Monthly Archives: June 2015

why bonds go down when interest rates go up

June 9, 2015 By in Basic Concepts, bond market Tags: , , , 2 Comments

This is  pretty straightforward story.  The example that follows is much too simple, but it makes the point.

 

Suppose I bought a 10-year Treasury bond with a coupon yield of 2.38%–the going rate–for $1000 yesterday afternoon. For my $1000 I get interest of $23.80 each year for ten years plus my $1000 back at the end of the term.

Let’s say that the Fed raises short-term interest rates sharply this morning, in a way that makes the yield on the 10-year rise to 3.00%–completely unrealistic, but this is just an illustration.

After this happens, for $1000 I can now get a 10-year Treasury that makes ten payments of $30.00 per year–a total over the next decade of $62 more than on the 2.38% bond–in addition to return of my $1000 at the end.

How much is my original 2.38% -coupon bond now worth? Put another way, how much would someone else now pay me for it?   I don’t know exactly   …but it’s certainly less than $1000.

 

navigating the next twelve months (i)

June 8, 2015 By in Current Market Thoughts, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , 3 Comments

As I wrote on Friday, I think we’re at an inflection point in the US stock market.  It seems to me the market is now beginning to take seriously the idea that the Fed will soon be beginning to raise interest rates from the current near-zero.

In one sense, this is not Wall Street’s first rodeo.  There are plenty of times in the past when the Fed has been reversing emergency monetary accommodation applied during a recession.  The investment community has already sifted through them ad nauseam.

On the other hand, the extent and duration of the current monetary easing are both without precedent.  At the same time, the way the market factors new information into stock prices has changed considerably over the last decade.  The goals and risk preferences of the Baby Boom, the most powerful retail influence on stocks, have shifted as well, as that generation has aged.

Boomers are more interested in income than in capital gains.  Hedge fund managers and algorithm-fashioners seem to have very short time horizons–almost reacting to information as it hits the news media rather than anticipating it.  (I almost cringe to write this last.  It reads a lot like the criticisms made by elderly patrician money managers of the past (whom I made fun of at the time) who held stocks for decades at a time and were struggling to adjust to the faster-paced market of my early years on Wall Street.  Still, I think what I’m saying is correct.)

Therefore, I think, we can’t just blindly apply generalizations from the past to our present situations.

two types of tightening

It’s important from the outset to distinguish between two types of Fed tightening:

–restoration of the real rate of interest from negative to positive as the economy recovers from recession, and

–raising the real rate of interest substantially above inflation in order to slow down an economy that’s potentially overheating.

Today, we’re dealing with the first kind, not the second.

what the past tells us

During past periods of Fed tightening of the first type, stocks have been volatile but have generally gone sideways to up.  Bonds, on the other hand, go down.

This, in itself, has implications for stock market strategy.  Stocks that resemble bonds the most tend to do particularly badly; (at least some of) those that resemble bonds the least do the best.

More tomorrow.

 

 

the May 2015 Employment Situation

June 5, 2015 By in bond market, Constructing a Portfolio, Current Market Thoughts, Employment Situation report, securities markets, stock market, Strategy Tags: , , , , , , , , Leave a comment

the May Employment situation

At 8:30 am, est, this morning the Bureau of Labor Statistics of the Labor Department made its usual release of the monthly Employment Situation.  The report showed the economy added +280,000 new jobs during May, substantially higher than economists’ estimates of +225,000.  Of the total, 262,000 positions were in the private sector, 18,000 in government.

Gains in government employment are almost exactly offsetting declines in mining/oilfield.

revisions

Revisions to prior months’ estimates added another 32,000 to the tally.

Average hourly earnings were up by 2.3%, year on year, showing no acceleration from their recent tepid growth, despite the low current unemployment rate (5.5%) and the sharp employment gains.

why the report in important for investors

What I find interesting is the financial market reaction to the positive report, namely:

–S&P 500 future have declined modestly

–the US$ is up by about a percent against the euro and the yen

–gold is down a percent in dollars (flat in euros or yen)

–in pre-market trading, financials (higher interest rate beneficiaries) are doing relatively well, utilities (whose attractiveness as income vehicles is lessened by higher rates) relatively poorly.

the message

In other words, the message the market is taking from the ES is that the Fed is going to begin to raise short-term interest rates relatively soon (September?).

I think this ES most likely marks an important turning point in market psychology.  Since early 2009, investors have taken heart–and portfolio positioning cues–from the idea that interest rates were extremely unlikely to rise and might possible decline. Investors who adopted an appropriate portfolio structure have been rewarded by seeing rates fall to what were initially undreamed of low levels.

That period is over.

