McLean Heuristics

Jim Parker

Predicting interest rate movements correctly is hard. Predicting them for a living is harder still. But getting it wrong is nowhere near as painful as the experience of those who lose their own money based on someone’s forecast.

A year ago, the Reuters news agency polled a group of people closer than just about any other community to those who actually decide rate movements. These were 16 money market dealers who do business directly with the US Federal Reserve.¹

The so-called primary dealers — banks or broker-dealers — are market makers for government securities. They consult directly with the US central bank and Treasury about funding the budget deficit and implementing monetary policy.

So if you wanted an informed view about the interest rate outlook, these might be the people you would call on first, which is what Reuters did when it asked the dealers for their forecasts for Treasury bond yields three, six and 12 months ahead.

Back in late September 2010, the dealers came up with a consensus forecast for US 10-year Treasury note yields rising from 2.50 per cent to 2.70 per cent in three months, 2.80 per cent in six months and to 3.20 per cent by September 2011.

So how did those forecasts turn out? Well, after three months, the yields had already surpassed the 12-month forecast at around 3.3 per cent. Another three months on, yields had topped 3.4 per cent, again well above forecasts. But then they started coming down again and by September 2011, were close to 2 per cent.

So the expert panel misjudged the trajectory for bond yields in terms of the magnitude of the increase in the first six months and then completely got the direction itself wrong in the subsequent six months.

But it wasn’t just the sell side that misjudged the market. In February, the world’s biggest bond fund PIMCO announced it had reduced its US government-related debt holdings from 22 per cent in December 2010 to just 12 per cent in January 2011, the lowest in two years.

In March, PIMCO announced it had eliminated government related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Federal Reserve ended its quantitative easing program.

But by August, PIMCO manager Bill Gross admitted he had made a mistake, telling the UK Financial Times that he felt like “crying in his beer”, so badly had he misjudged the movement in bonds in 2011.

“Do I wish I had more Treasuries? Yeah, that’s pretty obvious,” Mr Gross told the FT. “I get that it was my/our mistake in thinking that the US economy can chug along at 2 per cent real growth rates. It doesn’t look like it can.”

None of this is to impugn Mr Gross’ logic earlier this year in saying that the term risk of investing in government bonds was not worth the meager return.

But as tends to happen with forecasts, events intervene and those who maintained an exposure to Treasuries in 2011 have enjoyed solid returns in the intervening months. 

The chart above compares the relative yields of US Treasuries at various maturities in January this year versus more recently in September. You can see that the curve was relatively steeper earlier this year than it is now.

The yield spread between the 10-year bond and the 1-year bonds was just over three percentage points in January. By September, this term premium had contracted to two percentage points. The change reflects news in the intervening period. Sentiment about the US economy has deteriorated in that time and investors have become more averse to taking term risk.

Put another way, when yields fall, prices rise. So those whose net exposure was relatively longer earlier in the year have enjoyed a capital gain that was not available to those who took a bet against Treasuries early this year.

Now, Dimensional’s own research has shown there is a reliable relationship between current term spreads and future term premiums. So wider yield spreads predict larger term premiums, while narrower yield spreads predict smaller term premiums.

This is why we employ a variable maturity approach, varying the allocation towards short-term and intermediate bonds depending on the shape of the yield curve.

The advantage of this approach is we are only using information available in the market at the present time. There is no need for forecasts, which no matter how rigorous the underlying analysis can come undone as events and circumstances change.

The bad news is that financial markets have a tendency of sending even the most well informed and respected forecasters a curve ball. The good news is that you don’t have to take those sorts of risks if you don’t want to.

1. POLL: Rising Bond Yields Constrained by QE, Reuters survey, Sept 28, 2011

WHAT TO MAKE OF THE DOWNGRADE

The Standard and Poors downgrade of the credit rating of the United States was a culmination of a long cycle of financial and political events begun long ago.

