Market Comment — July 18th, 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 .
Nothing has changed
 We believe that the secular trend of lower interest rates will continue and interest rates
will eventually fall to new lows.
 Expectations for the economy reaching escape velocity are dismissing the reality of
how much progress is left to do. Bond prices do not reflect the facts.
This time looks and feels the same
Positive economic sentiment now is nearly identical to the last five major bond sell-offs in this
cycle. Interest rates were thought to continue rising in each case but resulted in dramatically
falling yields. We’ve collected several quotes from stories by Michael Mackenzie, US Markets
correspondent for the Financial Times, from near each peak in yields (fig.1). There are strong
expectations of a continued major rise in interest rates at each point. Emphasis (bolding) ours.
fig.1 10yr UST yields and significant yield back-ups from 2007
6%
Recession
10yr UST Yield
Significant Back-ups
5%
1
2
4%
3
4
6
3%
5
2%
# s indicate approximate time of
quotes on the following pages
1%
0%
2007
2008
2009
2010
?
2011
2012
2013
2014
2015
Data Source: Bloomberg
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013
Page 1 of 13
1 06/11/2008, “Inflation rhetoric triggers bond investors’ about-turn”, Financial Times, by
1.
Michael Mackenzie,
“When central bankers aggressively bang the drum on inflation, bond investors
quickly head for the exits. So it is not surprising that waves of selling have engulfed
global government debt markets. The catalyst has been a recognition among
traders that central banks, notably the European Central Bank, the US Federal
Reserve and the Bank of England may have to raise interest rates this year to
arrest the threat of higher inflation.”
What happened? The Fed lowered rates from 2% to 0% and the 10yr UST yield fell 2%
within six months.
2 06/10/2009, “Policymakers’ tricky route to exit door”, Financial Times, by Michael
2.
Mackenzie and Aline van Duyn,
“Two words have started doing the rounds of the world's financial markets a lot
earlier than expected: "exit strategy". As hopes rise for a sustained economic
recovery and risky assets from emerging market equities to corporate bonds rally,
attention is focusing on how central banks will unwind hundreds of billions of
dollars of support for the markets. "We could well be asking ourselves at the end
of the year whether policymakers did too much, in terms of the enormous amount
of liquidity that has been created, whereas at the start of the year investors were
questioning whether policymakers were doing too little," says David Bowers, joint
managing director at Absolute Strategy Research.”
What happened? The 10yr yield fell 77 basis points in the next 3 months.
3 04/6/2010, “Signs of strengthening US recovery lift mood”, Financial Times, by Michael
3.
Mackenzie and Dave Shellock,
“Fresh signs that the US recovery is gathering pace bolstered Wall Street
stocks and commodity prices on Monday, while Treasury bond yields reached 18month highs as investors considered the implications for Federal Reserve policy.”
and,
“Heightening the impact of the jobs data were numbers on Monday that showed
further expansion in the crucial services sector – which accounts for about 90 per
cent of the US economy – which suggested the recovery was spreading. The
Institute for Supply Management’s non-manufacturing index rose to 55.4 last month
from 53.0 in February, the highest for nearly four years and its third successive
increase.”
What happened? The 10yr UST yield fell 1.56% over the next 6 months
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013
Page 2 of 13
4 12/08/2010,“US growth forecasts spell pain for Treasuries”, Financial Times, by Michael
4.
