On the Interest Rate Outlook; and Why Beans?

From: aditya rana
Date: Sat, Sep 20, 2014 at 2:16 PM
Subject: On the Interest Rate Outlook; and Why Beans?
To: aditya <aditya.rana60>

Hi!,

Interest rates have been the key driver of returns for a variety of asset classes over the last five years, and are likely to continue to being so going forward. It is therefore important to develop an outlook for interest rates over the next several years as a key input into asset portfolio construction, and Jeffrey Gundlach, CEO and founder of the successful DoubleLine bond funds, has been highly successful over the last four years in anticipating interest rate movements for the year ahead (he correctly forecast a decline in U.S. Treasury yields and the outperformance of EM debt at the start of the year). This is reflected in the performance of his funds, with the Double Line Total Return Fund returning 9.29% per annum since its inception in mid-2010 (subsequent to him leaving the bond manager TCW where he was the top performing manager of their flagship fund for over 10 years), thereby allowing him to stake a legitimate claim to the title of "Bond King" which had been previously held by Pimco’s Bill Gross. Gundlach hosts a quarterly webcast where he presents his views on interest rates, the economy and on a variety of fixed-income asset classes and presented below is a summary of his latest quarterly: (https://event.webcasts.com/starthere.jsp?ei=1026698)

-Comparing the performance of a broad variety of fixed-income asset classes this year versus the previous years had some interesting standouts: U.S. High Yield posting a 5.5% return (7.4% in ’13) and EM Debt returning 12.1% (-5.8% in ’13).

-The big surprise this year was the movement in U.S. treasury yields, with 3 year treasury yields rising by 0.14%, while the 10 year yields dropped by 0.56% and 30 year yields fell by 0.73%. This was totally contrary to market expectations of a rise in yields across the yield curve.

-It is incredible to see the 30-year U.S. Treasury bond posting the third-highest year-to-date performance since 1974 (see chart below) – despite the low rate environment we are in today.

-The other fascinating story this year has been the global bond rally (see graph below) – with the exception of two countries which tightened monetary policy, global government bonds yields have fallen from about 0.25% to almost 2.0%.

-It is also interesting to note the largely synchronised move down in German government bond ("Bund") yields and U.S. Treasuries since 2000 – and particularly since 2008 (see graph below). While U.S. Treasury yields have moved higher last year, there is a limit to how much further they can go with Bund yields at 1%. Foreign buying of U.S. Treasury bonds increased by $600 BN this year, offsetting the impact of the Fed’s tapering. The relative attractiveness of treasury yields compared to government yields in other developed markets, plus the strengthening dollar, is perhaps the single most important factor today keeping U.S. treasury yields low. He expects the 10 year to trade in a 2.2% to 2.8% range (currently at 2.5%) over the next year.

-It is almost comical to note that market interest rate forecasts continue to expect rate increases in the developed world, with the latest average forecast expecting a 1.0% increase in rates in the U.S., Germany and the U.K. by end-2015. Investors have continued to fight this bond rally as reflected in the record short positions by both real money as well as speculators. While the great bond market rally ended in July 2012, and going forward bond yields are expected to post higher lows over the next three to five years, the rise will be gradual and a sharp rise in yields is a possibility only after five years or so. It is clear than Janet Yellen is a lot more dovish than some other members of the Fed and it is unlikely that she will allow a sharp rise in rates anytime soon. In this environment, their strategy is to enhance yield (through credit and other methods) while keeping duration relatively short (under 5 years).

-Holders of U.S. Treasuries continue to be dominated by the Fed and foreign central banks who together hold over 80% of all treasury bonds issued. Market sensitive investors like mutual funds hold only a tiny sliver of the market, thereby limiting the risk of a serious market sell-off.

-The Fed is highly unlikely to ever sell their treasury bond holdings as it will be very disruptive to the market. While the budget deficit has currently stabilised at around the 4% levels and should remain at these levels for a few years more, it is likely to rise in subsequent years due to the rising costs of entitlements. In addition, maturing treasury bonds held with the Fed are likely to force the Fed into another QE program around 2019-2020.

-GDP forecasts over the last four years have followed a declining trajectory over the course of the year – starting at around 3% and subsequently being reduced over the course of the year. This year is likely to be no different, with forecasts for 2015 to rise to around 3% by year-end. However, as the table below shows, the U.S. has not reached 3% growth since 2005, and the current forecasted growth for 2014 at about 2.1%, will still be lower than the 2.8% level reached in 2012 when growth concerns abounded. The possible rationale for the Fed to raise rates is to build a buffer against an economic shock (imported from Europe or perhaps even China) which would require reducing rates.

-While China’s economy has been similarly downgraded, its stock market clearly seems to have broken out on the upside (see graph below) for no apparent reasons – though a stronger dollar could be an underlying factor as its rise has been coincident with the rise in the Shanghai index – which remains extraordinarily cheap at the current level of 2200 and seems to be an attractive (though riskier) buy.

-Commodities have been down for the year and are currently at levels seen in 2010, reflecting soft global growth. Another factor behind this phenomenon could be the rise in the dollar which is the currency to hold versus the Euro or the yen.

