Interest Rates Heading Lower? Commodities Looking Good

Trying to discern the next direction of interest rates is tricky right now, but when I add up all the factors, it seems as if most of them are pointing to lower rates. The dominant player in the treasury market is likely to be the Fed, which has the ability to buy every treasury bond ever issued. The argument against rates going lower is that there will eventually be a US treasury default, but I would argue that the Fed will prevent that from happening by holding the line on interest rates. That doesn’t mean the dollar will do well, but that it is quite possible that rates will stay low no matter what. Oh, by the way, I’d try to buy some gold too!



* Yesterday I touched on a variety of subjects. One point I want to reiterate from yesterday’s blog was that the Fed has succeeded in moving the “printing of money” into the mainstream of acceptable policy responses. The process of printing money means the Fed will be taking fixed income securities out of circulation, and paying the holders of those bonds with newly created money. In turn, this puts pressure on interest rates to go lower. And when the Fed buys securities with longer term maturities, it puts downward pressure on rates in those maturity categories as well. Of the $1.725 trillion of money printing which the Fed did during 2009 and up to March of this year, this was the breakdown:


US Treasuries:              $300 billion

Agency debt securities:     $150 billion

Agency MBS:                $1.25 trillion


On average, I estimated at the time, that the duration of the securities was approximately 4 years, which resulted in the Fed taking about $7 trillion of duration out of the bond markets, which was predominately concentrated in Mortgage securities, and hence, should have had the greatest impact on mortgage rates. While that is the case, there is an element of transference, in which an influence on one set of rates, mortgage rates in this instance, will have a spill-over effect into other rates, in this case treasury rates, corporate bonds, and other high grade fixed income securities, including, but not limited to money market investments. And to a lesser extent, as US rates in general drop, money will likely flow to non-US fixed income securities as well for those investors who have a choice between currencies. But here is the point, as the Fed endeavors to buy securities, it will exert an downward influence on the interest rates on what they are buying, and in turn, this will influence all related interest rates.


Based on the outcome of the August 10th meeting, the Fed anticipated that it will see $400 billion of maturities or principal pay-downs on their $2 trillion portfolio, which amounts to 20% in total. The very act of re-investing these pay-downs and maturities will result in further downward pressure on interest rates, and will likely have a greater impact on treasury rates than MBS rates, since some of the MBS pay-downs will wind up as a refinanced mortgage, and will be sold into the market (marginally pushing those rates higher), while the Fed will be purchasing treasuries, which will directly lower those rates.


This is a very long lead in to a reader question about what they should do with their money, given that they are predominately in fixed income securities. Here is the reader’s question:


“Hi Rick, I’ve enjoyed reading your blog, and I’ve noticed that the advice seems a bit agnostic — that is, it does not consider what type of investor you might be.


For example, I am managing my family’s portfolio, which is tuned to a fixed-income situation, as well as my own which is a bit more aggressive.  I also suspect some of your audience may be even more accepting of risk…


It would be good to hear your point of view, tempered by the level of risk

individuals may be accepting…  i.e.: There has been a lot of contradicting

positions on bonds & bond funds recently, and an individual might be in one

camp or the other, depending on how risk-adverse he might be…


Any thoughts?” (End of readers question)


Ah, this is the $64 million question, or whatever level of money you invest. If you followed my strategies this year, you will remember that I was a little early to the bond market party, by purchasing 10 year treasury notes in March (at 3.7-3.8%), when only 1% of professional money managers had a bullish view on bonds, and of lower rates. I bailed out of this position in early-mid June, when the 10 year rate was at 3.1%. I have noticed that I am usually pretty good about entering a trade when the world is going the other way, and typically cash out of these trades once it becomes mainstream. Despite that victory, it remains to be seen what to do now, and rates are considerably lower than my early June bailout.


Here are my general thoughts:


1>   When the government has a chance to have such a large influence over all interest rates, by virtue of their open market activities, it is a force to be reckoned with, and for better or worse, investors are going to have to make decisions based on expectations of government actions;


2>   As I previously mentioned, in the late 1940s, there were 25 consecutive months of CPI readings above 8%, with an average inflation rate of 12.5%. Despite these inflation readings, the Fed held the line on interest rates by purchasing treasury bondswhenever they rose to 2.5%. Imagine that, 2 years of 12.5% inflation, yet the Fed held the line on interest rates at 2.5%. It’s been done before, and it can be done again.


3>   Despite all these bullish factors, there is a concern that the Fed might decide to be independent and a protector of inflation, and if the Fed does not play along with the low rate scenario, then those actions could trigger a collapse in the US bond markets.


4>   We are in a 30 year bull market for interest rates, see the attached graph. If I were to follow along with this scenario, it is quite possible that interest rates will make new lows. And since I have been in this business since the great bull market began, I can tell you that the mantra every time a new low in rates was made, was that we will never see another drop in rates as low as the low which just occurred. I have learned to never say never!


5>   If I overlay my very bearish forecast for US equities on top of my fixed income view, there is a very good chance we will see downward pressure on interest rates, at least over the short term. That still does not preclude some massive US debt crisis occurring later, but there is a very good chance that the next intermediate term (a few months) move will be lower in rates.


