A lot of experts will talk to you about investing in bonds. In recent months we have read and heard many opinions regarding fixed income market conditions from non-fixed income professionals. In fact, with the exception of Bloomberg News, the majority of the financial media has chosen to obtain fixed income market opinion from sources that do not have their boots on the ground of the fixed income market. There is real danger in getting one’s battlefield information from those who are miles away from the trenches or those whose knowledge is based purely on theory. Military history is filled with such folly.
The Vietnam War is one such event in which military planners got so much wrong. One of the first areas in which an ignorance of real combat conditions was in the air war. In the decade which preceded the United States entry into the Vietnam conflict, modern U.S. air warfare doctrine stated that air battles would be fought at supersonic speeds. Thus dogfighting was obsolete. As such, modern U.S. fighter jet design focused on high top speed and missile armament, at the expense of maneuverability and the use of guns. After the first few encounters with enemy jets over Vietnam, F-4 Phantom pilots reported that they were having difficulty dealing with the slower, but more nimble MiG-19 fighters.
The Phantom was built as a high-speed interceptor. By doing so it sacrificed maneuverability. Since air battles were supposed to be fought beyond visible range, the Phantom, was designed without a gun. Rules of engagement which required visual identification of enemy aircraft and the preferred tactics of enemy pilots for low altitude turning fights put the Phantom and U.S. pilots at a disadvantage. Another factor was, because dogfighting was supposed to be obsolete, U.S. pilots had very little training on the subject. In spite of pilot reports, U.S. military leaders held fast to the idea that the Phantom was well-suited to the task and did little to adjust to new realities. This was in spite of the fact that the U.S. Navy had a fighter (the F-8 Crusader) which was well-suited for the kind of aerial combat experienced over Vietnam. However, the Navy the U.S. Air Force and the Defense Department were all committed to the Phantom. As a result, U.S. pilots could not win complete air superiority in the early stages of the war. An additional problem was that air-to-air missiles of the time were notoriously inaccurate and prone to failure.
However, by 1969 (after four years of disappointing results), the United States Navy conceded that prior aerial warfare doctrine was incorrect for the situation over Vietnam and established the United States Navy Fighter Weapons School, also known as “TOPGUN.” The mission of the school was to teach dogfighting. This, plus the addition of a gun in the F-4 Phantom, turned the tide in the skies over Vietnam. The air war over Vietnam teaches multiple lessons:
In spite of the best planning, actual conditions rarely turn out as expected.
One must always acknowledge reality and maintain flexibility.
No matter how advanced one’s technology might be, it can be defeated by an intelligent and flexible opponent.
We draw parallels to today. Based on strategy reports and financial arguments we have read, many investment models appear poorly suited to today’s moderate growth and low-flation/disinflation environment. Only now are we hearing and reading comments from outside the front line of the bond market that the economy, interest rate environment and inflation conditions have probably changed. Still, many investment strategists continue to hold onto preconceived investment doctrine.
Is the bond market is underpricing growth and inflation?
We have read several reports published by the portfolio strategy department of a large investment firm which continually opines the bond market is underpricing growth and inflation, in spite of all evidence to the contrary. Pundits continue to point to the 5.3% Unemployment Rate as a sign employment conditions are not only healthy, but rather tight. This in spite of a U6 Rate over 10%, lackluster wage growth and global competition for labor (which might become more intense as emerging economies continue to slow). It appears that some strategists are unwilling to acknowledge that the war they are fighting is not the same as the one for which they were prepared.
Another problem is that we have many strategists who were never in combat. By this we mean, they understand the fixed income market from a theoretical perspective, but have a poor understanding of the fixed income market in the practical sense. When we combine rigid investment thesis with a lack of understanding of what makes the bond market react as it does, it becomes clear as to why so many predictions of higher interest rates, tighter credit spreads, etc. have (mostly) not come to fruition.
We’ve also noticed a simplistic approach to finding relative value. We have read “investment ideas” which are based on a bonds trading at higher yields/wider spreads than other similarly-rated bonds. Another idea we read this morning stated that fixed-to-float preferreds with five years of call protection were trading at wider spreads than fixed-to-float preferreds with ten years of call protection. The report compared the yield of five-year call and ten-year call fixed-to-float yields via a G-spread (non-callable duration-matched UST yields). Although it is true that ten-year non-call fixed-to-floats are trading tighter than 5-year non-call fixed to floats, there is a reason. The reason for the spread difference was not mentioned in the aforementioned report.
The reason is; if the Fed raises the Fed Funds Rate only slowly and modestly, Libor benchmarks for these fixed-to-float preferreds should rise only slowly and modestly. Since fixed-to-float preferreds tend to begin floating on their first call dates (if they are not called), it is possible that coupons of some fixed-to-float preferreds actually float lower when coupons begin floating. If the yield curve is fairly flat at the time fixed-to-floaters are set to begin floating, they might be called in rather than allowed to float.
The possibility that short-term rates could be fairly low in five years (the Fed could even be in another easing cycle by then) is why we suggest fixed-to-floaters with the widest floating spreads we can get (at least +300 basis points). We want to be protected from low short-term rates as much as we wish to benefit from rising short-term rates. Simply stating that spreads are wider is not enough. It is not that difficult to do. It only took us a few paragraphs.
Ground Control to Major Janet
Prices of long-dated U.S. Treasuries are trending lower today after comments by Fed Vice Chair, Stanley Fischer in which he stated that low inflation should be temporary, and after the Labor Conditions Index rose 1.1% versus a prior revised 1.4% (up from 0.8%). Although conditions are improving, labor markets have been improving at a slower pace in 2015.
Labor Market Conditions Index since 2009 (Source: Bloomberg and the Federal Reserve):
I believe a September tightening liftoff is on the table. I give it about a 60% chance. However, I believe that most of the upward pressure on interest rates should be on the short end of the curve, with the two-year UST yield rising more (perhaps significantly more) than the 10-year UST yield. Fed tightening should add to the fundamental strength of the U.S. dollar and thereby blunt inflation pressures. It could also hold down commodity prices.
Although the strong U.S. dollar is helping to hold down commodity prices, I believe there is more to low commodity prices than a strong USD and a supply glut. This year we are also noticing a drop in demand and/or slowing demand increases for many commodities, including energy. Thus, I do not expect a sharp rebound in commodities prices anytime soon. This should mean weak inflation pressures for the foreseeable future.
What is not known is; how much of a Fed tightening is already built in to the current value of the USD. We shall know more in just over a month.
Video Killed the Radio Star
I’m always listening to outside opinions. Iv’e found that we learn more that way. In a Barron’s article published this weekend, DoubleLine Capital’s Bonnie Baha made the following observation:
“Millennials just don’t have the same spending patterns their parents did. They see homeownership as a burden, not a goal.”
“Technology has also changed the workforce. Look at our industry—it takes half the amount of staff today that it took 10 or 20 years ago to do the same analysis. These big pervasive trends have pushed down the propensity for inflation to climb.”
I agree wholeheartedly. It seems so obvious that I am surprised that more financial professionals have not subscribed to this line of thinking. It seems that they need a TOPGUN lesson.
There has been much discussion regarding the IMF’s consideration of making the Chinese yuan a reserve currency. Specifically, concerns have arisen that the yuan could unseat the U.S. dollar as the world’s main reserve currency, or at least diminish its importance. First Trust economist , Brian Wesbury published a video explaining why such fears are overblown. With Mr. Wesbury’s permission, I have included a link to his presentation here.
About Thomas Byrne
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.