Fixed Income/Credit Market Strategy
By Julien B. Booth
July 31, 2015
Yield Curve – A lot Less Curvaceous
The beauty of the present macroeconomic environment is that there is a new “fiasco” to consume financial media, almost daily. While Greece and the Europeans have moved from center stage (though just yesterday IMF declined to participate in the 3rd bailout) we have fresh data on the U.S. economy – and it was not as robust as the talking heads had proclaimed.
U.S. GDP growth (first release) was 2.3% on an annualized basis – missing the estimate of 2.5%. The government measure of inflation was 0.2% by the last count, the ECI (employment cost index) is weakening, and the ten year U.S. Treasury is now at 2.22%. Amazing how the ten-year models to the GDP number, plus CPI! Prior period GDP reports were revised downward. This recovery has not been terribly robust by historical standards.
Credit investors (where we start our process) are often accused of being of the pessimistic view – not so! Eternal optimist we are, as we just want to avoid the cardinal rules 1-10 of investment management.
Rule #1: Avoid permanent impairment of capital. This rule remains the same through rule #10. Conservative folks always live to see another day without undue (preventable) misfortune. Not to say that we do not make our own share of execution mistakes!
2014 was a wonderful year to realize an oversight/mistake on our part (the massive decline of oil/gas/commodities). After much anguish, research and soul searching I believe we were correct to not “bottom fish” the bounce in oil and gas – leading to a much more pleasant outcome with the new lows that all commodities are touching this week. The particulars of individual company performance have become somewhat irrelevant with non-incoming producing commodities (in their inherent bulk state). It is purely a function of currency. Oil/gas and other commodities are priced in U.S. dollars. The U.S. dollar has become the KING currency – pressuring any commodity priced in U.S. dollars. Some quality color on the topic:
Monetary policy divergence manifests itself first in currencies, because currencies aren’t an asset class at all, but a political construction that represents and symbolizes monetary policy. Then the divergence manifests itself in those asset classes, like commodities, that have no internal dynamics or cash flows and are thus only slightly removed in their construction and meaning from however they’re priced in this currency or that. From there the divergence spreads like a cancer (or like a cure for cancer, depending on your perspective) into commodity-sensitive real-world companies and national economies. Eventually – and this is the Big Point – the divergence spreads into everything, everywhere. Some things will go up, and some things will go down. But the days of ALL financial assets inflating in lock-step … the days of everything, everywhere going up together … that’s over.
This text, while colorful, has been exactly correct since last summer when the end of U.S. monetary debasement (QE) came to an end. The below charts are quite helpful in seeing this relationship.
NET, NET – WE BELIEVE THE SURGING DOLLAR IS A LONG TERM PHENOMENON (UNTIL QE 4 ANYWAY), THAT THE FLATTENING YIELD CURVE IS A FANTASTIC PREDICTOR OF LOWER INFLATION-SLOWING DOMESTIC GROWTH, AND THAT INTEREST RATES WILL BE LOWER FOR LONGER GIVEN THESE FORCES.
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