Mackenzie,
“Economists have duly revised up their growth forecasts for 2011 towards 3.5 per
cent. Against the backdrop of stronger consumer and business spending,
bond yields are too low, particularly when compared with equities trading at
about 15 times earnings, say analysts. ‘There is a lot of pain in the market,’ says
Dominic Konstam, interest rate strategist at Deutsche Bank. ‘People are starting to
fear that bonds are expensive [compared] to stocks and the case can be made for
10-year yields moving towards 3.50 per cent.’”
and,
“‘Treasuries are on the losing end of this deal, from the standpoint of the improved
economic outlook, risk attitudes, and the US fiscal position,’ says Tony Crescenzi,
portfolio manager at Pimco. Higher Treasury yields also loom as an unwelcome
Christmas present for investors who have pumped record amounts of money into
bond funds this year. Appetite for bond funds in recent weeks has weakened with
investors fleeing state and city issued municipal debt, whose yields have followed
the path of Treasuries. Outflows could intensify heading into the end of the year and
spike early in January as investors focus on the rise in yields since the start of the
fourth quarter in October. ‘Historically, retail investors tend to follow the previous
quarter’s performance,’ says Michael Cloherty, head of interest rates strategy at
RBC Capital Markets. ‘It could get rougher for Treasuries early next year, once
investors head for the door.’ Any signs of a strengthening economy next month
will only accelerate the switch out of low yielding bonds into equities.”
What happened? The 10yr yield fell 82 basis points from this point within 10 months.
5 03/15/2012, “Bond Bulls caught in US Treasuries sell-off”, Financial Times, by Michael
5.
Mackenzie and Vivianne Rodrigues,
“The extent of this week’s selling, then, suggests the bond market is at a crucial
juncture. As evidence of economic recovery builds, and with the Fed dialling
back on hints of further monetary easing, investors are reassessing that
consensus trade. The question being asked is how long the US central bank will
maintain ultra-loose policy to encourage the lending by banks deemed essential for
recovery. For some bond investors, notably Pimco, the rise in yields spells trouble.
Pimco is among those that have recently bet yields will stay at very low levels for
this year. Official data released on Thursday revealed that foreign investors and
central banks were also big buyers of Treasuries in January and are now facing
losses on those purchases”
and,
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013
Page 3 of 13
“…as evidence mounts that the US economy is picking up pace, the need for
the Fed to undertake further easing via large-scale asset purchases lessens,
removing a key prop for Treasuries. In turn, the risk grows that bond investors
will capitulate and pour money into equities, and financials particularly, which are
still cheaply valued.”
What happened? The 10yr UST yield fell 95 basis points within 4 months.
And from a couple of weeks ago, 7/5/2013, “Payrolls reaction presages storms ahead for
investors”, Financial Times, by Michael Mackenzie,
“The steady improvement in the jobs market vindicates the view at the Fed
that some reduction in the pace of QE is warranted, with investors expecting a
starting date in September.”
and,
“There is no question that investors will closely scrutinise their holdings of bonds
and equities as the beginning of the end for QE looms. Hefty bond purchases by
the Fed have been a critical driver of asset prices on the upside this year. That’s
why any reversal stands to weigh heavily.”
and,
“Clearly the bulk of investor adjustment or pain will occur in the bond
market...”
See a pattern? In all of these periods, markets became convinced that the economy was
about to or had broken out, yet for all the hopeful sentiment, interest rates fell to new lows. We
correctly advocated being long Treasuries through all of these periods, and advocate being
long at this juncture as well.
Why do we think rates will fall?
The conventional wisdom is that the Fed has now committed to reducing stimulus, they were
the main reason rates were low, and so rates will begin to climb secularly. We don’t agree.
Firstly, the Fed has not committed to reducing stimulus (0% short-term rates), and in-fact we
guess that the economy won’t allow them to reduce bond purchases in September, let alone
wrap-up the QE program. The Fed (as they’ve been at pains to express) determines policy by
the same economic numbers we all watch; the economy always has and will trump the Fed.
Ben Bernanke, at the June 19, 2013 press conference said,
“I would like to emphasize once more the point that our policy is in no way
predetermined and will depend on the incoming data and the evolution of the outlook
as well as on the cumulative progress of our objectives.”
