Monday, December 29, 2008

It's always darkest before dawn -- why a panic rally can't be ruled out

Yields on 10-year Treasury bonds (currently 2.1%) have now fallen to almost the lowest levels ever recorded by the Fed. That's a remarkable statement, since the only time yields were lower was in 1941 (2.0%), just before the Japanese attacked Pearl Harbor. So you might say that not only are equities priced to a depression worse than we saw in the 1930s, and not only are corporate bonds priced to default rates worse than the worst of the 1930s, and not only are TIPS priced to years of outright deflation—all of which I've documented in earlier posts—but now Treasury yields are priced to conditions equivalent to the onset of a World War. That's an awful lot of pessimism out there.

Which means that in order to be bearish on the prospects for corporate bonds and stocks, you have to believe that what awaits us around the economic corner is at least as bad as a combination of the worst scenarios that modern man has ever witnessed: deflation, depression, and world war.

I can't rule out any one of these scenarios, I admit, but that they all occur together seems a bit of a stretch, to put it mildly. Especially when you observe the following:

Monetary policy has never been easier. The Fed has pulled out all the stops. All measures of money are at or near all-time highs. Bank lending is at or near all-time highs. All major central banks are in panic-easing mode.

Key inflation indicators are signaling inflation, rather than deflation. The dollar is below its average inflation-adjusted, trade-weighted value of the past 36 years. Gold is trading at $880, twice its average value, in inflation-adjusted terms, over the past 100 years. Crude oil is trading 25% above its average value, in inflation-adjusted terms, over the past 50 years. Non-energy commodity prices are trading 25% above their lowest level, in inflation-adjusted terms, over the past 50 years.

Housing prices have fallen more than 30% from their recent highs, in inflation-adjusted terms, yet sales activity is brisk and financing costs are lower than they have been in generations.

Key financial indicators such as swap spreads, agency spreads, and implied volatility are all significantly better than they were at the height of the panic a month or so ago.

The world has never been so interdependent on global commerce. U.S. exports are now over three times larger, relative to the size of our economy, than they were in 1970. Trade as a percent of GDP is at its highest level ever for all major economies.

The U.S. employment situation is not materially worse today than it was in the 2001 recession, which was the mildest in recent memory.

In short, deflation is unlikely because monetary policy has never been so easy; depression is unlikely because none of the conditions that led to the Great Depression (e.g., extremely tight money, rapidly rising taxes, massive government intervention in the economy, and a global trade war) exists today; and world war is unlikely because no economy today could afford a significant disruption in world trade. To be sure, Obama might give us massive government intervention, but that remains to be seen, he has cooled his anti-trade rhetoric, and he has apparently ruled out higher taxes for at least the time being.

If the year 2008 will be remembered for anything besides the election of Barack Obama, it will be the panic selloff which drove global equity markets down by 50%. Investors panicked at the possibility of a deadly combination of deflation and depression, triggered by the collapse of housing prices and a massive, forced unwinding of leverage, all amplified by a sudden drop in demand as consumers retrenched almost overnight. In their panic, investors were so desperate for safe havens that yields on cash fell to zero, and yields on Treasury bonds fell to levels below those which prevailed during the Great Depression. Credit spreads rose to their highest levels ever, as investors anticipated a massive wave of bankruptcies exceeding the worst that occurred in the Depression.

So what happens next?

Those who sold and are hanging out in cash and gold can take little comfort from the fact that they are earning no yield on their investment. What positive returns they may eventually realize would come only from a general deflation which drives down the prices of everything, thus boosting the purchasing power of their cash and gold holdings. In the meantime, those who still own equities are likely to receive dividend income of at least 3%, and those who own corporate bonds are likely to receive coupon interest of 6-20%. Those yields could be offset by a sharp rise in bankruptcies, or a further sharp deterioration in the economic outlook, but for the past month or so, equity prices have been relatively stable, and corporate bond prices have been increasing. Even commodity prices appear to be stabilizing. If prices don't fall, equity and corporate bond yields offer compelling values.