Now rates are highly unlikely to fall and may rise.  Although rates will doubtless rise very slowly and may reach “normal” at much lower levels than in previous economic cycles, this is an important distinction.  It implies that the market will (finally) reorient itself into anticipation of rising rates.  It doesn’t need to have a precise idea of where rates are headed.  The key thing is that the easing trend of the past seven years or so is behind us.

More on Monday.

 

 

the IMF request to the US–don’t start raising rates until 2016

June 4, 2015 By in Current Market Thoughts, economics, EU financial crisis, Federal Reserve, Recent Market Action, stock market Tags: , , , , , , 1 Comment

the report

In its annual review of the US economy, the IMF has included a request that the Fed postpone raising rates until the first half of 2016  (I’ve searched without success for the 10-page analysis on the IMF website, so I’m relying on the FT and Bloomberg for my information.)

To start with the obvious, this can’t be the first discussion of the idea of pushing back rate hikes between the IMF–dominated by EU interests–and the Fed.  The release isn’t the act of some nerdy economist (is there any other kind?) tacking the request on to a report that the top figures in the IMF didn’t review.

No, this is the IMF going on record as saying  it thinks the Fed beginning to normalize rates this year is a bad idea   …and that its request for delay has been rebuffed by the Fed.

the rationale

Its rationale seems to be that higher short-term interest rates might cause a sharp contraction in credit availability in the US and a consequent inadvertent loss in domestic economic growth momentum.  Given that the EU is counting on reasonable demand in the US for its exports, the follow-of effect of the US stalling might be disappearance of green shoots of recovery in the EU as well.

Higher rates might also cause the US dollar to rise.  While a stronger currency would slow the US economy further, it would also increase the attractiveness of foreign goods and services (including vacations) vs. domestic.  The latter factor would be an overall plus for the EU.  Companies would be the main beneficiaries, however.  Ordinary consumers would be hurt through a rise in the price of dollar-denominated goods like food and fuel.

the response

The consensus view in the US, I think, is that:

–official statistics understate the strength of the US economy,

–seven years of intensive-care-low interest rates in the US is long enough,

–a rise of .25% or .50% in rates would have no negative effect

–it might also be a positive, in the sense that the Fed would be signalling that the economy can at least partially fend for itself.

In short, the view is that prolonging anticipatory anxiety is far worse than raising rates a tiny bit and seeing what happens.

The EU economy, on the other hand, is maybe two years behind the US in absorbing the negative effects of the near collapse of the financial sector.  Instead of flooding the area with money–the US approach–it has relied on collective austerity to heal itself.   Sort of like leeching vs. antibiotics.

So the EU has less ability to deal with the negative effects of a US slowdown than the US itself has.  Dollar strength would be another blow to an already beaten-down EU consumer, fueling further politically disruptive far right sentiment, which to me already looks pretty ugly.

In the Greenspan era, the US would probably have accommodated the EU.  Post-Greenspan Fed chairs have made it clear, in contrast, that US interests come first.  The IMF comments reinforce that this is still the case.

proxy advisers (ii)

June 3, 2015 By in Portfolio management, proxy advisers Tags: , , , 1 Comment

Yesterday I wrote about the genesis of third-party proxy advisory firms as a result of SEC insistence that investment management firms fulfill their fiduciary duty to vote in the best interest of their shareholders at the annual meetings of portfolio holdings.

The media don’t really understand the function proxy advisory firms serve:  they’re low-cost insurance/evidence that the manager takes his proxy voting duties seriously.  As the de facto authority in this arena, the proxy advisor is the first line of defense if the SEC, the portfolio holding in question or clients have any questions.  Hiring the adviser also eliminates proxy voting as an administrative task for the investment manager, as well as as a source of internal friction among portfolio managers.

Jamie Dimon of JP Morgan should understand this as wel–but apparently doesn’tl.  Calling investment management firms lazy and irresponsible does him no good.   It seems to me his outburst will only serve to heighten the proxy advisers’ sense of mission in speaking out against high executive pay.

I do have one quarrel with the proxy advisers, though.  In an effort to grow, they’ve branched out into selling services to the corporations whose proxies they analyze.  To my mind, this is analogous to the pension consultants who also manage money or the accountants who have–to their regret–provided consulting services to audit clients.  In other words, it’s a conflict of interest.  They shouldn’t be doing this.

To see why, we only have to look at the sorry case of the accountants, whose consulting arms pressured their auditing colleagues to overlook problems with client firm’s accounts for fear of–or after threats of–losing lucrative consulting business if the auditors were too strict.

Even the possibility that this could take place with proxy advisers undermines their authority as pure ly objective sources.