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013
Page 4 of 13
In reality, there are too many important caveats to the much-heralded improvement in the labor
market. The low quality of the jobs being added takes away from the ultimate goal of
employment; higher aggregate income for the country. From “A Jobless Recovery Is a Phony
Recovery” by Mortimer Zuckerman, Wall Street Journal, 07/16/2013,
“The jobless nature of the recovery is particularly unsettling. In June, the government’s
Household Survey reported that since the start of the year, the number of people with
jobs increased by 753,000—but there are jobs and then there are “jobs”. No fewer
than 557,000 of these positions were only part-time. The June survey reported that in
June full time jobs declined by 240,000, while part-time jobs soared 360,000 and have
now reached an all-time high of 28,059,000—three million more part-time positions than
when the recession began at the end of 2007.
That’s just for starters. The survey includes part-time workers who want full-time work
but can’t get it, as well as those who want to work but have stopped looking. That puts
the real unemployment rate for June at 14.3%, up from 13.8% in May.” To get a proper read on the economy, it is important measure the distance between where we
are and where we need to go to be at full employment and full capacity. This is important
because this level of economic activity or state of low joblessness signifies the point at which
disinflationary pressures turn to inflationary pressures. Because the headline unemployment
rate (U6) has been declining almost solely by people dropping out of the labor force, a better
metric of the gap is the study done by The Hamilton Project at the Brookings Institute. The size
of these gaps are either continually dismissed or mistaken to be diminishing faster than the
economics show. Looking at the gap in two different ways corroborates the enormous
distance to close before we would expect interest rates to have bottomed in this cycle (fig.3
and fig.4).
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013
Page 5 of 13
fig.3 The unemployment rate overstates labor market progress. This is a
better metric of the work left to be done.
Jobs Gap (from The Hamilton Project)*
2008—2025
This gap wouldn’t close until 2020 if
we continued with the pace of the last
6 months, 202k.
*Each month, The Hamilton Project examines the “jobs gap,” which is the number of jobs that the U.S. economy needs to
create in order to return to pre-recession employment levels while also absorbing the people who enter the labor force each
month.
This chart shows how the jobs gap has evolved since the start of the Great Recession in December 2007, and how long it will
take to close under different assumptions for job growth. If the economy adds about 208,000 jobs per month, which was the
average monthly rate for the best year of job creation in the 2000s, then it will take until April 2020 to close the jobs gap. Given a more optimistic rate of 321,000 jobs per month, which was the average monthly rate of the best year of job creation in
the 1990s, the economy will reach pre-recession employment levels by January 2017.
*88,000 jobs is the average assumed labor force growth per month from January 2012-December 2025, therefore the economy must add at least that many individuals to close the jobs gap.
Data Source: The Hamilton Project at the Brookings Institute, http://www.hamiltonproject.org/jobs_gap/
They make a conservative
estimate for the growth of the
labor force
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013
Page 6 of 13
fig.4 The amount of work left to be done can also be expressed
by the output gap
Output Gap, Actual and Potential Real GDP (2005 dollars)
$17tn
gro
wt
h
2007—2022
wit
h4
%
rea
l
Potential Real GDP $2005 Dollars (CBO)
Actual Real GDP $2005 dollars (BEA)
res th
ssu row
e
r
P
lg
ion
rea
flat
%
n
th
i
3
o
ow
ith
ld t
l gr
o
w
a
h
e
r
res
2%
Th
with
$16tn
$15tn
$14tn
The output gap now, -5.8%
$13tn
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
$12tn
Data Source: Bloomberg
Certainly markets trade on where these gaps “will be” not just where they are today but the
distance is just too great to imagine them closed in the short-term. Interest rates in the last 50
years have never cyclically bottomed until the output gap was better than -2.7% (now, -5.8%).
Therefore, the most recent low in 10yr yields of 1.35% in July of 2012 is highly unlikely to be the
secular low.
The second prong to the prevailing logic is that rates are low only because of the Fed’s
actions. We don’t agree. The German 10yr Bund now yields almost a full 1% lower than the
US 10yr without a single dime of central bank money in their market and a similar rate of
inflation to the US. A sampling of interest rates around the world with a mix of QE and non-QE
central banks, shows that the 10yr yield in the US is cheap, not expensive (fig.5).
