Thursday, October 16, 2014

Update on Interest Rates

Well, interest rates got interesting fast after I posted my update Wednesday.  Here are updated versions of a couple of the graphs.

The market reaction seemed overblown compared to the information contained in the economic data that was released Wednesday.  I have been pleasantly surprised by the reaction from FOMC officials that suggests they are willing to loosen up, at least a little bit.  I'm not sure if it will be enough to make much difference.

In the meantime, labor markets continue to look strong.  So, I think we might still be looking at a situation of weak signs in financial markets but a strong economy in terms of production and employment.

I think this is a speculator's market.  These are the kind of situations I look for in individual equities, like in my current favorite Hutchinson Technologies.  The ability of markets to provide stable and efficient prices breaks down when the distribution of possible outcomes deviates from normal behavior.  For some time, prospects for HTCH on a 5 to 10 year horizon have been such that they are likely to be worth very little or something more than $10.  They have been trading in the $2 to $5 range.  The distribution of outcomes is kind of an upside-down normal curve.  It is highly unlikely that HTCH will be trading at $3 in 5 years.  This kind of situation causes the expected cash flows of the marginal investor to take a back seat to other issues, like reputation, fear of losses, etc.  Expected monetary returns can be very high, and returns to unobservable stock picking skills become very high.

We have a similar situation now in the broader market. It has been that way for some time.  Under QE, investors were split between high inflation expectations and worries about perma-QE at the zero lower bound.  I think the decline in the TIPS spread in 2013 might have reflected a reduced variance in expected inflation more than a reduced mean expectation for inflation.  In fact, that was the subject of my very first post on this blog, and a couple of follow ups.

After the rate increases in mid 2013, through most of 2014, I had a slightly bullish position on rates (short bonds) that I traded as a synthetic short option.  (I traded so that I gained from mean reverting volatility).  That is because I forecasted a positive labor market for 2014.  I predicted that, on net, the distribution of possible outcomes in the near future would become less variable.  This is because the taper of QE3 would quell fears about inflation while the strengthening labor market would quell fears about deflation.  I expected housing to eventually recover more strongly than others seemed to expect, which would eventually bias markets even more away from deflation worries.  In the meantime, I traded the transitory volatility in the day to day markets.

I think we have mainly gotten to the place I expected us to.  Except, housing credit markets haven't seemed to recover enough to pull home prices up to levels that would re-establish a sustainable housing credit market.  So, I have retracted my bullish position on real estate and home building for now, and my bullish position on interest rates (bearish on bonds).  And, the volatility dynamics are now reversed.  Instead of reverting to the mean with declining volatility, the end result for interest rates is now probably a two-tailed monster.  Much like with HTCH above, the odds that June 2017 Eurodollar contracts will expire at 2% are very low.  But, the problem is we don't know if they will expire at 0.1% or at more than 3%, and much of the outcome depends on coming arbitrary Fed decisions.  So, a directional speculative position will eventually pay off very well here.  But, which direction is anyone's guess.  The trick now will be to take a position on that direction before the market fully prices it in.

In the meantime, this tipping-point context might mean that seemingly small pieces of information in one direction or the other could create large swings in market prices.

That said, looking at the forward Eurodollar curve, this recent move doesn't look as pessimistic as it first did.  With such a large decline in equities, it seemed like the market reaction was a reaction to more possible demand shocks.  But, especially after recovering a little, the change in rates looks like it has come mostly from an expected delay in rising rates, which could reflect some pessimism about near-term markets, but this pessimism appears to be paired with an expectation of a counter-effect of appropriately looser monetary policy.  The end result of the last three days' interest rate moves has been a move back in time of about 1 month in the first rate hike and a slightly slower expected rate of rate increases after that.  The expected date of the first rate hike had already begun moving back earlier in the month, so that, as a whole, since early October, the expected date of the first hike has moved from about June 2015 to about September 2015, according to my model.  I think that's a lot smaller change than some observers realize.

As we move out on the yield curve, forward rates had collapsed since the beginning of the year, from more than 5% to about 3.5%, and the last leg of that collapse had come in early October, along with collapsing inflation expectations.  But, with the rate drops this week, the forward rates at the long end of the curve actually held their own.

I suspect that the long end of the curve is partly a comment on the odds of being stuck at the zero lower bound.  Long term rates have shrunk by about a third, and the slope of the curve during the rate hike phase (2015-2018) has also dropped by about a third (from about 34 to about 23 bps per quarter).  This could represent a bifurcated expected outcome distribution, with a 2/3 chance of seeing rates increasing at more than 1% per year starting sometime around 2015-2016 and topping out at around 5%, and a 1/3 chance of never leaving zero.  (The slope still seems a little low, which I attribute to a weak housing credit market.)  Anyway, if this is a true reflection of market expectations, then the flip out this week may not have reflected any increase in the odds of staying at zero.

