Bonds, Credit and Houdini

Once again the Wall Street consensus bond yield forecast was wrong. Indeed it has tended to be wrong now for over twenty years, as described in Market Notes 38.  In some circles repeatedly coming to the wrong conclusion is regarded as a form of insanity. But most economists on Wall Street don’t have to be right as no-one checks their track record. How long do you suppose they would survive if they were trading their own money? 

Even now economists are still telling us that 10 year yields near 4% are clearly wrong. Why is it such a radical idea to ask whether it is just possible that the bond market is right and conventional economic thinking is wrong? Shouldn’t we at least investigate the possibility and weigh the evidence? Does the bond market rally and the dramatically twisting yield curve provide us with no new information?

I was once asked to give a presentation to J.P.Morgan clients alongside Dennis Weatherstone, J.P.Morgan’s Chairman, on the subject of how in practice the firm’s economic forecasts were used to trade and invest the company’s own capital. I made my excuses. It was a good subject but not one I wanted to answer in front of our clients, economists and the Chairman.

At about the same time as this presentation our economists produced a forecast that the US economy would be in recession in 6 months time, and I had to go to a meeting to discuss how we should position for this outcome.  To cut a long story short it turned out that 6 months later the US economy grew at a 6% rate! If we had committed to a position based on the coming recession we would have lost a fortune and probably our jobs as well, although strangely no-one suggested that the economist who produced the wrong forecast should lose his job.

To be effective as a trader or investor I believe you have to be first and foremost a market analyst. While you should be open to any idea that can help in this regard, an economist’s forecast may not help you very much. An economist’s forecast does not deal in probability, risk, entry point, exit point if wrong, valuation, timing or many other factors that influence the market. Don’t get me wrong. As far as I can tell most economists are well trained, with great credentials and are often persuasively plausible. But a good trader has to do his own homework. Ideas are more than welcome but if they don’t make sense in the context of market conditions they are not much use. I do know some good economists and analysts, but all the good ones use the market for constant feedback, and this makes their ideas far more useful and sharpens their analysis. But the best economist I know is the bond market itself, and I am amazed at how dismissive so many analysts are of the recent bond market rally and flattening yield curve.

What is the bond market suggesting?

The chart shows that 30 year yields are once again close to recent record lows. As bond yields are closely correlated with the sum of real growth and inflation this is the market’s way of saying that it expects a relatively weak economy with low inflation.

The dramatic flattening of the yield curve is the markets way of saying that higher short term rates are expected to be highly effective in lowering nominal growth in the economy. This has been a remarkable reaction given how low interest rates still are and seems to be indicating that the peak of interest rates in this cycle may be unusually low. This is another way of saying that the economy is unusually fragile and vulnerable to higher short term interest rates.

 

          Bond market logic

In these notes we have often argued that there are many reasons why the bond market could rally and so it is not a stretch for us to suggest that the bond market far from being an anomaly is logically reflecting what is happening in the economy. It may be heresy to say this on Wall Street but the argument is remarkably simple.

In short the US has been on a monumental credit binge for several years, which is beginning to reach it limits. During a credit binge the air becomes thin, everyone becomes light-headed and everything seems to become remarkably easy and effortless. Before long we can imagine remarkable things must be true. Credit becomes so plentiful that is seems anyone can buy anything they want. Asset prices soar giving the impression of great wealth. Before long people are explaining the economy as if it is something more than just a credit explosion. Record productivity, strong and flexible underlying American economy and system, leadership in research and development are all used to justify what everyone seems to be experiencing. While there is always an element of truth in all these explanations most of them are hard to measure or separate out from other influences.

What is undeniable though is that the credit expansion, with low interest rates and record fiscal stimulus, have been unprecedented and this provides a far more convincing explanation of what is going on. Unfortunately there has never been a credit boom without a credit bust, and we have become so conditioned to believe that the credit boom will last for ever that very few people are prepared for the inevitable credit bust, but this is what the bond market could be beginning to signal.

The credit Boom

It is remarkable that asset prices have been so strong for so long while savings have collapsed to near zero. The Greenspan Fed has turn orthodox economics on its head. Savings apparently no longer seem necessary when there is ample credit and asset prices are high and rising (at least partially because of the credit expansion).

What happens when a country has virtually no savings, like the US? In such a case any credit growth must be considered excessive. Since 2000, credit expansion in the US has been running at a $2.6 Trillion average annual rate, according to Dr Kurt Richebacher, or around 25% of the economy. Principally this has come from home equity extraction as shown below. 

For the most part, credit excess may find three different outlets:

1. rising prices of goods and services,

2. rising prices of financial and tangible assets,

3. rising trade deficit.

Most people focus on consumer prices, but the trade deficit and rising asset prices are also symptomatic of credit excess. It has become common folklore that rising financial assets just reflect economic growth feeding into profits and then prices, but few realize that core economic profitability has not been very strong. The table below shows the record of Nonfinancial profits, manufacturing and retail trade. These have all had a very poor profit performance taken over the last several years.

This point seems to be confirmed by the near record level of corporate insider selling in 2004 and in January this signal has intensified. According to Thomson Financial there was $55 of selling for each $1 of buying, a record monthly ratio of corporate selling to buying for over a decade. Corporate insiders are without a doubt the best informed market participants and their behaviour clearly suggests there is little confidence in the current market recovery.

 

Much of the growth in profits recently has resulted from many temporary effects,  such as from strong commodity prices, a weak dollar and tax cuts, not underlying profitability. In addition since 2000, average weekly earnings in real terms have virtually stagnated. An economy with weak underlying wage and profit growth can hardly be characterized as a strong economy. The conclusion is therefore that credit has played a far greater part in asset price performance and growth than is widely accepted or understood.

Furthermore, the explosive growth in consumer spending, has been supported once again by credit growth rather than wage growth. Spending from this source has also been excessive. The chart below shows the correlation between the current account deficit and consumer spending. The US is living way beyond its means and this is another sign of excessive credit creation.

 

Summary

Investors should understand that one of the best economic forecasters is the bond market itself, and should take time to interpret the message it is sending. It should not be a surprise that it differs, sometimes a great deal from consensus economic opinion, and it should be remembered that it has a far better track record.

We have argued that the US economy is not strong in underlying terms as many would have you believe. An explosive credit boom has enabled living standards to meet or exceed expectations, in the absence of core wage growth as well as underlying profits growth.  The evidence of this looks very compelling.

The signs of excessive credit creation are very clearly reflected in the trade deficit as well as in the high valuation of stock and tangible asset prices. Inflation has picked up somewhat but there are so many strong deflationary trends which have kept this subdued to date.

On this analysis there is almost no chance of an easy escape from the credit boom given its scale and longevity, but the credit bust will have to occur sooner or later. All credit eventually has to be repaid or forgiven. Alan Greenspan’s supposed genius in producing a wonder economy in the US is nothing more than an old fashioned massive credit expansion. He may be leaving the helm at the Fed just in time to dodge the downside of the coming credit bust, but we will need to find a replacement with the skills of Houdini, if we are going to achieve either a soft landing or avoid a severe recession. 

This outlook is wholly consistent with current bond market behaviour. Given its track record it would be foolish for anyone to dismiss what the bond market has been indicating. The bond market is telling us that the US economy is unusually weak and fragile to even a slow moderate rise in interest rates from record low levels. This is what you would expect to see in an underlying weak economy in a very mature credit boom.

 

 

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