If a global deflation, depression and trade war fail to materialize (and surely we aren't on the verge of a world war, are we?), there is going to be a gigantic gap between the returns on cash and just about every other financial asset in the world. Financial markets abhor such gaps, otherwise known as arbitrage opportunities, and the opportunities could spur rapid increases in prices for stocks and corporate bonds.

It is extremely regrettable that world financial markets are in roller-coaster mode, and a good deal of the blame lies with erratic monetary policy and massive government intervention in housing markets (i.e., Freddie and Fannie). But just because financial asset prices have been in free-fall this past year does not mean that the global economy is going to collapse. We’ve seen a sudden panic selloff, so we might soon see a sudden panic rally, especially if today's problems are financial in nature and the financial markets are healing themselves rapidly. The financial meltdown of the past year could be followed by a "melt up" next year. Even if it's not a panic rally which ensues, at the very least I think it pays to be optimistic given the extreme degree of pessimism evident in today's markets.


Taylor Frigon Capital Management said...

Great post. Totally agree that "erratic monetary policy and massive government intervention" has led to the "roller-coaster mode" -- not just 2007-2008 but throughout the entire Greenspan era which was marked by volatile monetary policy culminating in a series of booms and busts since the 1990s. Obviously the most recent one is more excessive than its predecessors. Do you foresee anything that will moderate these increasingly excessive swings?

Gerry Frigon
Taylor Frigon Capital Management

Scott Grannis said...

The events of recent years will provide much grist for the world's economic majors to study. I can only hope that a consensus develops which then informs policy in the future. It might take a few years, however. The bad thing about economics is that it is not a science, and bad ideas can get turned into destructive policy way too often.

I hold out some hope that, thanks to the internet, folks like me can perhaps have some influence on the future course of events. Knowledge that is widely and quickly disseminated can't be a bad thing.

Regina said...

Thanks Scott,
Another great post. I think the next 2 years are going to prove a difficult landscape to trade, especially in the OTC space. Taking FX as an example, while spreads on forward rates and implied vols are not at the insane highs they were recently, they're still all but untradable, and when they do converge enough to put on a few bets it will be only in the short-dated tenors (<=3 months). Not exactly healthy, and certainly not for people who want to deal. This is FX, which is generally very liquid. Regards,Regina

Scott Grannis said...

Regina: I find it hard to believe this problem will last another two years. Liquidity has already started to improve, and further improvements could come more rapidly than the the initial improvements. Once a virtuous circle gets started, we should be Ok, and I think we are in the early stages of this already. At least I hope so.

Brian H said...

Great post Scott. Thanks for the long-term perspective.

Taylor Frigon Capital Management said...

Scott - thanks for the reply. Let's hope so!

Unknown said...

Based on that chart... could you make a good argument for shorting the 10 yr treasury? Even the smallest increase in interest rates could generate a 20-30% drop in 10yr treasury prices...

Likewise, if interest rates go even lower treasury prices could rise real quick creating a costly short squeeze.

Scott Grannis said...

I think it's clear that if stocks rally, as they are now, the yield on 10-yr Treasuries will rise. Any sign of economic recovery, and/or any sign that deflationary pressures are diminishing, will be VERY bad news for holders of Treasury bonds. I think the risk/reward for Treasuries is very skewed towards the side of loss. So shorting the 10-yr is a good idea if you're optimistic that the economy can avoid disaster. Bear in mind that shorting the 10-yr has a cost, since the yield curve is positively slowed, of about 1.5% a year, so you need yields to rise just to break even. That happened today, by the way, as yields rose 15 bps.

Unknown said...

How about 10 yr treasury strips... Those would be less costly to short, right?

Scott Grannis said...

The yield on 10-yr Treasury strips is actually about 75 bps higher than the yield on 10-yr Treasuries, so it's not cheaper to short strips.