Outside the Box

Hoisington Quarterly Review and Outlook – Second Quarter 2015

July 22, 2015

In today’s Outside the Box, my good friend Lacy Hunt of Hoisington Investment Management reminds us that since the 1990-91 recession, the 30-year Treasury bond yield has dropped from 9% to 3%, a downward move nearly identical to the decline in the rate of inflation, which fell from just over 6% in 1990 to 0% today. Therefore, Lacy says, “(I)t was the backdrop of shifting inflationary circumstances that once again determined the trend in long-term Treasury bond yields.”

During that 25-year period, though, there have been nine significant backups, when yields rose an average of 127 basis points, despite weakening inflation. Lacy attributes these periods to an “intermittent change in psychology … a strong sentiment that the rise marked the end of the bull market, and a major trend reversal was taking place.”

It’s happening again today, Lacy asserts; and he ticks off four misperceptions that have pushed Treasury bond yields to levels that represent significant value for long-term investors. They are:

  1. The recent downturn in economic activity will give way to improving conditions and even higher bond yields.
     
  2. Intensifying cost pressures will lead to higher inflation/yields.
     
  3. The inevitable normalization of the Federal Funds rate will work its way up along the yield curve causing long rates to rise.
     
  4. The bond market is in a bubble, and like all manias, it will eventually burst.

Lacy builds a strong case that fundamental economic forces are exerting downward, rather than upward, pressure on inflation. It’s a contrarian view – certainly not mainstream at this moment – but considering that Lacy has been right for well over 30 years, consistently pointing out through the nine periods when everybody was proclaiming the end of the bond bull market that the fundamentals were still pointing in the direction of lower interest rates.

I’ve had some late-night discussions with Lacy trying to figure out what would make him a bond market bear, and we have discussed what it would take for rates to truly rise long-term. I look around, and right now I don’t see those conditions.

Inflation is close to zero (as measured by the CPI) over the last 12 months. Commodity prices are back where they were 13 years ago (Bloomberg Index in chart below). The Fed is on track to, maybe, kind of, sort of, timidly, slowly raise interest rates starting sometime this fall, with Janet Yellen suggesting in her latest testimony that September might be the date. If trading runs to form, that will make the dollar stronger and put further pressure on price inflation. Just because rates go up on the short end of the curve does not mean the long end will follow. The tail does not necessarily wag this dog.

Make no mistake, I think that one day rates are going to rise and we will see the end of this bond bull market. I’ve been on the record for multiple years now that we’re going to see a final low in interest rates in the next recession, whenever that is. When that time comes you need to be ready to back up the truck and refinance every bit of debt that you can. In the meantime take advantage of the low rates at the low end of the curve. And pay attention to Lacy.

I was in the gym this afternoon training with The Beast. He normally plays rock ’n roll and heavy metal and we pump iron to a heavy beat. For whatever reason today, he was playing pop country. I know I’m from Texas and all, but I’ve just never been a big fan of country music. My kids didn’t hear it growing up, but several of them have become big country-western fans. Even my middle son, Chad, who likes to listen to rap and other similarly worthless attempts at music, has now become a country-western fan. That was one I didn’t see coming.

One of the singers started talking about the things he liked about growing up country: sweet tea, juicy cantaloupe, cane poles, and rebel flags – a litany of growing up in simpler times in the country. Each image in the singer’s long list brought back good memories. I doubt many of the younger generation have ever actually fished with a cane pole and cork bobber with twine, but the image still seems to make them wax nostalgic.

It’s a symbol, and like all symbols it invokes emotions and feelings. A good writer is constantly using symbols to create a mood for his readers, giving us word pictures that move us or inspire us, make us angry or fearful, make us joyous or peaceful.

Interestingly, I seem to find that same nostalgic mix everywhere in the world I go. I suppose it’s tied up with family and friends. In a world that seems to change around us moment by moment, we want to hold on to a few things we think are dependable.

Right now my plans are to drive down to the south of Austin on Sunday and spend the evening with George and Meredith Friedman. George has a home deep in the hills of Texas, and it’s been too long since we’ve been able to sit down and review what’s happening in the world. What better way to spend a summer day? I’m really looking forward to it. I have reason to believe we might be able to find a country station or three or four on that road trip. A little nostalgia every now and then is good for the soul.

Have a great week. Maybe I’ll even see if Lacy is around and drop by his office on the way back to Dallas. But for right now, let’s take a look at his latest essay.

Your watching the world go by too fast analyst,

John Mauldin, Editor
Outside the Box

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Hoisington Quarterly Review and Outlook – Second Quarter 2015

Misperceptions Create Significant Bond Market Value

From the cyclical monthly high in interest rates in the 1990-91 recession through June of this year, the 30-year Treasury bond yield has dropped from 9% to 3%. This massive decline in long rates was hardly smooth with nine significant backups. In these nine cases yields rose an average of 127 basis points, with the range from about 200…

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abbjrmd@gmail.com

July 23, 10:14 p.m.

In reply to jpenfolod@rcn.com, my concern would be more with large cap multinationals given the strong dollar and slowing global economy. I believe that the safest longerterm investments in equities are domestic particularly mid and small cap but one must be value conscious and selective.  This favors well managed mutual funds over individual stocks for most investors. I would rather have preservation of capital in money market funds than risk loss of capital as rates rise while making up for any inflation through domestic equity investments.

abbjrmd@gmail.com

July 23, 10:09 p.m.

The potential flaw in the basis of this commentary is his assumption that inflation as reported by the government is accurate while most individuals have seen higher than reported prices year on year in NON-discretionary prices—-food, insurance, medical care particularly which constitute the majority of their spending.
On the other hand, everytime stocks sell off, bonds serve as a safety net and rates go down——stocks while at fairly high valuations are not in bubble territory and not out of line with the yield on government bonds.  Another observation made by Carl Swenlin recently was the monthly PMO crossing down which is advanced warning of a possible bear market in stocks.  I would not risk owning debt at such low rates given the current risk of rising rates which might follow actual inflation as detailed above.

jpenfold@rcn.com

July 23, 5:24 a.m.

The US still drives the global economy and it is suffering stagnation at the lower entrepreneurial, credit consuming, productivity driving end of the economy. That end is being crushed by the growing regulatory burden which does not not harm in the least large cap.  That will end if a new Administration radically reduces the regulatory burden and wont, even we meaningful tax reform.

Alsalim.ali@gmail.com

July 23, 5:02 a.m.

“Inflation will not trough as long as the US economy continues to become even more indebted.”

“the secular low in Treasury bond yields is not likely to occur until inflation troughs and real yields are well below long-run mean values.”

Unless we pass a psychological indebtedness threshold and end up in a hyper inflationary scenario triggered by a loss of confidence (let’s assume yields stay low, debt service cost rises as a % of government budget - weakened by dwindling tax revenues in a low growth environment)

... in that case the fundamental inflation drivers are irrelevant.