Category Archives: Bonds

Suddenly, “De-Dollarization” Is A Thing

For what seems like decades, other countries have been tiptoeing away from their dependence on the US dollar.

China, Russia, and India have cut deals in which they agree to accept each others’ currencies for bi-lateral trade while Europe, obviously, designed the euro to be a reserve asset and international medium of exchange.

These were challenges to the dollar’s dominance, but they weren’t mortal threats.

What’s happening lately, however, is a lot more serious.

It even has an ominous-sounding name: de-dollarization. Here’s an excerpt from a much longer article by “strategic risk consultant” F. William Engdahl:

Gold, Oil and De-Dollarization? Russia and China’s Extensive Gold Reserves, China Yuan Oil Market

(Global Research) – China, increasingly backed by Russia—the two great Eurasian nations—are taking decisive steps to create a very viable alternative to the tyranny of the US dollar over world trade and finance. Wall Street and Washington are not amused, but they are powerless to stop it.

So long as Washington dirty tricks and Wall Street machinations were able to create a crisis such as they did in the Eurozone in 2010 through Greece, world trading surplus countries like China, Japan and then Russia, had no practical alternative but to buy more US Government debt—Treasury securities—with the bulk of their surplus trade dollars. Washington and Wall Street could print endless volumes of dollars backed by nothing more valuable than F-16s and Abrams tanks. China, Russia and other dollar bond holders in truth financed the US wars that were aimed at them, by buying US debt. Then they had few viable alternative options.

Viable Alternative Emerges

Now, ironically, two of the foreign economies that allowed the dollar an artificial life extension beyond 1989—Russia and China—are carefully unveiling that most feared alternative, a viable, gold-backed international currency and potentially, several similar currencies that can displace the unjust hegemonic role of the dollar today.

For several years both the Russian Federation and the Peoples’ Republic of China have been buying huge volumes of gold, largely to add to their central bank currency reserves which otherwise are typically in dollars or euro currencies. Until recently it was not clear quite why.

For several years it’s been known in gold markets that the largest buyers of physical gold were the central banks of China and of Russia. What was not so clear was how deep a strategy they had beyond simply creating trust in the currencies amid increasing economic sanctions and bellicose words of trade war out of Washington.

Now it’s clear why.

China and Russia, joined most likely by their major trading partner countries in the BRICS (Brazil, Russia, India, China, South Africa), as well as by their Eurasian partner countries of the Shanghai Cooperation Organization (SCO) are about to complete the working architecture of a new monetary alternative to a dollar world.

Currently, in addition to founding members China and Russia, the SCO full members include Kazakhstan, Kyrgyzstan, Tajikistan, Uzbekistan, and most recently India and Pakistan. This is a population of well over 3 billion people, some 42% of the entire world population, coming together in a coherent, planned, peaceful economic and political cooperation.

Gold-Backed Silk Road

It’s clear that the economic diplomacy of China, as of Russia and her Eurasian Economic Union group of countries, is very much about realization of advanced high-speed rail, ports, energy infrastructure weaving together a vast new market that, within less than a decade at present pace, will overshadow any economic potentials in the debt-bloated economically stagnant OECD countries of the EU and North America.

What until now was vitally needed, but not clear, was a strategy to get the nations of Eurasia free from the dollar and from their vulnerability to further US Treasury sanctions and financial warfare based on their dollar dependence. This is now about to happen.

At the September 5 annual BRICS Summit in Xiamen, China, Russian President Putin made a simple and very clear statement of the Russian view of the present economic world. He stated, “Russia shares the BRICS countries’ concerns over the unfairness of the global financial and economic architecture, which does not give due regard to the growing weight of the emerging economies. We are ready to work together with our partners to promote international financial regulation reforms and to overcome the excessive domination of the limited number of reserve currencies.”

To my knowledge he has never been so explicit about currencies. Put this in context of the latest financial architecture unveiled by Beijing, and it becomes clear the world is about to enjoy new degrees of economic freedom.

China Yuan Oil Futures

According to a report in the Japan Nikkei Asian Review, China is about to launch a crude oil futures contract denominated in Chinese yuan that will be convertible into gold. This, when coupled with other moves over the past two years by China to become a viable alternative to London and New York to Shanghai, becomes really interesting.

China is the world’s largest importer of oil, the vast majority of it still paid in US dollars. If the new Yuan oil futures contract gains wide acceptance, it could become the most important Asia-based crude oil benchmark, given that China is the world’s biggest oil importer. That would challenge the two Wall Street-dominated oil benchmark contracts in North Sea Brent and West Texas Intermediate oil futures that until now has given Wall Street huge hidden advantages.

That would be one more huge manipulation lever eliminated by China and its oil partners, including very specially Russia. Introduction of an oil futures contract traded in Shanghai in Yuan, which recently gained membership in the select IMF SDR group of currencies, oil futures especially when convertible into gold, could change the geopolitical balance of power dramatically away from the Atlantic world to Eurasia.

