Iron Capital Insights

  • Iron Capital Insights
  • June 7, 2011
  • Chuck Osborne

Old Habits Die Hard

I’m not sure how it happened, but someone has caused a rally in the bond market. Commodity prices have been dropping, although not as fast as they should. Stock prices have been falling faster than they should, and bonds are rallying.

The yield on the ten-year Treasury has dropped from 3.5 percent to just below three percent. For those who need a refresher, bond prices move in the opposite direction of interest rates, so a drop in the yield equals an increase in the price. To understand the oddity here one must put all of this in context.

The Federal Reserve has been buying up Treasuries in a program commonly referred to as QE2. Some have estimated that the Fed’s purchases represent as much as 30 percent of current demand for Treasuries. This program is about to end. Economically if the largest purchaser of Treasuries stops buying, the price should go down, not up.

Down the street from the Fed our representatives in Congress are debating whether to raise the debt ceiling. Treasury Secretary Tim Geithner has told us that if this does not occur then all these Treasuries will be in default and the world will actually come to an end on August 2, not October 21 as that other guy predicts.

Moody’s is threatening a downgrade of Treasuries. Bill Gross, the man who manages more bond assets than anyone else in the world, has very publically taken a short position in Treasuries. Yet, the Treasury market rallies?

I can understand the market ignoring Geithner’s warning of sudden doom on August 2. I don’t believe anyone seriously believes that Congress will not raise the debt ceiling. In the interim we are witness to a lot of political theater and some smaller amount of actual negotiation between the Administration and Congress. However, does anyone not think QE2 is going to end? Does no one care that the world’s preeminent bond man is going short and one of the largest rating agencies is considering a downgrade?

The bond market’s answer? “No.” It doesn’t care. How can this be? We have been pondering this question for weeks now, and have come up with only one somewhat satisfactory answer: old habits die hard.

Shortly after the earth cooled and mankind started walking on it, that talking baby in the E-Trade commercials and his trading friends invented the ‘risk-on risk-off trade.’ We see it everywhere. The simple version is evidenced in almost every individual portfolio I have ever seen (before it comes to Iron Capital, that is), made up of nothing but equities and cash. The self-proclaimed “savvy” investor usually talks about going into and out of “the market” – a statement which is evidence enough of a lack of actual savviness. The professional version of the same disease is the rotation between Treasuries and anything else that isn’t a Treasury.

In other words, the only explanation we can come up with for the piling into Treasuries is that, with all their current faults, Treasuries are still the safe haven for temporarily parking money when you don’t know what else to do.

The unfortunate part in this knee-jerk reaction is that safety in investing is not, as some believe, a permanent design feature. The ‘stocks are risky and Treasuries are safe’ mentality is naïve to say the least. Let’s not forget that it was the mortgage-backed securities with their quasi-government backing making them “almost as safe as Treasuries,” which caused the market meltdown of 2008. Safety is not a function of product design; it is a function of price compared to actual value. In that light, Treasuries are not looking so safe today.

There are those who disagree with this position and will claim that the risk to principal is overstated. I believe they are missing the point. We often repeat the quotation from Benjamin Graham that a sound investment offers safety of principal and an adequate return. As I write, the 10-year Treasury offers a return of 3.125 percent. Even if we are wrong about the risk to principal, I don’t know many who would call that an adequate return. Graham says the purchase of securities which fail his test – any part of his test – is not investing but speculation, and that is exactly what the risk-on risk-off traders are doing.

Chuck Osborne, CFA
Managing Director