• Decades ago, politicians and regulators beat the drums for expanded offering of mortgages to all people. Home ownership was the right of all. Overextension of this “right” led to securitization of mortgages on a scale never intended, or sustainable, and the resulting worldwide failure of those underlying investments caused massive trouble for the issuers and holders of those bonds. Western governments stepped in to bail out troubled institutions, while global investors took their losses, and cast a wary eye on anything financial from the US, particularly the promises of our government, regulators, businesses and rating agencies. The crisis weakened financial institutions and the governments who bailed them out.
• Deficit spending became more a matter of course than an exception. The partly artificial real estate and construction boom following the turn of this century buoyed our nation into believing the good times were here to stay. Recovery from the 2000 to 2002 downturn was helped by tax reform, and some of the expansion was real, but little consideration was given to expansion of the public sector. Benefits were heaped on entitlement beneficiaries and government workers at all levels on an unsustainable trend. Reforms to Social Security and Medicare were put off, and states expanded their spending to ever higher levels.  We were fighting wars on several fronts, and traditional measures of austerity were never contemplated during these periods, in fact, public sector expenses expanded as political payoffs to reduce attention to the cost of this war effort.
• Federal, State and Local taxes for both individuals and businesses are already at high levels. Business taxes are some of the highest in the Western world. Lack of reform on tax policies, like the Alternative Minimum Tax, means that residents of high-tax states like New York, California and New Jersey have combined tax rates above 50%. Retirees collecting Social Security have some of the highest effective marginal brackets – more so than even some of the wealthiest taxpayers. At the same time, about half of all income-earners pay no taxes, other than Social Security and Medicare taxes, for which there is no relief no matter how little one earns.
• Reform must take place, and the bickering, name-calling and finger-pointing among our political leaders must slow. We need solutions, which are present, but there cannot be more of the same and business as usual. If taxes cannot be increased, and expense reductions are tough, our nation must do what any entity in trouble must do; sell assets. Most recently, European banks forced Greece to consider asset sales to solve part of their issues, and we must do the same. The US government owns financial assets, private companies, government-owned enterprises, wireless bandwidth and massive amounts of real estate (both domestic and foreign), which can be sold to raise capital. We need creative thinkers in government to solve this problem.
• In spite of the selloff last week in equity markets, and the concern over US credit quality, US Government bond yields actually fell. Remember, bond yields have an inverse relationship to bond prices. So, when US bond yields drop as they did last week, it tells us that people are rushing to buy US bonds – indicating a flight to perceived quality. The yield on the ten year US Treasury Note fell to 2.42% by week end August 5.  So much cash flowed into bank accounts last week, that several US banks began charging for holding the cash of large depositors. There was actually more concern in financial markets over the financial condition of European countries and institutions. At the same time, several firms announced estimates that US multinational corporations are holding more than $2 trillion of cash in overseas banks, in part to avoid US income taxes on that cash generated from income.
• Standard and Poors has made it very clear for months, that the politicians needed to get together and cut spending by at least $4 trillion over ten years or risk a downgrade. That did not happen with the deal of last week, and therefore the downgrade took place as expected, likely to be followed by a downgrade by rating firm Moody’s. The downgrade was not a surprise to global markets, economists, or US citizens. In our blog article “Dissecting the Debt Crisis”, we wrote about the likelihood of a downgrade occurring even if a debt ceiling deal were to be struck.
• We now have a true global economy, and not every country is in trouble. Rather, many are performing well, as are many companies around the globe. Previous country downgrades and economies of those lower-rated countries have a mixed track record of good and bad market performance following a downgrade. As was demonstrated in our blog article entitled “Sovereign Debt Ratings – How Important Are They?”,  the equity markets of countries with less than perfect credit ratings can perform very well.
• In spite of all the negatives, it is clear that most investors will not be able to meet their goals on the meager returns from financial assets such as CDs and savings accounts. For many, a flight to these types of assets means almost certain long-term failure in achieving retirement and other goals. If, like most of us, your goals require greater growth than CDs and savings accounts provide, then a balanced portfolio of equities and fixed assets is a prudent choice.

