Merrily Rolling Down the Yield Curve

Your humble and chronically bemused blogger drank the Kool-Aid today and added a substantial amount of a specific type of bond to his IRA holdings, transforming zero-yielding cash into a zero-coupon Treasury bond of 8 years duration. This was done while continuing to hold a substantial percentage of our family savings in gold and while being aware that the MIT Billion Prices Project is showing a price inflation rate that makes my 2.64% implied annual yield a loser in real terms.

(Do I contradict myself? Very well, then I contradict myself.)

Here is the thinking behind my latest speculative foray into bonds.

Basically this is a play for modest capital gains.

First, one must understand that when one buys a bond, one's broker will quote you a yield. But the reality is that the transaction is one in which price is the reality. The yield you are quoted is, forsooth, a derived value. It is not a toxic derivative as in CDO-squared sorts of derivatives, but it is a derivative value. In the case of most bonds, which pay coupon interest periodically before the borrower is supposed to return the invested principal, computation of effective yield is more complex than most people realize. One has to make assumptions about such matters as reinvestment returns on the interest payments, for example. Furthermore, standard bond tables assume that the interest is reinvested at the coupon rate of the bond. In a world where short-term money yields nothing, however, that calculation ends up overestimating the real return that a lender receives.

If one's goal in purchasing a bond is to attain a capital gain, the purest bond is one that pays no interest and thus does away with the reinvestment problem. This bond, commonly called a zero-coupon bond, trades at a price with a yield that can be computed with a compound interest calculator. Here is how to make lemonade with zero coupon bonds. First, one should have a non-callable bond. You have to be confident of the maturity date.

This is where Treasuries are almost unique in bond land.

Next, you want a positive yield curve, which is one in which the annual yield is higher as the duration of the bond increases.

So when I called up the broker today, I asked for the prices and yields on 7 and 8 year Treasury bonds. They were about 84 and about 81 respectively, correlating with yields of 2.44% and 2.64%. I purchased some 8 year (2019 maturity) bonds at around 81. What this means is that assuming los Federales are still in business in 8 years, they promise to pay me $100 for each $81 worth of bonds today, but they will pay me nothing till then. Annualized that's about 2.6% yearly. However, if I want to make a similar investment but want $100 back in 7 years rather than 8, I will have to fork over $84 today.

Let's now look forward one year. Let us say that for whatever reasons, the yield curve is unchanged. In that case, I will then be the owner not of an 8 year bond, but rather I will own a 7 year bond. All things being equal, the value of my bond will have risen from 81 to 84. Taking the fractions into account, my 2.6% bond today will rise 4.0% in value (from 81.18 to 84.47). It's a form of financial alchemy, in a sense. All I need to get a 1-year return almost equal to the return from lending money to the government for 30 full years is for the interest rate structure to simply not change.

This sort of activity is called rolling down the yield curve. It is one of the SOPs among bond portfolio managers.

In making this bet, I am taking the point of view that the Economic Cycle Research Institute is correct in its call for Treasuries rather than stocks or industrial commodities as preferred investments in the months ahead. In this scenario, we should remember that as recently as November last year, the 5-year Treasury traded with a yield below 1.1%. And that was merely in the setting of a growth slowdown, at a time when gold and silver prices had already been surging for months. What if there is a full-blown global industrial downturn, with oil in the $60-80/barrel range and copper at $3/pound or less? And perhaps silver at $25/ounce again, or lower? Who knows where the herd will take Treasury prices in the seemingly unending cascade of financial asset inflation that has been occurring for decades?

In that (quasi-)recessionary scenario, there is the potential for this boring debt instrument to return 5-10%, possibly in as little as 6 months.

Of course, there are numerous risks to this approach, most obviously the one that price inflation makes this 2.6% yield look trivial. My answer to that is ownership of gold so long as interest rates are at or below the general price inflation rate, no matter what the economic cycle is doing. I would then supplement that by adding economically sensitive, "weak dollar" assets when economic activity appears to be troughing or accelerating. But in a world where there are central authorities who are determined to make savers pay to recapitalize financially weak financial institutions by forcing them to receive rates on money in the bank that are below the rate of price inflation, one thing is mathematically certain.

Pitiful as a yield of 2.6% may be, it is greater than zero.