In April 2016 China made a major move to become the new center for gold exchange and the world center of gold trade, physical gold. China today is the world’s largest gold producer, far ahead of fellow BRICS member South Africa, with Russia number two.

Now to add the new oil futures contract traded in China in Yuan with the gold backing will lead to a dramatic shift by key OPEC members, even in the Middle East, to prefer gold-backed Yuan for their oil over inflated US dollars that carry a geopolitical risk as Qatar experienced following the Trump visit to Riyadh some months ago. Notably, Russian state oil giant, Rosneft just announced that Chinese state oil company, CEFC China Energy Company Ltd. Just bought a 14% share of Rosneft from Qatar. It’s all beginning to fit together into a very coherent strategy.

Meanwhile, in Latin America:

De-Dollarization Spikes – Venezuela Stops Accepting Dollars For Oil Payments

(Zero Hedge) – Did the doomsday clock on the petrodollar (and implicitly US hegemony) just tick one more minute closer to midnight?

Apparently confirming what President Maduro had warned following the recent US sanctions, The Wall Street Journal reports that Venezuela has officially stopped accepting US Dollars as payment for its crude oil exports.

As we previously noted, Venezuelan President Nicolas Maduro said last Thursday that Venezuela will be looking to “free” itself from the U.S. dollar next week. According to Reuters, “Venezuela is going to implement a new system of international payments and will create a basket of currencies to free us from the dollar,” Maduro said in a multi-hour address to a new legislative “superbody.” He reportedly did not provide details of this new proposal.

Maduro hinted further that the South American country would look to using the yuan instead, among other currencies.

“If they pursue us with the dollar, we’ll use the Russian ruble, the yuan, yen, the Indian rupee, the euro,” Maduro also said.

The state oil company Petróleos de Venezuela SA, known as PdVSA, has told its private joint venture partners to open accounts in euros and to convert existing cash holdings into Europe’s main currency, said one project partner.

This first step towards one or more gold-backed Eurasian currencies certainly looks like a viable and — for a lot of big players out there — welcome addition to the global money stock.

Venezuela, meanwhile illustrates the growing perception of US weakness. It used to be that a small country refusing to take dollars could expect regime change in short order. Now, maybe not so much.

Combine the above with the emergence of bitcoin and its kin as the preferred monetary asset of techies and libertarians, and the monetary world suddenly looks downright multi-polar.

By John Rubino via ZeroHedge

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Highly Unusual US Treasury Yield Pattern Not Seen Since Summer of 2000

Curve watchers anonymous has taken an in-depth review of US treasury yield charts on a monthly and daily basis. There’s something going on that we have not see on a sustained basis since the summer of 2000. Some charts will show what I mean.

Monthly Treasury Yields 3-Month to 30-Years 1998-Present:

https://mishgea.files.wordpress.com/2017/09/yield-curve-2017-09-07b1.png?w=768&h=448

It’s very unusual to see the yield on the long bond falling for months on end while the yield on 3-month bills and 1-year note rises. It’s difficult to spot the other time that happened because of numerous inversions. A look at the yield curve for Treasuries 3-month to 5-years will make the unusual activity easier to spot.

Monthly Treasury Yields 3-Month to 5-Years 1990-Present:

https://mishgea.files.wordpress.com/2017/09/yield-curve-2017-09-07a3.png?w=768&h=454

Daily Treasury Yields 3-Month to 5-Years 2016-2017:

https://mishgea.files.wordpress.com/2017/09/yield-curve-2017-09-07c1.png?w=768&h=448

Daily Treasury Yields 3-Month to 5-Years 2000:

https://mishgea.files.wordpress.com/2017/09/yield-curve-2017-09-07d.png?w=768&h=453

One cannot blame this activity on hurricanes or a possible government shutdown. The timeline dates to December of 2016 or March of 2017 depending on how one draws the lines.

This action is not at all indicative of an economy that is strengthening.

Rather, this action is indicative of a market that acts as if the Fed is hiking smack in the face of a pending recession.

Hurricanes could be icing on the cake and will provide a convenient excuse for the Fed and Trump if a recession hits.

Related Articles

  1. Confident Dudley Expects Rate Hikes Will Continue, Hurricane Effect to Provide Long Run “Economic Benefit”
  2. Hurricane Harvey Ripple Effects: Assessing the Impact on Housing and GDP
  3. “10-Year Treasury Yields Headed to Zero Percent” Saxo Bank CIO

By Mike “Mish” Shedlock

Fed Warns Markets “Vulnerable to Elevated Valuations” [charts]

Hussman Predicts Massive Losses As Cycle Completes After Fed Warns Markets “Vulnerable to Elevated Valuations”

Buried deep in today’s FOMC Minutes was a warning to the equity markets that few noticed…

This overall assessment incorporated the staff’s judgment that, since the April assessment, vulnerabilities associated with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets…

According to another view, recent rises in equity prices might be part of a broad-based adjustment of asset prices to changes in longer-term financial conditions, importantly including a lower neutral real interest rate, and, therefore, the recent equity price increases might not provide much additional impetus to aggregate spending on goods and services.