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013
Page 7 of 13
fig.5 Sovereign rates around the
world
10yr Yields
07/18/13
United States
2.53%
Canada
Czech Republic
Denmark
Finland
France
Germany
Hong Kong
Japan
Norway
Singapore
Sweden
Switzerland
Taiwan
UK
2.38%
2.01%
1.67%
1.81%
2.17%
1.52%
2.19%
0.81%
2.60%
2.43%
2.07%
0.99%
1.45%
2.26%
It is important to understand that high interest rates
in the 1970’s and 80’s are a one-off phenomenon in
the entire known history of interest rates. Consider
this quote from Sidney Homer and Richard Sylla’s
highly regarded A History of Interest Rates, “...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.”
It is commonly stated that the average rate on the
10yr US Treasury for the last 30 years is around 6%
and thus for rates to ‘normalize’, rates should move
back to this level. But the last 30 years includes
this incredible anomaly. More suitable
environments to consider are the period after the
Great Depression and the period after Japan’s
property bubble burst in 1990. Both of these
periods are similar to now in that they are in the
aftermath of financial crises. These periods are
Data Source: Bloomberg
also termed ‘Balance Sheet Recessions’ (Richard
Koo), or the contraction phase of the ‘Debt supercycle’ (Bank Credit Analyst). In the 20 years after
the stock market peaks in these periods, Japan’s 10yr government bond averaged a yield of
2.51% and the US averaged 2.71%. Altogether, after the Great Depression, there were more
than 14 years that the US 10yr was below 2.50%! (fig.6)
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013
Page 8 of 13
1
fig.6 After financial crises, rates stay low for a long time.
US 10yr yields, starting at stock market peaks
Great Depression and Great Recession
4.5%
10yr UST starting 08/1929
4.0%
10yr UST starting 10/2007
3.5%
10yr Yields remained below
2.5% for 14 years!
3.0%
2.5%
2.0%
1.5%
1.0%
1929
2007
1934
2012
1939
2017
1944
2022
1949
2027
1954
2032
Data Source: Bloomberg, Global Financial Data
Many representative indicators are signaling weakness
1. US GDP: The first release of 2nd quarter GDP (and final revision to Q1) comes in two
weeks. Given Wall Street’s steady lowering of Q2 GDP forecasts due to weak trade
balance and inventory numbers, the Fed’s average forecast of 2.45% real GDP in 2013
is getting near impossible. They would need two quarters above 3% in the second half
to get there. Because they will have to revise their numbers lower, and because
Bernanke has reiterated the QE reduction schedule is contingent on their forecast, we
think that the current QE tapering schedule will have to be re-evaluated (fig.7).
2. In UPS’ (United Parcel Service) latest earning release, they warned, “Overcapacity in
the global air freight market, increasing customer preference for lower-yielding shipping
solutions, and a slowing U.S. industrial economy drove revenue and operating profit
below expectations.” In Fedex’s latest earnings release, the CEO said, “FedEx Ground
posted another strong year and FedEx Freight margins continued to improve. These
positive developments did not fully offset tepid economic growth and customer
preference for less costly international shipping services.” Both of the widely watched
ISM purchasing manager indices are reflecting this reality as well (fig.8).
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013
Page 9 of 13
fig.7 GDP is not accelerating
US Quarterly Real GDP (SAAR)
For 2013, the Fed (on average)
expects growth of 2.45% as of
their June forecasts
2008—2014
6%
4%
2%
0%
Q4 2013
Q3 2013
Q2 2013
Q1 2013
Q4 2012
Q3 2012
Q2 2012
Q1 2012
Q4 2011
Q3 2011
Q2 2011
Q1 2011
Q4 2010
Q3 2010
Q2 2010
Q1 2010
Q4 2009
Q3 2009
Q2 2009
Q1 2009
Q4 2008
Q3 2008
Q2 2008
Q1 2008
Q4 2007
Q3 2007
Q2 2007
Q1 2007
Q4 2006
Q3 2006
Q2 2006
Q1 2006
-2%
But assuming a 2nd quarter of
1% growth, the 2013 average
so far is 1.4%. The Fed’s
2.45% will have to be revised
lower.
