- A 2yr U.S. Treasury is yielding 0.25%, an implied real yield of around negative 2%
- A 10yr pays you 1.6% right now. So in other words, nothing.
- A 30yr — thirty year – currently yields 2.7%. Given the wide range of outcomes, that’s a nearly-guaranteed money-losing proposition at some point before it matures.
Yields in other countries aren’t much better. In fact, the U.S. doesn’t even have the lowest rate in the world on its government securities. A German 10yr gets you 1.2%. A Swiss 10yr pays 0.5%. Even an Australian 10yr pays a paltry 2.8%. Do you really want to hold Aussie Dollars if this China slowdown is secular and not just cyclical? Is 2.8% enough compensation for that?
Yields in the corporate space are just as depressing. Investment grade corporate bonds will give you around 3.8% while standard junk won’t even get you 8%.
I don’t believe in strong-form (perfect) market efficiency. But I do believe that markets are pretty darn efficient mechanisms. And I believe that a majority of the time their behavior can be explained in a somewhat rational context.
The only sense you can make of what’s happening right now in the bond space is that the market really, really loves bonds. It needs them and what they provide. Apparently, it needs them desperately. Not even Morrissey and Johnny Marr understand the depth of that hopeless longing.
The Yield Vigilantes
Back in the awesome days when the tech boom was grabbing hold and I had a full head of hair, there was this wonderfully colorful term, “bond vigilante.” It grew out of the famous James Carville quote,
I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.
The idea was that if a government was up to no good and doing fiscally irresponsible and inflationary things, bond investors would simply rally together and sell the country’s debt, creating natural, upward pressure on interest rates. That, in turn, would make it more costly for the government in question to borrow. Believe it or not, the yo-yos that run this country (and others) have a pretty solid grasp on basic game theory. In normal times in normal markets, the concept of the bond vigilantes kept governments relatively honest. Basically, it kept countries with printing presses from using them.
I give the guys in Washington D.C. a hard time every now and again. But these are smart folks. Seriously. They might not be as smart as the guys on Wall Street, but the motive for power is just as strong as the motive for profit. So don’t underestimate them and their capacity to do clever, self-serving things.
Especially the guys at the Treasury. In a sense, the U.S. Government is a monopoly supplier of the most risk-free asset in the world. Think about that for a moment.
Since the financial crisis, demand for risk-free assets has been through the roof. And the Treasury, to their credit, realized this very early on. With that realization came the knowledge — and a smug grin, no doubt — that they could get away with some pretty radical endeavors. If I hopped in my time machine and visited you during the Clinton administration (when you had more hair, too) and told you that the government was going to print $2 trillion and that interest rates would freaking go down, you’d have laughed. You’d have thought I was nuts. Though you probably would have thought I was nuts anyway, some crazy dude stepping out of a bizarre contraption and claiming he was from the future.
I’d make the case that the U.S. Government is knowingly exploiting the world’s demand for safe haven assets, even beyond its direct manipulation of rates on the front end of the curve. It knows that there are people out there who need some yield and can’t take a lot of risk and are willing to just take whatever they can get rather going too far out the risk curve.
So allow me to introduce the concept of the “Yield Vigilante.” According to Google and their index of roughly 8.3 zillion webpages, I’m the first to use it.
So who is a Yield Vigilante? In its simplest sense, it’s someone who’s starving for yield.
- It might be a large pension fund with a specific yield mandate for its benefit programs.
- It might be an institution with a lot cash to manage and a need to keep risk manageable .
- Or it might be another government who needs to buy securities to generate yield for its own reasons.
A retiree living off an investment portfolio and a fixed income is also a Yield Vigilante. One of those guys may not make much difference. But they’re all basically the same. When they act collectively and in aggregate, the “Retail Yield Vigilante” can be just as powerful as any other whale in the market.
Who, you ask, is going to keep rates from getting too high? These guys.
The reason why it works is recency bias. Anchored in our brains — and especially in the brains of our friends, the Yield Vigilantes — is that 1.6% Treasury yield. It’s what happened recently and it becomes the biased basis for our projections of the future. So when they see a yield of 2%, they lock it down. They buy bonds, keeping pressure on rates to the downside.
Regardless of which way rates go, I believe that this phenomenon will set up some outstanding opportunities for cyclical bond trades. When rates get to a local extreme, simply go the other way. Make use of the range. It’s worked for a long time, though arguably not as well as simply buying bonds and holding them.
At some point that trend of endlessly lower rates will stop. This chart isn’t too different from that chart that everybody saw in the late 90′s where it just looked like equities would keep going endlessly higher and that buy-and-hold was the best, simplest strategy to employ. Passive equity strategies had worked pretty well up until 2000, but then they completely fell apart, left in the dust by active strategies. The same is almost certain to happen over the next decade in the bond market.
But more than that, the trend in rates has to change because it’s approaching the lower bound. Nominal yields aren’t going to plow into negative territory. I’ve been on record for the last couple of years as believing that our long-term yield chart will resemble Japan’s where it trends lower and lower and lower and then just flattens out for a decade or two. Any attempts to trend upward will be thwarted by the Yield Vigilantes.
Comparing the U.S. to Japan is dangerous. But the future of our bond market could look very similar, if for different reasons:
For the time being, I’m betting on the Yield Vigilantes. Forget about meaningfully higher rates any time remotely soon. If you’re using that as your macro backdrop, it’s going to be a frustrating decade. It’s a tail-risk possibility, to be sure, but I’d be very skeptical of any scenario that involves rates that go up quickly. If I could capture decent premium, I’d want to sell insurance guarding against that outcome. I think there’s a skew between the perceived odds and true odds.