According to one view, the easing of financial conditions meant that the economic effects of the Committee’s actions in gradually removing policy accommodation had been largely offset by other factors influencing financial markets, and that a tighter monetary policy than otherwise was warranted.

Roughly translated means – higher equity prices are driving financial conditions to extreme ‘easiness’ and The Fed needs to slow stock prices to regain any effective control over monetary conditions.

https://i2.wp.com/www.zerohedge.com/sites/default/files/images/user3303/imageroot/2017/08/14/20170816_FOMC11.png

And with that ‘explicit bubble warning’, it appears the ‘other’ side of the cycle, that Hussman Funds’ John Hussman has been so vehemently explaining to investors, is about to begin…

Nothing in history leads me to expect that current extremes will end in something other than profound disappointment for investors. In my view, the S&P 500 will likely complete the current cycle at an index level that has only 3-digits. Indeed, a market decline of -63% would presently be required to take the most historically reliable valuation measures we identify to the same norms that they have revisited or breached during the completion of nearly every market cycle in history.

The notion that elevated valuations are “justified” by low interest rates requires the assumption that future cash flows and growth rates are held constant. But any investor familiar with discounted cash flow valuation should recognize that if interest rates are lower because expected growth is also lower, the prospective return on the investment falls without any need for a valuation premium.

At present, however, we observe not only the most obscene level of valuation in history aside from the single week of the March 24, 2000 market peak; not only the most extreme median valuations across individual S&P 500 component stocks in history; not only the most extreme overvalued, overbought, over bullish syndromes we define; but also interest rates that are off the zero-bound, and a key feature that has historically been the hinge between overvalued markets that continue higher and overvalued markets that collapse: widening divergences in internal market action across a broad range of stocks and security types, signaling growing risk-aversion among investors, at valuation levels that provide no cushion against severe losses.

We extract signals about the preferences of investors toward speculation or risk-aversion based on the joint and sometimes subtle behavior of numerous markets and securities, so our inferences don’t map to any short list of indicators. Still, internal dispersion is becoming apparent in measures that are increasingly obvious. For example, a growing proportion of individual stocks falling below their respective 200-day moving averages; widening divergences in leadership (as measured by the proportion of individual issues setting both new highs and new lows); widening dispersion across industry groups and sectors, for example, transportation versus industrial stocks, small-cap stocks versus large-cap stocks; and fresh divergences in the behavior of credit-sensitive junk debt versus debt securities of higher quality. All of this dispersion suggests that risk-aversion is rising, no longer subtly. Across history, this sort of shift in investor preferences, coupled with extreme overvalued, overbought, over bullish conditions, has been the hallmark of major peaks and subsequent market collapses.

The chart below shows the percentage of U.S. stocks above their respective 200-day moving averages, along with the S&P 500 Index. The deterioration and widening dispersion in market internals is no longer subtle.

https://i0.wp.com/www.zerohedge.com/sites/default/files/images/user3303/imageroot/2017/08/14/20170816_huss.png

Market internals suggest that risk-aversion is now accelerating. The most extreme variants of “overvalued, overbought, over bullish” conditions we identify are already in place.

https://i1.wp.com/www.zerohedge.com/sites/default/files/images/user3303/imageroot/2017/08/14/20170816_huss1_0.png

A market loss of [1/2.70-1 =] -63% over the completion of this cycle would be a rather run-of-the-mill outcome from these valuations. All of our key measures of expected market return/risk prospects are unfavorable here. Market conditions will change, and as they do, the prospective market return/risk profile will change as well. Examine all of your investment exposures, and ensure that they are consistent with your actual investment horizon and tolerance for risk.

Source: ZeroHedge

Greenspan Nervous About Bond Bubble

https://tse4.mm.bing.net/th?id=OIP.y37-EDY0aF-MRQCrDknuwQERDk&w=256&h=200&c=7&qlt=90&o=4&pid=1.7Equity bears hunting for excess in the stock market might be better off worrying about bond prices, Alan Greenspan says. That’s where the actual bubble is, and when it pops, it’ll be bad for everyone.

“By any measure, real long-term interest rates are much too low and therefore unsustainable,” the former Federal Reserve chairman said in an interview. “When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.”

While the consensus of Wall Street forecasters is still for low rates to persist, Greenspan isn’t alone in warning they will break higher quickly as the era of global central-bank monetary accommodation ends. Deutsche Bank AG’s Binky Chadha says real Treasury yields sit far below where actual growth levels suggest they should be. Tom Porcelli, chief U.S. economist at RBC Capital Markets, says it’s only a matter of time before inflationary pressures hit the bond market.