In a world where little except the air we breathe is cheap, beating zero with the chance for capital gain due to a possible major deceleration of economic activity seems reasonable to me.

Copyright (C) Long Lake LLC 2011

ECRI Rings a Bell

From the Economic Cycle Research Institute:

WLI Growth Falls to 40-Week Low
May 14, 2010

(Reuters) - A measure of future U.S. economic growth fell to a four-week low in the latest week while its annualized growth rate hit a 40-week low, indicating a slowdown in the recovery in the coming months, a research group said on Friday.

The Economic Cycle Research Institute, a New York-based independent forecasting group, said its Weekly Leading Index fell to 132.0 in the week ended May 7, from 134.7 the previous week.

The latest figure is the lowest level since April 9, when it stood at 131.3.

The index's annualized growth rate fell to 12.2 percent, from 12.7 percent, its lowest level since July 31, 2009, when it stood at 11.2 percent.

"With WLI growth falling to a 40-week low, the pace of improvement in the overall economy is set to slacken in the months ahead," said Lakshman Achuthan, managing director of ECRI.

As has been pointed out interminably in this blog, economic reality is what it is. Rising stock prices mean little. The above press release says it all. Stocks are falling because the second derivative of growth in the economy has already occurred, it would appear, and not at a very high level. Now we are looking at decreased exports to Europe as the euro collapses; worries about oil production and damage from the Gulf oil spill, and the like.

Most important to the leading indicators is the drop in the 10 year Treasury yield. As the economy grows, the case for ZIRP recedes. Most of the leading economic indicators are interest-rate related. Whoops! The classic pattern after a recession is for a decline in the rate of growth of the economy as the growth continues in a decelerating fashion. Think lift-off of a rocket ship from Cape Canaveral. It's a two-way market now. But it is NOT a new recession--though if oil prices skyrocket related to the spill, all bets are off.

Copyright (C) Long Lake LLC 2010

Is ECRI's Optimism Sign of an Impending Market Top?

The top-notch economic forecasters at the Economic Cycle Research Institute are human, as was discussed recently by Mish; to read his extensive and often-incisive comments, click HERE. ECRI's caution about the economy all through 2008, and their increasing concern beginning on or about early September, was useful to my investing. However, how useful is ECRI at extremes?

Here are some comments from ECRI in late February 2009 in WLI Remains Near Cyclical Low, as the bear market was within days of ending (though not at its bottom):

The annualized growth rate inched up to negative 24.0 percent from negative 24.5 percent. "While the WLI rose for the first time in six weeks, it still remains near its cyclical low," said Melinda Hubman, research associate at ECRI. "An economic recovery is not at hand," Hubman added. The weekly index rose due to lower interest rates and stronger housing activity, with the gauge partly offset by a decline in stock prices, Hubman said.

OK. "An economic recovery is not at hand." Implicit message to investors: don't buy. And, of course, said recovery was not "at hand". No criticism from yours truly. But if you bought then and help the SPY, you'd be up about 50% as of today. Similarly, if you bought in mid-late October and November 2008 based on plunging WLI and WLI growth rate and held till today, you would be up. You would have been down a lot temporarily, and all this is with perfect hindsight.

And, ECRI has pounded the table on the economy, and you can actually chart the upmove in its WLI growth rate and correlate it with the stock averages.

Where are we today?

ECRI says: US Recovery Poised to Trounce Any Obstacle
October 16, 2009
(Reuters) - A weekly index of future U.S.economic growth edged down in the latest week, but its yearly growth rate rose to a new record high that further suggests signs of a tapering recession, a research group said on Friday.
The Economic Cycle Research Institute, a New York-based independent forecasting group, said its Weekly Leading Index slipped to 128.1 in the week to Oct. 9 from an upwardly revised 129.1 the previous week, which was originally reported as 128.3.

But the index's yearly growth rate climbed to a fresh all-time high of 27.9 percent from 27.4 percent the prior week, which was revised higher from an original 26.1 percent.

The group's data has posted annualized economic growth at record high rates since September. Earlier this year, the growth rate was struggling to dig itself out of deeply negative territory.

"Such a pronounced, pervasive and persistent upswing in the WLI and its components assures that this economic recovery can overcome any obstacles in the months ahead," said ECRI Managing Director Lakshman Achuthan.

