This week, I wanted to discuss the elephant in the (investing) room – almost all investments are very rich now.  Rather than slamming your head against the wall when you see the Fed about to hike again and tens are still sub-2.0%, or wondering how the S&P could possibly be above 2000 with such terrible earnings and prospects, think about the markets from the perspective of a pension fund.  You are supposed to be earning 7% for the many retirees whose money you are managing.  As the baby boomers keep retiring, you have larger and larger payments going out and your asset returns are struggling.  How do you earn 7% in this environment?  Is there any investment that looks that good right now?!?  Fixed income, equities, FX or commodities?

  • Even though the yields look terrible, you still need to buy fixed income to somewhat match your outflows (payments). With low rates, it costs you a fortune to replicate your liabilities.
  • The Central Banks have bought up an absurd amount of longer term debt, to try and stimulate their respective economies. Some of them continue reinvesting, even though they have hiked.  So they drive up prices even more.
  • Regulations require financial institutions to hold more high quality assets. So they drive up prices even more.
  • Trade surplus and FX manipulating countries need to park their money somewhere. So they drive up prices even more.
  • People expecting China / Europe / EM / the Middle East to fall apart are going to invest in the long end for protection. So they drive up prices even more.
  • And as terrible as US fixed income may look, the Europeans and Japanese think it’s a steal, since they are staring at negative rates at home. So they drive up prices even more.
  • You go reaching for yield in some junk bonds and they get annihilated the end of last year and early this year.
  • Trying to grab for additional return in commodities and EM last year also got you nuked.
  • How about equities? The P/Es on equities look terrible.  And companies are levering up – companies can get really cheap funding, so why not issue some debt and buy back stock?
  • You decide to get some help from some smart hedge fund managers. The guy you hired decided to invest 29% of your money in some company that basically buys other companies, (unethically) jacks up prices and uses questionable accounting practices.  That company (Valeant) is down 90% from the high.


What do you do?  As more and more people start to retire or get closer to retiring, there is just a lot of money out there chasing fewer “good” investments.  And it’s not just pension funds.  It’s anyone who needs to invest – workers, retirees, companies, insurers, college endowments, sovereign wealth funds, etc.  This is going to cause assets, and fixed income assets in particular, to become very rich.  But as we all know, just because something is rich does not mean it can’t get richer.


160328 10yr downtrendI am definitely NOT saying that investments will be rich forever.  This 30+ year downtrend (see chart) will break eventually.  Why?  Because I am of the opinion that one of the causes of this are the baby boomers.  And the total magnitude of this effect on all investments (fixed income, equities, etc) will be on the order of ten trillion dollars.  I will discuss this further in a future post.  In any event, this effect could start waning in the years ahead, as they do less accumulating / investing and instead do more spending / redeeming.  And thanks to “wise” government spending, the supply of debt will continue to go through the roof.  It’s very possible if we break the trend, we could break really hard.  But as my new BFF Gundlach would say, “things could get worse before they get better.”  Or in this case, assets could get higher before they get lower.  So when we trade, we need to trade with the elephant in mind, until we get that decisive break.


What is the point of this depressing babble?  It seems to me that you need to adjust your view of rates (and equities, and any other investment), in light of this elephant.  In particular,

  • Say you like buying EDZ7-Z8 at only 27bps because the Fed will be hiking more than once in 2018. That may be true.  But is it any less true that Z6-Z7 looks too low at 27 bps?  Or Z8-Z9 looks too cheap at 23.5bps?  So when you look at Z7-Z8, you need to take into account the elephant that is causing tens to be at 1.9%.  The long end is going to be the sum of its parts.  So if you like Z7-Z8, you also have to ask, what is going to give?  You can keep buying Z7-Z8, but unless the other year spreads get smaller, and/or ten year yields go higher, it’s not going to move.  You basically could have expected ten year yields to be higher at any point in the last year or two.  What is different now?  I’m not saying there isn’t value in being short.  But you have to beware the elephant.
  • The best shorts may be closer to the front of the curve, where you won’t have to wait years for potential Fed activity to give it a jolt. The front end of the curve will be more directly controlled by the Fed.  And with so little being priced in and the acceleration of the Choi Curve, it still offers value.
  • Market-based inflation measures, like 5y 5y forwards, may not be as relevant. There is just unusually large demand for the long end of the curve.  The fixed income markets are under stress, and so this may not a clean read on the inflation data.  It’s mind-numbing that the Fed pays so much attention to it, when there is a lot of noise in the data AND they are one of the many factors that keep rates low.


Stay tuned for Part II.  Also, I have some exciting new CA announcements coming in the next few weeks.