticipated that an economic performance in line with their expectations would not entirely eliminate currently large margins of unemployed labor and other resources until perhaps the later part of 2005 or even later,'' the minutes said.

Companies may be slow to hire because they're counting on productivity gains. While an acceleration of the economy reduced worries about disinflation, ``those concerns had not been eliminated,'' the minutes showed. The lack of inflation and concern about unemployment help explain why the central bankers left the overnight benchmark rate at a 45-year low of 1 percent.

The U.S. economy has added 328,000 jobs in the four months that ended in November. Companies had been shedding jobs from February through July.

``The extent to which recently positive labor market developments might be harbingers of substantial further employment gains was unclear at this point, given evidently continuing business efforts to respond to growing demand by improving productivity rather than hiring new workers,'' the minutes said.

Productivity grew at a 9.4 percent annual rate in the third quarter, the fastest in two decades.

Fed Chairman Alan Greenspan, in a speech today, cautioned against protectionism that might arise from political concerns over lingering unemployment. The unemployment rate stood at 5.9 percent in November, down from 6 percent the previous month.

Greenspan

``We as a nation have not engaged in significant and widespread protectionism for more than five decades,'' Greenspan told the World Affairs Council in Dallas. ``The consequences of moving in that direction in today's far more globalized financial world could be unexpectedly destabilizing.''

FOMC members said the shape of the economy's expansion was ``atypical,'' resulting in limited guidance from past periods to judge the current economic outlook. They added that the strength of holiday sales ``should provide an improved basis for judging the underlying momentum of the expansion.''

The Fed committee saw the risks of additional disinflation diminishing, helped by greater levels of resource utilization and the weaker dollar.

Treasury Securities

The yield on the Treasury's 4 1/4 percent note maturing in 2013 fell 3 basis points to 4.28 percent at 2:27 p.m. New York time as investors bought securities after the minutes. The dollar gave back some of its gains against the euro to trade at $1.2174 compared with $1.2157 before the report.

The unusual nature of the economic expansion also required ``adaptations'' in communication strategy, the Committee said. Several options were discussed, the minutes said, and ``in the absence of a consensus at this meeting the members agreed that further study under the guidance of a working group comprised of committee members was desirable.''

The Fed's economics staff ``continued to point to substantial strengthening in the economic expansion during the second half of the year,'' the minutes said. ``Given the substantial slack in ongoing resource utilization, the staff forecast anticipated some slight downward pressure on core consumer price inflation.''

Particularly note:

``Members generally anticipated that an economic performance in line with their expectations would not entirely eliminate currently large margins of unemployed labor and other resources until perhaps the later part of 2005 or even later,'' the minutes said

Greenspan seems to be signaling that he doesn't see a serious abatement in the unemployment rate for the next 2 years.

[Wildbill]

Especially if he and his "advisors" start pushing for yet another tax cut. This guy and his party are just out of control and everything they do just digs the hole deeper. Partisan politics is so getting out of hand these days I have never been so disgusted. Republicans don't stand for anything other than pet issues that they think gets them elected or serves the interests of their donors. It is getting so blatantly obvious that is the case. This current term has been nothing about passing good policy and everything about trying to create edges for themselves that can make this the party that dominates the next decade or two of politics. We will all pay the price soon enough and I think your prediction of inflation rising after next year's election is right on the money. GW won't even care anymore, he will just use that to spin some other misguided policy.

[adios]

Personally I think higher tax revenues would just give rise to an increase in fed government spending. The only thing that I've seen where the feds have been successful in controlling govt spending was Graham-Rudman. To be fair looking at the Clinton admin budgets, he initiated welfare reform, was able to keep Medicare/Medicaid spending growth inline with GDP growth, and reduced DOD spending significantly in terms of GDP. The federal govt under Clinton benifitted greatly on the revenue side by an extremely long business expansion and capital gains in the markets. Bush more or less inherited a recession which has led to significant decreases in govt revenues over a prolonged period of time. The USA hasn't seen anything akin to this prolonged period of decreased revenues since 1930-1933. Rightly or wrongly the Bush administration has seen a need to significantly increase defense spending from the levels of the Clinton administration. Remember that in terms of percentage of GDP, the Clinton administration spent the least amount on defense since the years immediately following WWII. I'll add that there was justification for this since the Clinton administration followed the end of the Cold War very closely. Medicare/Medicaid expenditures have grown in a non linear manner under the Bush administration. Clinton and Bush seem to have approached Medicare/Medicaid differently and IMO Clinton deserves his due for what he was able to accomplish in controlling Medicaid/Medicare expenditures. I'm fairly certain that Bush administration policies regarding Medicare/Medicaid have in part caused the big uptick in Medicare/Medicaid expenditures. A Medicare/Medicaid reform bill was just passed and the conservatives seem to be divided on whether or not it will ultimately lead to linear growth in expenditures. Time will tell. Getting back to tax cuts, I believe that they're a necessary precursor to less government spending. I'm sure many will disagree though.

[Czech_Razor]

The link to the article didn't work (for me), so I hesitate to comment on it, but given the present interest rate environment, why on earth would you want to buy a bond that (1) locks in the low interest rates, and (2) maximizes the reaction to interest rate moves?

Also, as an aside, this forum (http://www.aimrpubs.org/ap/issues/v2002n1/toc.html) is about the most cogent, if academic, discussion on the equity risk premium that I've found.

Anthony

[GeorgeF]

Bill Gross, PIMCO bond guru, has an opposite opinion. In particular Gross has some interesting mortage advice.

http://www.pimco.com/LeftNav/Late+Breaking+Commentary/IO/2003/io_dec03.htm