Time to Build a Portfolio of Real Things
Today is “quadruple witching,” with a variety of options and futures contracts expiring. This adds a unique complexity to market behavior. The dust will settle next week, and derivatives will be less of an issue. In addition, FOMC comments and subsequent interpretations throughout the week have added to price volatility.
Like a scratched record, we return to the 10-year Treasury and the rise in rates as a present and future impairment to the financial markets. There is a scent in the air, and it would seem the bond market smells inflation. Is it a transitory trend or a secular shift? While it is too early to say, that remains one of the most critical calls of the decade ahead. Deutsche Bank raised their full year inflation estimate to 3% this week. The FOMC communique noted a new inflation estimate for 2021 of 2.4%, up from 1.8% last time they met. This week, in spite of ultra-dovish policy remarks from Jerome Powell, stocks failed to follow through on the upside and bonds moved lower, suggesting that Powell’s dismissive attitude toward inflation is being overrun by investor concerns. The major equity indexes declined between one half and one percent, while the small cap Russell 2000 fared worse, losing 2.53%.
Is there an interest rate threshold that begins to create “disorderly market conditions” and requires additional gargantuan QE/bond buying? Yes, but no one knows where it is precisely. Three percent on the ten year is an easy speculation, though likely lower given the amount of leverage pumped into the system over the last three years. We’ll consider the Z-1 report with that point in mind. Before I do that, let’s shift perspectives.
To take the other side of the argument, the strongest justification for rates going lower is a shockingly large QE scheme that sets both prices and rates exactly where the FED wants them (yield curve control). Silencing the voice of the “bond vigilante” (where rates become an irrelevant market signal) redirects that protest into the FX markets, where the dollar will surely pay a dear price.
Discussing the ten-year treasury is apropos given the flow of funds report, the Z.1, out last week. The bottom line is that credit expansion on this scale has never ended well.
My colleague Doug Noland summarizes it thusly: “The Credit Bubble continues to be fueled by a mind-boggling expansion of government debt. Outstanding Treasury securities jumped $700 billion during the Q4. For the year, Treasuries surged an unprecedented $4.582 TN, or 24%, to a record $23.601 TN. Treasuries rose $5.759 TN, or 32.3%, over two years. Since the end of 2007, Treasuries have ballooned $17.550 TN, or 290%. Treasuries ended 2020 at a record 113% of GDP, up from 42% to end 2007.
Agency (GSE debt and MBS) securities gained another $248 billion during Q4 to surpass $10 TN ($10.114 TN) for the first time. This boosted 2020 growth to $685 billion (7.3%), the largest expansion since 2008.”
Analysts disagree on the sustainability of this pile of debt obligations, primarily based off of whether rates can be maintained at a low level. Take rates lower, and a larger quantity of debt is not a concern—all other things being equal (the cashflow requirements are indeed manageable). If rates move higher, you may find a variety of solvency issues emerging in both the corporate and government debt markets. Rolling over existing debt becomes more costly—perhaps too costly. That endgame appears to be quickly approaching. The alternative is for the Fed to nationalize the debt markets, which has its own set of consequences.
We are very bullish on hard assets; no surprise there. This economic and financial market backdrop continues to support building a portfolio of real things, preferably with dividends.
Performance for the week was flat, with the following trends in play. IFRA, the I Shares US Infrastructure ETF, was unchanged for the week. Oil was hit particularly hard by concerns over demand in light of increased Covid numbers in South America and new lockdown measures in France. The Alerian MLP, representing energy infrastructure, was down 4.67%. Oil Services (OIH), typically more volatile, lost 10.57%. The Goldman Sachs Commodity Index, energy heavy, was off 3%, while the S&P Global Natural Resources was off 2.95%. The Dow Jones US Real Estate index declined 88 bps. The Dow Jones Utilities fell 56 bps. Gold finished the week positive 56 bps. Silver was flat for the week. HUI, the “Gold Bugs Index” was up 3.01% for the week.
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