Most of our clients have been through financial upheavals before, and made it through just fine. A steady hand, patience and a strong focus on the long-term, along with sound planning-related adjustments will get you through this time.

As always, please keep us abreast of any of your changing circumstances as we keep you apprised of planning opportunities. In the interim, steady as she goes.

http://online.wsj.com/article/SB10001424053111903366504576492512709525754.html?mod=wsj_share_tweet

We thought you might appreciate the following article penned by DFA’s Weston Wellington. It really underscores why we shouldn’t allow sensational media headlines to dictate our investment strategy.

“The Best of Times, The Worst of Times”

For the twelve-month period ending May 31, 2011, equity investors around the world enjoyed the equivalent of blue skies and bright sunshine while the economic news was partly cloudy at best. Among forty-five developed and emerging-country stock markets tracked by MSCI, all but four had double-digit total returns (in US dollar terms), and twenty-six had returns of 30% or more.

If someone had told us a year ago that global markets would stage such a broad-based rally, we would have been inclined to think that trends in employment, housing, and financial distress were about to take a pronounced turn for the better. It seems hard to argue they have done anything of the sort. Somehow, despite gloomy financial page news that keeps repeating itself, equity prices marched substantially higher.

The moral of the story? Investors should be skeptical of their ability to predict future events and even more skeptical of their ability to predict how other investors will react to them.

Past performance is no guarantee of future results.

Last week we came across an “Economic and Policy Watch” update prepared by a major investment bank that reviewed recent government proposals to address the nation’s funding crisis. Titled “It Just Gets Worse,” the report chided policymakers for actions that “look like a poor cover for loose money, rising inflation, and fiscal problems,” and warned that “government financing needs are corrupting monetary policy.” As a result of these ill-advised tactics, the bank had turned “more negative” on the outlook for financial stability and saw “little hope of improvement in the inflation/currency mix.”

Amidst the barrage of news coverage from dozens of sources probing the US debt/default/downgrade issue, such a conclusion might seem unremarkable. We found it of interest because the focus of the report was not the US Treasury but the government of Indonesia, and it appeared over a decade ago, on July 16, 2001.

Sovereign Debt Ratings – The Rest of the Story…

We’ve been bombarded lately with dire predictions about this country’s budget crisis, and the frightening ramifications if the US were to default on any of its debt. But let me ask you: Do you personally believe that the US government will default on its debt payments? Or do you believe – as most do – that politicians on both sides of the aisle have been using the debt issue as a political bargaining chip, and that some sort of 11^th hour agreement will be struck to allow the US to pay its creditors? Do you think any of these politicians want to go down in history as being part of the group that refused to come to an agreement, and forced the US into default?

Regardless of which date politicians and economists might have us believe is the “drop dead” date, has anything substantive changed in the US economy over the past few months? Everyone knew about this pending deadline more than two months ago on May 16^th when the story first broke about the US reaching its debt limit. The economy has undergone no significant changes/shocks in the interim. Stocks have remained relatively stable up until this week where we’ve seen some heavier selling.

Interestingly, The US Treasury…

In 2010, prominent industry analysts warned of a looming fiscal crisis among state and local governments. Some experts even predicted widespread municipal bond defaults in the US.¹ Investor fears intensified in late 2010 when the municipal bond market experienced one of its largest selloffs in decades, which drove down prices and raised yields.² While factors unrelated to credit concerns may have contributed to the selloff, some investors were motivated by a perception of rising credit risk among municipal bond issues.³

So, is the municipal bond market at risk of massive default?

As noted, September was a relatively good month for US stocks—total return for the S&P 500 Index was 8.92%, the best September result since 1939. Small cap stocks sparkled as well, with a total return of 12.46% for the Russell 2000 Index, the fifth-best month since inception of the index in January 1979.

Hindenberg Omen Flames Out (cont’d)    (Use the “back” button to return to the blog.)