-4%
-6%
-8%
-10%
Data Source: Bloomberg
fig.8 Several purchasing manager indices are at pre-recessionary levels
Manufacturing, Service, and 2 sub-indices of purchasing manager indices
2005—2014
70
These indices are largely at
their lowest level of the
recovery, not consistent with an
accelerating recovery.
65
60
55
EXPANSION
50
CONTRACTION
45
ISM Manufacturing
40
ISM Manufacturing (Employment)
35
ISM Service
ISM Service (New Orders)
30
25
20
2005
2006
Data Source: Bloomberg
2007
2008
2009
2010
2011
2012
2013
2014
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013 Page 10 of 13
3. The recent sell-off in Treasuries has resulted in mortgage rates 1% higher in just 2
months. This is a reversal of 2 years of work by the Fed to make housing more
affordable. As a result, the first housing statistics we’ve been able to see since the
rate rise have looked very soft. (fig.9 and fig10).
fig.9 Higher mortgage rates of 1% in the last two months have
hit housing activity
Bankrate.com 30yr fixed mortgage rate
2011— 07/12/2013
5.5%
5.0%
4.5%
this….
4.0%
3.5%
3.0%
1/1/2011
7/1/2011
1/1/2012
7/1/2012
1/1/2013
7/1/2013
MBA Mortgage applications index, Purchases and Re-fis
2011— 07/12/2013
Index level is unit-less, used to compare from one point to another point
1100
1000
900
caused this….
800
700
600
500
400
300
1/1/2011
7/1/2011
1/1/2012
7/1/2012
1/1/2013
7/1/2013
Data Source: Bloomberg
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013 Page 11 of 13
fig.10 Many housing indicators are still bouncing on the bottom. Charts are
“L” shaped, not “V” or “U” shaped. Rising mortgage rates do not help.
Case-Shiller 10 city Home Price Index
2005-2014
$240k
$220k
Due to the 2 month delay
release schedule of this
index, we haven’t yet seen
the effect of higher rates on
this.
$200k
$180k
$160k
$140k
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
New Housing Starts (SAAR, thousands)
2005-2014
2,630k
2,130k
1,630k
1,130k
630k
130k
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2013
2014
Building Permits (SAAR, thousands)
2005-2014
A first look at these
statistics after rates have
risen, and they hadn’t
recovered much to begin
with.
2,630k
2,130k
1,630k
1,130k
630k
130k
2005
2006
2007
2008
2009
2010
2011
2012
Data Source: Bloomberg
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013 Page 12 of 13
4. Copper is highly regarded as a leading indicator of global demand. It is nicknamed
“Dr. Copper” for this reason. The only signal this metal is sending is that of a weak
global economy (fig.11)
fig.11 Dr. Copper has been slowly decreasing for two years.
Active Copper Futures Contract, USD/lb.
10/31/2010-07/17/2013
$500
$450
$400
$350
-34.7%
$300
$250
10/31/2010
10/31/2011
10/31/2012
10/31/2013
Data Source: Bloomberg
In summary, this is what we are seeing, and it leads us to conclude that interest rates haven’t
bottomed out in this secular cycle. None of it is rocket science and once you discount the
optimistic bias of the markets, it isn’t that hard to agree with either. We don’t dig around
searching for ways to spin the economy negatively, we just have to be pragmatic to make
money over time and we strongly believe that because US interest rates are the market best
correlated to fundamentals, that we have to get the primary trend right before we can get
anything else right.
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 7/18/2013 Page 13 of 13