-Regarding inflation, 10 year U.S. treasury yields continue to have a safe buffer over the inflation rate (PCE deflator at 1.8%) which is actually a even a bit lower than the level in 2012 (when deflation fears abounded), despite the recent tick-up. In addition, all measures of inflation expectations have been very subdued in recent years.

-The big conundrum for Yellen and the Fed is the long term decline in the share of wages and salaries in the GDP (see graph below) and, despite the recent tick-up, the trend is not showing any clear signs of a reversal. This key factor is likely to keep the Fed from making any substantial rate increases for a while.

-Wage inflation has also been rather subdued, as reflected by the changes in the inflation-adjusted average hourly wage earnings which are not showing any clear signs of moving higher (see graph below). In addition, inflation-adjusted average hourly wage earnings for the lower 70% of the working population income brackets has declined over the last five years.

-Even if the Fed embarks on a interest rate tightening cycle, it is likely that long-terms yields will remain steady if not move lower as seen in the previous tightening cycle from ’04 to ’06 (see graph below) – and that is certainly the way the treasury market seems to be moving this year.

-He continues to be negative on the housing market with new home sales showing no signs of recovery (see graph below). In addition, since 2012 housing prices have been moving higher while the ownership has been declining (only just reaching its historical average) , pointing to prices being driven by speculation (investment funds and second homes) rather than fundamental buying (see second graph below).

-His best picks in terms of asset classes are: EM dollar debt, U.S. private mortgages, Indian and Chinese stocks. Investment grade corporate bonds are currently the most overvalued in history (more than two standard deviations over the long term average), while high yield bonds have cheapened a bit from being the most overvalued in history at the start of the year.

Fascinating insights into the treasury bond market and the reasons why rates are likely to remain low for a while longer. While the Fed may commence on its rate increase cycle next summer, the path is likely to be very gradual and the long-end of the treasury curve could hold steady. This environment will be supportive of income generating risk assets ranging from EM debt, developed world high yield debt, EM local currency debt and EM, peripheral Europe and Japanese stocks. As noted in earlier missives, while there are likely to be market downdrafts around times of rate increases, they should be used as buying opportunities (if you have been able to lighten risk and increase cash during the rallies). An alternative course would be to hold your breath and stay the course!

Regarding timing of a Fed rate hike, I present below an interesting observation from Scott Minerd of Guggenheim Partners:

"Contrary to the Federal Reserve’s forecast in its “dots,” a labor market conditions index from the Federal Reserve Bank of Kansas City suggests the timing of the Fed’s first rate hike should be no earlier than late 2015, or possibly even 2016.

The index, cited by Yellen in her recent Jackson Hole speech, uses 19 labour market indicators to measure overall job market conditions. In the prior two rate hike cycles, the index was positive before the Fed began raising rates. The underutilization in the labour market, combined with recent inflation softness, suggests the Fed should maintain the current level of policy rate for a considerable period of time."

Why Beans?

Beans and lentils ("legumes) have been a staple diet of many traditional cultures around the world, and studying the eating habits of centenarians in the five "Blue Zones" (which have the highest ratio of centenarians to the whole population) around the world it is interesting to note that legumes are a key component of their diets. Excerpts from a recent article highlight the benefits of beans

Written by: Michael Greger M.D. on September 16th, 2014

-Beans, beans, they’re good for your heart; the more you eat, the…longer you live? Legumes may be the most important predictor of survival in older people from around the globe.

-Researchers from different institutions looked at five different cohorts in Japan, Sweden, Greece, and Australia. Of all the food factors they looked at, only one was associated with a longer lifespan across the board: legume intake. Whether it was the Japanese eating their soy, the Swedes eating their brown beans and peas, or those in the Mediterranean eating lentils, chickpeas, and white beans, legume intake was associated with an increased lifespan.

-In fact, it was the only result that was plausible, consistent, and statistically significant from the data across all the populations combined. We’re talking an 8% reduction in risk of death for every 20 gram increase in daily legume intake. That’s just two tablespoons worth!

-If, however, one wants to decrease their lifespan, studies suggest eating a bean-free diet may increase our risk of death. Having arrived at the one dietary fountain of youth, why aren’t people clamoring for beans? Fear of flatulence. So is that the choice we’re left with: Breaking wind or breaking down? Passing gas or passing on? Turns out that people’s concerns about excessive flatulence from eating beans may be exaggerated.

-A recent study involved adding a half-cup of beans every day to people’s diets for months to see what would happen. The vast majority of people experienced no symptoms at all. However, a few percent did report increased flatulence, so some individuals may be affected. Even among those that were affected, 70% or more of the participants felt that flatulence dissipated by the second or third week of bean consumption. So we’ve just got to stick with it.

-The bottom line is that an increasing body of research supports the benefits of a plant-based diet, and legumes specifically, in the reduction of chronic disease risks. In some people, increased bean consumption may result in more flatulence initially, but it will decrease over time if we just keep it up. Doctors should recommend a bean-filled, plant-based diet to their patients, as the nutritional attributes of beans far outweigh the potential for transitory discomfort. The long-term health benefits of bean consumption are great.

Here’s to adding legumes to our daily diet!

Regards,

Aditya

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