“The real problem is that when the bond-market bubble collapses, long-term interest rates will rise,” Greenspan said. “We are moving into a different phase of the economy — to a stagflation not seen since the 1970s. That is not good for asset prices.”

Stocks, in particular, will suffer with bonds, as surging real interest rates will challenge one of the few remaining valuation cases that looks more gently upon U.S. equity prices, Greenspan argues. While hardly universally accepted, the theory underpinning his view, known as the Fed Model, holds that as long as bonds are rallying faster than stocks, investors are justified in sticking with the less-inflated asset.

https://assets.bwbx.io/images/users/iqjWHBFdfxIU/ihXc5XfbOfv0/v2/800x-1.png

Right now, the model shows U.S. stocks at one of the most compelling levels ever relative to bonds. Using Greenspan’s reference of an inflation-adjusted measure of bond yields, the gap between the S&P 500’s earnings yield of 4.7 percent and the 10-year yield of 0.47 percent is 21 percent higher than the 20-year average. That justifies records in major equity benchmarks and P/E ratios near the highest since the financial crisis.

If rates start rising quickly, investors would be advised to abandon stocks apace, Greenspan’s argument holds. Goldman Sachs Group Inc. Chief Economist David Kostin names the threat of rising inflation as one reason he isn’t joining Wall Street bulls in upping year-end estimates for the S&P 500.

While persistently low inflation would imply a fair value of 2,650 on the benchmark gauge, the more likely case is a narrowing of the gap between earnings and bond yields, Kostin says. He is sticking to his estimate that the index will finish the year at 2,400, implying a drop of about 3 percent from current levels.

That’s no slam dunk, as stocks have proven resilient to bond routs so far in the eight-year bull market. While the 10-year Treasury yield has peaked above 3 percent just once in the past six years, sudden spikes in yields in 2013 and after the 2016 election didn’t slow stocks from their grind higher.

Those shocks to the bond market proved short-lived, though, as tepid U.S. growth combined with low inflation to keep real and nominal long-term yields historically low.

That era could end soon, with the Fed widely expected to announce plans for unwinding its $4.5 trillion balance sheet and central banks around the world talking about scaling back stimulus.

“The biggest mispricing in our view across asset classes is government bonds,’’ Deutsche Bank’s Chadha said in an interview. “We should start to see inflation move up in the second half of the year.”

By Oliver Renick and Liz McCormick | Bloomberg

LIBOR Index To Be Phased Out By 2021

https://i0.wp.com/www.occupy.com/sites/default/files/medialibrary/ss-120718-libor-scandal-04.ss_full.jpg

Unofficially, Libor died some time in 2012 when what until then was a giant “conspiracy theory” – namely that the world’s most important reference index, setting the price for $350 trillion in loans, credit and derivative securities had been rigged for years – was confirmed. Officially, Libor died earlier today when the top U.K. regulator, the Financial Conduct Authority which regulates Libor, said the scandal-plagued index would be phased out and that work would begin for a transition to alternate, and still undetermined, benchmarks by the end of 2021.

https://i0.wp.com/www.zerohedge.com/sites/default/files/images/user5/imageroot/2017/07/20/20170727_libor_0.jpg

As Andrew Bailey, chief executive of the FCA, explained the decision to eliminate Libor was made as the amount of interbank lending has hugely diminished and as a result “we do not think markets can rely on Libor continuing to be available indefinitely.”

He is right: whether as a result of central banks effectively subsuming unsecured funding needs, or simply due to trader fears of being caught “red-handed” for simply trading it, the number of transactions directly involving Libor have virtually ground to a halt. According to the WSJ, “in one case banks setting the Libor rate for one version of the benchmark executed just 15 transactions in that currency and duration for the whole of 2016.”

As the WSJ adds, the U.K. regulator has the power to compel banks to submit data to calculate the benchmark. “But we do not think it right to ask, or to require, that panel banks continue to submit expert judgments indefinitely,” he said, adding that many banks felt “discomfort” at the current set up. The FCA recently launched an exercise to gather data from 49 banks to see which institutions are most active in the interbank lending market.

Commeting on the decision, NatWest Markets’ Blake Gwinn told Bloomberg that the decision was largely inevitable: “There had never been an answer as to how you get market participants to adopt a new benchmark. It was clear at some point authorities were going to force them. The FCA can compel people to participate in Libor. What can ICE do if they’ve lost the ability to get banks to submit Libor rates?”

Gwinn then mused that “in the meantime, what’s today’s trade? The U.K. has Sonia, but the U.S. doesn’t have a market. There’s still so much uncertainty at this point” Yesterday, “a Libor swap meant something. Now you can’t rely on swaps for balance-sheet hedging.”

And so the inevitable decision which many had anticipated, was finally made: after 2021 Libor will be no more.