All in all, I would say that this week's move signals some confidence in forward monetary policy.  Let's hope that's true.


  1. Excellent blogging. But, I think you need to pay attention to the idea that there is a glut of capital globally. Thus, rates will be pressed down even absent other macroeconomic trends.

    1. My forecast is for one of three outcomes:

      1) rates stuck at zero
      2) rates very slowly rising up to maybe 3-4% if housing remains stagnant
      3) rates rising at a typical pace if housing gets a second wind, getting pushed too high by the Fed (but likely at a level lower than the previous cycle peak) and collapsing with another demand shock.

      How low do my expectations need to go? ;-)

  2. TravisV here.


    Back in February, you wrote the following post on bond vs. stock allocation:

    Does that reflect your current thinking on the subject ("Buy Equities, but not for the reason you think you should.")? Or have you updated your thinking?

    1. Yes. For the passive investor at holding periods of more than 10 years long term bonds add risk to a portfolio. Especially in the current context, eventually we will revert to a higher interest rate level, and we should see a larger equity premium when that happens.

      For the tactical investor, this context presents tactical opportunities. The problem for equities is that in the low interest rate context the destruction of the equity premium comes from permanent losses stemming from demand shocks. If you can exit equities during these episodes, then you will capture equity premiums in this context similar to the 1945-1975 time frame. Easier said than done. I will be trying to short equities and take bond exposure at some point when a demand shock seems imminent.

      Real estate is a good way to get bond - like exposure with excess returns now, except that, cyclically, it is liable to correlate with equities during a demand shock.

      What is your allocation strategy?

    2. TravisV here.

      I see your point on shorting equities ahead of demand shocks. However, I'm not sure it's possible to consistently succeed at identifying central bank surprises before they happen......

    3. I agree. I wouldn't recommend it to anyone but a full time speculator. I'll let you know how it goes, when the time comes. ;-) I've been doing pretty well with interest rate forecasts the last couple of years, but even though I've been relatively accurate, I've gotten burned on execution from time to time. I think some sort of naive re balancing is probably a better way to capture some contrarian gains for most long term investors.
      I think your allocation below is pretty smart, especially right now. There might be some correlation between equities and real estate if we have another shock like 2008, but in practically any outcome I think this allocation will be optimal for longer time periods. And considering real estate recovery has come with absolutely no help from credit markets, the Fed would really have to try hard to get real estate to fall significantly.

    4. TravisV here.

      The S&P 500 rally of the past six days is a good example of how it is to make macro bets with stock / cash allocation changes.

      But anyway, some key info in case you're not aware of it:

      (1) Bullard's dramatic flip-flop (last week)

      (2) HUGE rumor that the Germans might finally allow QE:

      (3) As a result, U.S. inflation expectations have rebounded! BEAUTIFUL!!!!!

    5. Tomorrows CPI report could be a big deal.

      I hope the German rumor is true.

      I liked the Fed's signals, but I hear today that they are likely to go ahead and finish QE3 on schedule. I don't know if it would matter much. I think the much bigger news is the negotiations with Fanny & Freddie and the banks. If they can manage to loosen up mortgage regulations in a reasonable way, maybe mortgage credit will come back. I don't think we can inflate without QE if the mortgage market remains DOA.

    6. TravisV here.

      Thanks! Imagine that 5-year inflation expectations fall below 1.2%. I think the Fed would change its timeline significantly.

      Today's CPI report cannot be very important. The Fed is taking it with a grain of salt since oil prices inflation expectations and stock prices (especially global) have crashed.

      I'm still not capitulating to the "U.S. follows 1990's Japan" pessimists........

    7. Think like a speculator, Travis. It could be important BECAUSE the Fed is taking it with a grain of salt! ;-)

    8. TravisV here.

      This seems neutral-to-negative: "“German lawmakers rip ECB over corporate bonds report”

    9. TravisV here.

      Just saying we don't really know what's going on behind the scenes. That article might be a lot of fury signifying nothing. The rumors of possible QE have persisted despite public outcry among German politicians. Both things can happen: German elites cut a deal for QE behind the scenes and then complain publicly.

      Not sure whether U.S. stocks and oil prices fell today due to that news out of Germany or due to the shootings in Ottawa, Canada:

  3. TravisV here.

    Allocation: about 10% cash, 45% equities / ETFs, 45% real estate.

    For equities, I rarely use options. Generally only willing to build big positions in high-quality. Holding period can be pretty darn long. Worship Warren Buffett.

    Some Buffett favorites have been dipping lately and I've been buying.

    I bought Bank of America (A LOT), Goldman Sachs, Nestle, Unilever. Sold Procter & Gamble.

    Quanta Services isn't ultra-cheap but I've got a small position in it.

    Stocks on my radar screen (but I haven't pulled the trigger):

    ExxonMobil, Cummins, Ford, Hertz, Avis Budget, Posco Steel, PKX (iShares South Korea), Deere, Lindsay

    If Colgate-Palmolive falls significantly, I'll buy it (potential 3G acquisition candidate?)