I won’t bet on the Yield Vigilantes forever, though. At some point I’ll have to change my toolkit. The bond space isn’t too different from the world of physics. For the most part, Newtonian physics does a really good job explaining the world around us and what we see. But in certain strange environments e.g. the very, very small (whether that’s atomic particles or interest rates), we need a set of different and often contradictory rules: quantum mechanics.
There is no Unified Theory of Finance, one mighty framework that explains it all. You need different tools for different environments.
With that, let’s see if we can design a proper strategy for investors.
What to do about it
In a world that’s deleveraging it may sound sensible to deleverage right along with everybody else. But like any other trend, I think this is one where contrarians who fade the herd can make out rather well.
You might say, “hold on a second Mr Smartypants, didn’t you tell us in your book — shameless plug! — that the strategy was to avoid the sovereign debt, banking systems, and currencies of over-leveraged economies and buy real assets and the equity of unloved, under-priced companies?”
Yes. Yes, I did say that.
But if you read between the lines of that statement, you’ll see that what I’m really saying is to avoid things that will be forced to deleverage, things that are already saddled up with too much debt. Many of those unloved and under-priced companies — known by another name as “deep value” — are entities that have capacity to expand credit.
And for what it’s worth, value and deep value, especially if it pays a dividend, is the hottest thing in the market right now. I started singing the praises of large cap dividend stocks back in 2009. Today, pretty much every guest I hear on Bloomberg Radio says that this is the sector of the investment world where investors should be. Now I’m wondering if that trade isn’t getting a little crowded. The Yield Vigilantes are on that in full force.
McDonald’s just issued a bunch of debt at 0.75%. 0.75%! If your business could borrow money for under 1%, what would you do with it? You’d better believe that McDonald’s is going to do something productive with it. I’ve talked about McDonald’s several times before here and over at Seeking Alpha. They fit the parameters of what I wrote about the book.
McDonald’s has been killing it since 2009, even with a large pullback this year. That’s an amazing chart for a company with relatively little risk. Right now it pays a 3.2% dividend. In a historical context, that ain’t great. But by today’s standards, the Yield Vigilantes will gobble it up. I mean, you’d much rather have that than a THIRTY YEAR US TREASURY YIELDING 2.7%, wouldn’t you? With demand for less-risky assets almost certain to remain high and the Yield Vigilantes almost certain to stay hungry, ask yourself how low a stock like McDonald’s can realistically go.
But don’t take what I say too seriously. I was wrong about a lot of things back in 2009. I thought rates would rise and my beloved San Francisco 49ers would stink for years to come. I’m thrilled to be wrong about the latter, but you and I are probably both gnashing our teeth that I botched the former. Think about how different the world and your investment portfolio would be if you had access to moderately low risk investments that paid normal yields. If the idea of taking sensible, “businessman’s risk” in exchange for 5 or 6% gets you excited, guess what, you’re a Yield Vigilante.
Full disclosure, I don’t personally own McDonald’s or any other individual stocks. Nor does my firm. But I did borrow a bunch of money last year to buy a much bigger, nicer house than I ever thought I’d need. (Additional disclosure: the lovely Mrs. Concord differs on this perspective of “need.”) So in a sense, I have “put my money where my mouth is” on the idea of borrowing capital at a low rate if you can and have a productive use for it, or investing in companies that can do the same thing.
The main risk right now in the bond market is Ye Ol’ Risk in the bond market: it’s the risk that rates get out of hand and spiral higher, reconciliation of the fear that the dollars you’ll be getting paid back in the future will be worth substantially less than originally expected. When it happens, it often happens quickly.
To get back to physics for a moment, think of the bond market as a super-saturated solution — like a big bottle of diet coke. If you manipulate the environment, you can create a weird equilibrium. Ratchet up the pressure and you can squeeze in more CO2 gas than you’d otherwise be able to under normal conditions. When you take the cap off, gas will slowly escape. So long as nobody shakes or drops the bottle you can pass it around and everyone can enjoy a cool, fizzy beverage. But if something comes along and does shake the bottle, or if the guy from MythBusters shows up and drops in a Mentos, you can get an instant explosion.
An explosion is what it’ll take, too. A jump condition that rewrites market psychology in a single stroke. But absent that, the Yield Vigilantes will keep sipping and sipping. They are very thirsty. The unstable, abnormal equilibrium will persist.
Ultimately it’s a question of ideology. You either believe that rates are going to blow up and inflation will get out of hand and the U.S. is totally screwed, game over, later y’all I’m off to my bunker. Or you believe rates are going to go splat, unable to peel themselves off the sidewalk, and the U.S. will continue to muddle along and flirt with little bouts of deflation.
Heck, I suppose there’s also a middle ground where we have uncomfortable-but-not-crazy inflation and rates trend higher for a decade or two. But I’ve found that most investors sort themselves into either of the first two camps.
It’s possible to make money in any of these scenarios. I wish I could tell you which will happen. But I’m betting on “splat” because of the Yield Vigilantes. I think that’s the outcome where the perceived odds are are lower than the true odds. That’s what I’m using as my macro backdrop.
I don’t mean to push back too forcefully against the brilliant Mr. Gross of Newport Beach. His firm is a self-admitted Bond Vigilante. Will PIMCO or China stop buying U.S. Treasuries because they’re worried about an Inflationary Dollar? Will they sell those bonds short in an aggressive bet on higher rates? Three rounds of quantitative easing and it hasn’t happened yet. I think there are plenty of investors around the world more than happy to gobble up some bonds on short-term interest rate spikes, long-term fundamentals be damned.
The Bond Vigilantes are a dying breed. They may be extinct already.
In their place a new species has arisen. Viva the Yield Viglantes!