Below is a brief history of what to many was and still remains the most important rate:

  • 1986: First Libor rates published.
  • 2008: WSJ articles show concerns with Libor. Regulators begin probes.
  • 2012: Barclays becomes first bank to settle Libor-rigging allegations. U.K. regulator pledges to reform the benchmark.
  • 2014: Intercontinental Exchange takes control of administering Libor.
  • 2015: Trader Tom Hayes gets 14-year prison sentence after Libor trial.
  • 2017: U.K. regulator plans to phase in Libor alternatives over five years.

Yet while anticipated, the surprising announcement of Libor’s upcoming death has taken many traders by surprise, not least because so many egacy trades still exist. As BLoomberg’s Cameron Crise writes, “There is currently an open interest of 170,000 eurodollar futures contracts expiring in 2022 and beyond – contracts that settle into a benchmark that will no longer exist. What are existing contract holders and market makers supposed to do?

Then there is the question of succession: with over $300 trillion in derivative trades, and countless billion in floating debt contracts, currently referening Libor, the pressing question is what will replace it, and how will the transition be implemented seamlessly?

The FCA’s CEO didn’t set out exactly what a potential replacement for Libor might look like but a group within the Bank of England is already working on potential replacements. “However, any shift will have to be phased in slowly.”

Bailey said it was up to the IBA and banks to decide how to move Libor-based contracts to new benchmarks. After 2021 IBA could choose to keep Libor running, but the U.K. regulator would no longer compel banks to submit data for the benchmark.

The Fed has already been gearing up for the replacement: last month the Alternative Reference Rates Committee, a group made up of the largest US banks, voted to use a benchmark based on short-term loans known as repurchase agreements or “repo” trades, backed by Treasury securities, to replace U.S. dollar Libor. The new rate is expected to be phased in starting next year, and the group will hold its inaugural meeting in just days, on August 1.

The problem with a repo-based replacement, however, is that it will take the placidity of the existing reference rate, and replace it with a far more volatile equivalent. As Crise points, out, “since 2010 the average daily standard deviation of three month dollar Libor is 0.7 basis points. The equivalent measure for GC repo is 4.25 bps. That’s a completely different kettle of fish.”

So as the countdown to 2021 begins, what replaces Libor is not the only question: a bigger problem, and perhaps the reason why Libor was so irrelevant since the financial crisis, is that short-term funding costs since the financial crisis were virtually non-existent due to ZIRP and NIRP. Now that rates are once again rising, the concern will be that not does a replacement index have to be launched that has all the functionality of Libor (ex rigging of course), but that short-term interest rates linked to the Libor replacement will be inevitably rising. And, for all those who follow funding costs and the upcoming reduction in liquidity in a world of hawkish central banks, this means that volatility is guaranteed. In other words, this forced transition is coming in the worst possible time.

Then again, as many have speculated, with the next recession virtually assured to hit well before 2021, it is much more likely that this particular plan, like so many others, will be indefinitely postponed long before the actual deadline.

Source: ZeroHedge

Exploring The Death Spiral Of Financialization [video]

Each new policy destroys another level of prudent fiscal/financial discipline.

The primary driver of our economy–financialization–is in a death spiral. Financialization substitutes expansion of interest, leverage and speculation for real-world expansion of goods, services and wages.

Financial “wealth” created by leveraging more debt on a base of real-world collateral that doesn’t actually produce more goods and services flows to the top of the wealth-power pyramid, driving the soaring wealth-income inequality we see everywhere in the global economy.

As this phantom wealth pours into assets such as stocks, bonds and real estate, it has pushed the value of these assets into the stratosphere, out of reach of the bottom 95% whose incomes have stagnated for the past 16 years.

The core problem with financialization is that it requires ever more extreme policies to keep it going. These policies are mutually reinforcing, meaning that the total impact becomes geometric rather than linear. Put another way, the fragility and instability generated by each new policy extreme reinforces the negative consequences of previous policies.

These extremes don’t just pile up like bricks–they fuel a parabolic rise in systemic leverage, debt, speculation, fragility, distortion and instability.

This accretive, mutually reinforcing, geometric rise in systemic fragility that is the unavoidable output of financialization is poorly understood, not just by laypeople but by the financial punditry and professional economists.

Gordon Long and I cover the policy extremes which have locked our financial system into a death spiral in a new 50-minute presentation, The Road to Financialization. Each “fix” that boosts leverage and debt fuels a speculative boom that then fizzles when the distortions introduced by financialization destabilize the real economy’s credit-business cycle.

Each new policy destroys another level of prudent fiscal/financial discipline.

The discipline of sound money? Gone.

The discipline of limited leverage? Gone.

The discipline of prudent lending? Gone.

The discipline of mark-to-market discovery of the price of collateral? Gone.

The discipline of separating investment and commercial banking, i.e. Glass-Steagall? Gone.

The discipline of open-market interest rates? Gone.

The discipline of losses being absorbed by those who generated the loans? Gone.

And so on: every structural source of discipline has been eradicated, weakened or hollowed out. Financialization has consumed the nation’s seed corn, and the harvest of instability is ripening in the fields of finance and the real economy alike.