    And if Wells Fargo falls to $40, I might put my entire net worth into it! :)

  4. TravisV here.

    Stock idea of the day: Goodyear Tire!!!!!!!

    Also check out this great interview with David Tepper!

    1. Thanks Travis.

      Do you see any patterns in the US firms that are getting slaughtered lately?

    2. TravisV here.

      I think it's generally about what you'd expect.

      Two other high-quality companies where the sell-off is possibly irrational: Viacom and Diageo.

      I just thought it was irrational for the market to punish Nestle and Unilever so much relative to Procter and Colgate.

      Generally, it's all about beta / debt / operating leverage.

      Small caps have high beta relative to large caps so they've fallen more.

      Hertz, Avis, Goodyear have tons of debt. And Hertz and Avis have tons of operating leverage. Tons of fixed (sunk) costs relative to variable costs.

      The probability that Hertz and Goodyear will go bankrupt has certainly increased.

      There's also industries with natural cyclicality: Ford and Cummins have fallen off a cliff.

      The relative strength of the U.S. economy has held up companies like Wells Fargo, Union Pacific and Berkshire Hathaway so far. Waiting to see if I'll get a significant dip in those. I think it would be a great buying opportunity (particularly in Wells Fargo).

      I wish a smart Asian market monetarist could explain the weakness in China / Asia to me........

    3. Interesting.

      I'm working on a new series of posts, although I'm not sure how soon I will get it finished and posted, regarding this sort of thing.

      Capital Asset Pricing Model and Modern Portfolio Theory seem to sweep a lot of things under the rug since, by definition, we can assume that the market basket of securities is market cap weighted. The lack of required transactions in the market portfolio lends a sense of stability to the portfolio that lends itself further to the tendency to "all else equal" modeling in time series - static betas, risk free interest rates, market weights, etc.

      One place where this plays out is with unstable betas. If demand shocks lead a firm to have a capital allocation outside it's optimal equilibrium (say, by having revenue decline so that market cap declines while bond holders are locked in to existing funding) then beta can be increased through financial and operational leverage issues.

      So, for stocks like these, they are a beta play, in that their vulnerability to demand fluctuations creates a high response to market moves. But, I think that much of the potential gain comes from changes in beta. So, for instance, for a firm with a beta of 2, if improved sentiment causes a market increase of 10%, the firm might see an increase of 20% in it's equity value. But, improved conditions might also bring it back to an optimal capital and operating position so that its beta declines to, say, 1.5. The added value of this change in beta could dwarf the value of the market-correlated move itself, especially at a time like now when the Equity Risk Premium is very high.

    4. This can be addressed in a DCF model by using cyclically normalized relative valuation measures for the terminal value. But, if you're modeling cash flows of various weighted outcomes out 5 years to get to that terminal value, then I think it might be appropriate for the values of the better outcomes to be discounted at the lower discount rate that those outcomes would be associated with.

      Not doing that could create a negative bias in valuations, especially for high beta stocks, because the poorer outcomes would need to be discounted at a higher rate, but if those outcomes lead to an investment with very high capital losses, then the weighted expected values of those poor outcomes would be fairly insignificant in your total expected valuation.

      So, making this adjustment would provide much higher present values in cases where outcomes have high variance, and I think those present values would be more accurate than valuations that use static discount rates.

    5. TravisV here.

      Stock idea of the day: Geospace Technologies!!!

      Zero long-term debt, so much safer than Hertz, Avis, Goodyear.

      Market capitalization = 1.1x tangible book value.

      Institutional buyers (see below)?

    6. TravisV here.

      I have been buying a lot of Bank of America stock since it's had a decent earnings report but still dipped.

      Here are some great articles analyzing why Buffett might be so concentrated in bank stocks like WFC and BAC.

  5. TravisV here.

    Warning: here's a macro position David Tepper made that was horribly incoherent (and a disaster):

  6. TravisV here.

    Kevin, my dad tried to make the "when profit margins mean-revert, stock prices will fall" argument today. I am re-reading this analysis from you and it is AWESOME!!

    Any updates on your thinking?

    1. Thanks Travis. Your reminder of those posts has nudged me to make a new post, which will probably be up in the morning.

      I think those posts provide a useful way of looking at it. I would add the caveat that they are hypothetical examples. I think the numbers are undeniable and the adjustments they point to are real. But, long term leverage changes happen very slowly. Also, while I think short term changes in risk premiums and interest rates do create the tendencies I outline, when they are accompanied by demand shocks, the effects may be dwarfed by issues of capacity utilization, capital disequilibria, etc.
      But, at our current place in the business cycle, where much of the operational and financial disequilibria have been worked out and corporate leverage as declined significantly back to the long term trend, I do think this framework is a strong counter argument to concerns about profit margins.