The report's yearly growth gains are in step with U.S. industrial production figures released earlier on Friday that suggest the third quarter closed out with surprisingly strong economic growth.

"IP numbers are very much in line with our April forecast that recession would end over the summer," said Achuthan, who has said chances of a double-dip recession are highly unlikely.

Meanwhile, the VIX collapsed under 21 today briefly, closing down 1.34% while the SPY closed down nearly 1%. As these indices normally move together, this is another negative divergence; another finger on the scale on the bear side.

Given that the certainty that the U. S. economy is mature, then exactly what the economy does for a quarter or two has little meaning in the context of stocks being valued at (say) 20 times their yearly earnings and 50 times their dividends, or 10-30 year bonds.

The public has shown extremes of optimism on standard measures for months, and this is a common phenomenon early in bull markets; and it is also standard for insiders to avoid buying. After all, they get nervous in depressions and bear markets, and they may not be rich with cash after the bear market. These facts are why certain seers have been short the market and wrong for months.

Meanwhile, stores are closing in the wealthy area in which I am renting a cottage, and the mid-range housing market is above the Fannie/Freddie conforming loan limit and remains weak. In the real world, I know almost no one who really cares about the stock market anymore as anything but a game, and the general feeling is "God Bless Bernanke" for saving the financial system.

The collapse in the VIX this month suggests that at the least, matters have moved beyond the successful speculative rally stage into the complacency stage. There are lots of profits to be taken in stocks that have gone up 3-7 times in 7 months.

The good news is that value stocks such as WMT, MCD, GSK and others are seeing rising prices.

The averages may or may not move much, but watch for rotation into the quality names that have seen little or no bull market since March. And

Copyright (C) Long Lake LLC 2009

The ECRI Doth Pound the Table Too Much

The Economic Cycle Research Institute may be going a bit overboard. It is by now hardly a surprise that, with new home construction near zero, auto sales not much more than half their high, with unprecedented monetary stimulus in the U. S. and elsewhere, the longest economic banana since the Great Depression will give wa y to some degree of growth one of these days. Growth of 1% - which merely equals population growth- counts as growth, though it will not feel very good.

Why then does the ECRI come out today with the following news release (through Reuters, as always): WLI Virtually Pounding Table on Recovery, which states:

"With WLI growth rocketing up almost 30 percentage points in six months, it's virtually pounding the table about the recession ending this summer," said Lakshman Achuthan, managing director at ECRI.

(The WLI = Weekly Leading Indicators.)

Within the past week, I saw a clip of an interview with Dr. Achuthan, who at the end of the interview not only predicted that growth would resume by Labor Day, but he recommended that stocks were a good investment.

I feel that this last statement is an absolute no-no. While the stock market has been a leading indicator for the economy, it's circular to then say that the leading indicators are good predictors of the stock market. I would be more bullish if he had warned people that stocks, up 40% or so from their low point less than 4 months ago, and at above-average P/E ratios and historically low dividend yields, may be poor investments. He certainly could have done well to have pointed out that had one bought the stock market as the end of the 2001 recession loomed, much lower lows lay ahead a year and a half later.

David Rosenberg points out that the Conference Board's Leading Economic Indicators, which are strongly positive, would have been slightly lower on the last report if they were limited to the real world indicators; all the money-finance indicators such as money supply, stock market and yield curve are what are predicting growth. In other words, it's all about "stimulus".

He is not impressed.

The bull market that peaked in 2000 far exceeded the valuations reached in 1929. The crash, adjusted for inflation, since 2000 has been tremendous, but has only brought valuations at best back to average. The Federal Government now controls or directly influences massive segments of the economy; this will probably lower the P/E ratio. Purveyors of used stocks need volatility to make their money. When the ECRI goes from cheerleading its predictive ability (it is a business, after all) to cheerleading the stock market, it's no longer AAA-rated; and neither is the market it is flogging.

Copyright (C) Long Lake LLC 2009

ECRI BULLISH ON ECONOMY

In a perhaps unprecedented action, the Economic Cycle Research Institute has a long, detailed free writeup today here on why it is forecasting the end of the recession soon.

It is a "must read".

Copyright (C) Long Lake LLC 2009