Source: ZeroHedge

Bob Rodriguez: “We Are Witnessing The Development Of A Perfect Storm”

Bob Rodriguez: “We Are Witnessing The Development Of A Perfect Storm”

Robert L. Rodriguez was the former portfolio manager of the small/mid-cap absolute-value strategy (including FPA Capital Fund, Inc.) and the absolute-fixed-income strategy (including FPA New Income, Inc.) and a former managing partner at FPA, a Los Angeles-based asset manager. He retired at the end of 2016, following more than 33 years of service.

He won many awards during his tenure. He was the only fund manager in the United States to win the Morningstar Manager of the Year award for both an equity and a fixed income fund and is tied with one other portfolio manager as having won the most awards. In 1994 Bob won for both FPA Capital and FPA New Income, and in 2001 and 2008 for FPA New Income.

The opinions expressed reflect Mr. Rodriguez’ personal views only and not those of FPA.

 I spoke with Bob on June 22.

In a recent quarterly market commentary Jeremy Grantham posited that reversion to the mean may not be working as it has in the past. What are your thoughts on mean reversion?

There will be a reversion to the mean. We are in a very difficult and challenging time for active managers, and in particular, value style managers. Many of these managers are fighting for their economic lives.

Given that I am no longer involved professionally in managing money, I believe the standards in the industry are being compromised; monetary policy has so totally distorted the capital markets. You are now into the eighth year of a period that is unprecedented in the likes of human history.

The closest policy period to what we have now would have been between 1942 and 1951, when the Fed and Treasury had an accord to keep interest rates low. Interest rates were artificially held lower to help finance the World War II effort. With the renewal of inflation after the war, a policy war developed between the Treasury and the Fed on the continuation of a low interest rate policy. The Treasury-Fed of 1951 brought this period to a close. But that is the only time we’ve had a period of nine years of manipulated, price-controlled interest rates.

This was a historical policy I discussed with my colleagues upon my return from sabbatical in 2011: what could unfold were controlled, manipulated and distorted pricing that could disrupt the normal functioning of the capital markets. The historical cycles that Jeremy would be referring to that entailed a reversion to the mean could be distorted, for a period of time, by this type of monetary policy action.

But I do not believe the economic laws of gravity have been permanently changed.

At a Grant’s Conference last year Steven Bregman asserted that indexation in general and ETFs in particular were factors in the under-performance of active managers and are potentially a bubble. Are you familiar with his work and what are your thoughts on ETFs? What is driving the flow of mutual fund assets to passive strategies and what can or should fund companies do in the face of this trend?

I go back to a speech I gave in 2009, Reflections and Outrage, and buried within that speech is a section that said that if active managers did not get their act together then the likelihood would be that passive strategies would continue to take market share. When you have a market that is distorted by zero interest rate policy, David Tepper said it very well many years ago, “Well, you’ve got to ride it.”

It’s a rocket ship that’s going up. If you are fully invested in the right areas, you have a shot at out-performing. However, if you are an active manager who has a valuation discipline, given the valuation excesses in the capital markets now and that have been developing for the past several years, then an elevated level of liquidity would be held, if you were allowed to do so. As such, you will likely underperform the market.

Active managers have not demonstrated a value-add to an appreciable extent over the last 20 years. When I look back at what happened prior to 2000, if an active growth stock manager could not see the most extraordinary distortion and elevated, speculative market in history, when will they? In the lead up to the 2007-2009 financial crisis, many value-style managers did not cover themselves in glory either. If you looked at what their major stock ownership concentrations were, they were very much in large banks and various types of financial institutions that were going to get crushed in the credit downturn. If they couldn’t acknowledge or identify the greatest credit excess in history, when will they?

I’m picking on both growth- and value-style managers for missing two of the great bubbles in history. This miss led to capital destruction. Now we have a clueless Fed, in my opinion, that has never known what a bubble is beforehand. It is accentuating one that has been developing as a result of its policy insanity of QE. Markets are going straight up predicated on it.

The public looks at these outcomes and says, “Why should I pay higher fees to managers who can’t outperform or can’t even identify a major speculative blow off. I might as well be fully invested. I might as well be in an ETF or index fund.”

Thus, since 2007, indexing or passive activities have risen from approximately 7% to 9% of total managed assets to almost 40%. As you shift assets from active managers to passive managers, they buy an index. The index is capital weighed, which means more and more money is going into fewer and fewer stocks.

We’ve seen this act before. If you didn’t own the nifty 50 stocks in the early 1970s, you underperformed and, thus, money continued to go into them. If you were a growth stock manager in 1998-1999 and you were not buying “net” stocks, you underperformed and were fired. More and more money went into fewer and fewer stocks. Today you have a similar case with the FANG stocks. More and more money is being deployed into a narrower and narrower area. In each case, this trend did not ended well.

When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.

We are witnessing the development of a “perfect storm.”