6>   Very short term, there have been bullish consensus readings coming from the futures markets that traders are exceedingly bullish, at 98%, and as that occurs, it means that the pool of potential buyers is limited, and that the next move is likely to be lower in price, higher in rate. This helps explain some of the bond markets correction since Friday. So we need to temper any bullish expectations with the idea that this is a crowded trade, and subject to swift corrections (higher rates).


When I add up all these factors, I am supposed to be bullish, yet there is something gnawing at me when I consider my concerns about the fiscal plight of the US government, and our “spend until eternity” scenario, which the Obama administration forecasts in its budgets for the next 10 years. Probably the best solution is to invest in bonds and duration through the upcoming fall, but to be prepared to shift course as the climate, and the situation dictates.


Along the lines of this theme, and in response to yesterdays blog, a reader sends in this comment:


“Good post, Rick. Here is a thought:


If the Fed is just going to print money to keep the stock market from going down, inflation will be a short distance down the road, as stocks are sold at prices far in excess of where they should be and people will be taking money out of the market and putting it into circulation (or under their mattress).

The old saying “you can’t fight the tape” might need an update: “you can’t fight the guy with the money printing press.”  The Fed will underpin the market for equities, just like it is for homes.  


This implies that all the market indicators developed over the centuries are now invalid, because “the house” is playing with funny money to make sure all the patrons, at least those with political connections, win and are happy and Judgement Day is put off a little longer.  


The Fed can’t raise interest rates much because the entire quadrillion $ unregulated derivatives market (CDS’s, etc.) will implode, taking with it every bank and currency. Interest rates can’t go much below zero, because people will switch to gold (your money is so bad, you have to pay me to borrow it).


With very low interest rates, it makes no sense to invest or lend to produce anything, due to the risk involved.  Hence, the supplies of manufactured and imported goods could begin to dry up.  It’s worth watching the shipping indexes, as well as local suppliers inventories to see if this comes to pass.  This Depression will be different — some people will have money, but like a Soviet store, there won’t be much to buy with it, comrade.” (end of readers comment)


There are a few points which this reader makes that I want to highlight:


1>   In the bond business, we DO say, “Never fight the Fed”. That remains our mantra. As the Fed did in the 1940s, they can easily underpin the treasury market and keep rates low.


2>   Eventually our money will become funny money, if we print enough of it. Part of the reason why it might take so long for our currency to become bankrupt is because our trading partners with US dollar surpluses, continue to stockpile dollars, and in the case of China, uses their dollar hoard to issue more of their own currency. It is when they run into problems with their currency, and have to sell dollars to make good on their bank losses, and other bad, Yuan denominated investments, is when the fun (or trouble) will begin for the US. So who knows when the day of reckoning will come, but when it does, it spells trouble for the US treasury market, and the dollar. Although I will add that if the Fed buys up all the treasuries it needs to, then it is possible that we will just have a dollar problem and not a treasury securities crisis.


3>   My gut feel is that investors will gravitate to commodity investments with their hoards of cash, especially in an environment of very low rates. If I was not so bearish the stock market, I would say that you should be buying commodities now. Instead, I am content to see if a falling stock market over the next few months manages to drag commodity prices lower. If it is perceived that the dollar is ‘funny money, then it is likely that investors will do whatever they can to convert this funny money into something else. In turn, that will create positive growth in these related sectors, and the industries which support the commodities complex.


What seems apparent to me is that we are entering another phase of money printing, and this will cause us the dollar to ultimately devalue. My discussion of relative value of alternative foreign currencies is coming, but not today. As I said yesterday, currencies will be manipulated by their sponsors, so as to promote exports, so on average, I do not think there are many places to hide. Nonetheless, the one currency which cannot be manipulated is Gold, which is the ultimate currency, and has been used for thousands of years. I do not think it will take that long before gold’s prominence will rise again.


* As for the first readers question as to what to do in the realm of fixed income investments from a personal basis, I would say that you have a rather difficult task. To the extent that you are already invested in a bond portfolio, I would say to hang on to it for the time being. As for new investments, or to replace maturities, I would be very cautious about committing too far down the yield curve. If you have to invest in very long term securities, which I would characterize as being 10 years or more, I would stick with corporate debt of companies you believe will make through the depression we are in. But I would emphasize that you should be careful of any corporate debt whose viability was called into question during the 2008/2009 financial crisis.


As for investing in TIPS (Treasury Inflation Protected Securities), I would wait to see how they fare through what I believe will be another repeat of 2008, when the real yield jumped as deflationary expectations forced the price of these bonds down. I would keep some powder dry for a time when you can buy TIPs at better levels, quite possibly this fall.


One other vehicle I do like for investing money for the short term, is in pre-refunded municipal securities. These securities are backed by US treasuries, and they have higher tax free yields than corresponding taxable US treasury rates. I hate money market funds, which typically invest money in short dated securities, often at a yield to the fund of 0.25%. But by the time the fund takes out their fees, you are usually left with a return below 0.1%. While not too risky, some money funds did break the buck in 2008, and might do so again in the future, so I would suggest that you should have your brokers hold any cash, as cash, with a 0.0% yield, and no risk. Don’t let them tell you that their money fund, at a 0.03% yield is risk-less; it is not!


I would also consider owning some gold. Since the returns on dollar fixed income has dropped so dramatically, the opportunity cost of owning gold is much lower. And as with the Yen in addition to Gold, those assets which carry at the lowest interest rate, have done the best over the last few years, and I expect them to continue to do so in the future.