The Wall Street Journal has reported that central banks from Switzerland to South Africa are investing their reserves in equities. How should investors respond to the participation in the price discovery system by players that can print money and may not be performance-driven?

The last thing I ever wanted to do as a professional was allocate capital to areas that government was buying. With governmental-driven decisions there are virtually no penalties for bad decision making. Look at the rank stupidity of Dodd-Frank, or Paulson, Bernanke, and Greenspan. They were clueless before each of the last crises. They helped drive a system off the tracks. What penalty have they paid? None! They get to keep their pensions.

But when you have central banks deploying capital and their cost of money is zero, they destroy the capital-asset pricing mechanism; they destroy comparability; the distortions continue.

As a dedicated contrarian, the last place I want to invest money is where governments are deploying the capital because they are so totally distorting the market.

How did the discipline of value investing as you practiced it at FPA, change over the course of your career, particularly since the financial crisis?

It’s an interesting question and I’ve asked myself that many times.

The markets moved more slowly prior to this century – the ebbs and flows, the decision-making and the conveyance of information. With the advance of electronics and the internet, the speed of dissemination of news accelerated. I don’t believe that judgments have improved; just the speed has accelerated and the time frames of patience have shortened.

I bet my entire business in the spring of 1998 when for the prior 11 or 12 years I ran my mutual fund, the FPA Capital Fund, on fumes, with 1% to 2% cash and sometimes even less than 1%. Had you held liquidity, with short-term bond yields in the high-single to double-digits, you would have underperformed the stock market by anywhere from 900 to 1,100 basis points. By 1998 the consultant’s mantra was to be “fully invested.”

I went out in the spring of 1998 arguing that the equity market was becoming excessively priced, and it continued to do so. I sought permission to move my liquidity limits from 7% to 10% which were the typical maximums, to upward of 30%. I had to fight every client on that. By the spring of 2000, without losing any money and avoiding the carnage, I took a little bit over a 50% reduction in my assets under management. I got fired. In 2007-2009, I did far more preparation and communication prior to that crisis and entered it with 45% cash.

In the first phase of a debacle like what went on in the financial crisis, it doesn’t matter whether you are a virgin or are the opposite. When they raid the entertainment house and you happen to be a person walking by, just out of the church right next door, you get caught with all of the people there.

In the aftermath the police discover, “Oh, you shouldn’t be here.” Well, it’s the same way in a crash; virtually everything gets hit. Then in the second and third stages, the real values start to unfold and you get a greater differentiation. That is what happened with my fund between 2007 and 2009 and subsequently.

A cash level of 45% was a real tough strategy for clients to handle. I had one client say, “Please stay fully invested for my account and just do your thing with the others.” I said, “No, the price you ask me to pay is too high. By being fully invested managing your money, I will contaminate my thinking, which will negatively affect my other clients. I’m sorry, that’s a price too high to pay.” I said, “Where do you want me to return the money?” He said, “Let me think about it.” The next day his response was, “Okay, you’ve got flexibility.” But I still took over a 50% hit in redemptions during that crisis.

Looking back at these two prior major cycles, it is far more difficult for a value manager to hold liquidity today in light of the policies that are being deployed. These are the worst fiscal and monetary policies in human history.

If I were still professionally managing money, despite my background of pain-and-suffering from being redeemed, my liquidity allocation would be north of 60% today.

So-called “smart-beta” products have become very popular, particularly those that incorporate a quantitatively-driven value strategy based on the Fama-French factor models. For investors that want a value-oriented portfolio, what concerns should they have with these strategies?

I have never seen a quantitative strategy succeed longer term. They are predicated on models. The models are predicated on history. When history changes, they have to develop a new factor model.

We witnessed this in the last cycle. There was an article in the WSJ quoting a quant manager who said on a Wednesday, we had experienced a 1-in-10,000 year event. On Thursday, we had a 1-in-10,000 year event. On Friday we had a 1-in-10,000 year event. A former colleague wrote an email that weekend that said, “I have a quick question to ask. On Monday, are we safe for the next 30,000 years?”

All of these strategies are meant to enhance or give an essence of how you are going to try and minimize risk and enhance return. When you are in an environment where the lead entity, the Federal Reserve, has its foot on the scale and is distorting the information coming out of the capital markets, where interest rates can go to zero, what is the proper hurdle rate for budgetary or capital allocation decisions? These actions distort the price comparison or discovery process in the capital asset-pricing model. This is highly disturbing.

By the way, I wrote a piece in 2008 before the Fed even knew they were going to balloon their balance sheet. It said they would have to increase the balance sheet by at least a trillion to a trillion and a half. They hadn’t got to that realization yet.

After 45 years of watching the Fed, the only Fed chairman that was worth spit was Paul Volcker. The last great central banker that we had in the last 110 years other than Volcker was J.P. Morgan. The difference is, when Morgan tried to contain the 1907 crisis, he wasn’t using zeros and ones of imaginary computer money; he was using his own capital. As long as you have anointed centralized bureaucratic decision makers like the Federal Reserve, that in many ways is similar to the concentrated decision making structure of the former Soviet Union, decisions will be late and generally wrong. The Fed is a large organization and like all large organizations, there are internal pressures where they try to come to a consensus, and so they do.

This is not how you make your greatest decisions.

If there is one piece of investment advice you would offer to a young professional embarking on a career now, what would that be?

I will give the same advice that I got when I was a very young professional back in 1973. I was two years into the field and a gentleman spoke before my investment class. After everybody had walked out, I walked up to Mr. Munger and I asked him, “Sir, if I could only do one thing that would make myself a better investment professional, what would you recommend?” He responded, “Read history, read history, read history.” I have done that over the years. Had you read about the banking crisis of 1907 and what preceded it in the 1890s, you would have recognized it in a form in 2007.

If there is one piece of management advice that you could offer to that same person, what would that the?

You must have two things – discipline and integrity. Compromise either and you will fail.

That’s true in all walks of life.

Yes, but it’s very easy to use the justification that this time is different.

The world has changed. I gave a speech in 2001 to some pension advisors. I said, “Look at you people out there.” I hadn’t shown them my chart yet but I said, “Look at what we have just gone through. We had the greatest, the highest level of computerization in the history of man, the most timely acquisition to information, the highest percentage of advanced degreed professionals and college graduates in the field, and we got an outcome no different than 1974, 1929, 1907. There is something more here going on.”

Then I held up two hand-written stick figures – I was not a good artist. They were cows and they were talking to one another. One cow said to the other, “Glad we’re not part of the herd.” The other cow said, “Yea.” The next exhibit was an aerial shot. It showed the two cows are in a ravine, so they can only see themselves. But all around them is the herd. I looked out and said, “People, whether you realize it or not, you are part of the herd. All you have to understand is one word, now let’s say it all together. Moo.” What a way to influence friends and make new clients.

How are you investing your personal assets?

I am at my lowest exposure to equities since 1971. They represent less than a fraction of one percent. Liquidity is north of 65%, all in Treasury-type securities, nothing beyond a three-year term. I do not trust what is going on fiscally or monetarily, and I’ll circle back on this in a moment. The balance is in rare fully paid-for physical assets.

Circling back, after I stepped down from daily money management at the end of 2009, I took a sabbatical. One of my goals was to meet a gentleman by the name of David Walker, the former comptroller general of the U.S. He wrote a book called Comeback America that I read in January of 2010. I sent my review to Dave. Two days later Dave called me and said, “My name is Dave Walker. Is this Bob Rodriguez? If so, I want to thank you for your review.” That’s how we came to know one another. I’d used his work for over 10 years. For the next three and a half years I was a sponsor of his program, Comeback America. He closed it down in 2013, a complete unmitigated failure.

Think about the budgetary battles of 2011; the only thing that was cut was defense. Two thirds of the expenditure cuts that were going to get controlled under the system would not occur until after 2016. Funny how that works. In the presidential debates, only one candidate used a word that I think has now left the English language, “sequester.” That was Bush and it was to eliminate sequestration to raise defense spending.

The 2016 election was one of the most important elections in the last 80 years. Back in 2009 I said if we do not get our economic house in order sometime between 2014 and 2018, we could see a crisis of equal or greater magnitude than the 2007-2009 crisis. I also argued that we would have a substandard recovery that would be no better than 2% real GDP growth for as far as the eye can see. Productivity and capital spending would be substandard. All of those have played out.

Here we are in 2017. I have seen absolutely nothing that would give me any degree of confidence that Washington will get its act together. We are into a period of expanding deficits. We are hitting a time where the entitlements are worsening in terms of their funding status. We are in a decade that is unprecedented from anything that we’ve seen before with monetary policy and fiscal policy.

Why on Earth should I allocate capital into a system where the scales are completely manipulated, price discovery is distorted, and the Fed doesn’t have a clue what’s going on? They’ve missed every economic forecast for the last nine years straight. Why would anybody pay any attention to what those people are doing?

I have confidence in one thing. The Fed will blow it.

My thoughts are very much analogous to those of Lacy Hunt. Where Lacy and I part company is what happens after the deformation hits. He would argue that we will be in a dis- or deflationary period for an extended period of time; therefore, you should own 30- and 20-year Treasury bonds.

I’m not so sure about that scenario. It occurred in Japan because it has a very cohesive society. That is not the case in the United States or in Europe. Our patience will be far shorter. At some point, in no more than one to two years, the Fed would likely panic and panic big time, and we will see QE on steroids. We will see monetary inflation. Lacy and I have a similar view. But the really big question is what the outcomes will be on the other side of this mess. Both of us could be very right, or very wrong, or partially in between.

I am managing my estate in a hedged fashion because what we are going through is without any precedent in human history. How can anybody have confidence that their particular view is the right view?

Source: ZeroHedge