The Modern Bear Trap

A colleague asked me for my thoughts on this piece by Bob Rodriguez. It is your usual anti-Fed, value investor screed. For example, he writes:

As for optimism, I would have some if I could see the insanity of the present monetary and fiscal policy environments changing for the better. But that seems like a very long, long shot. In the past two years, I’ve grown far more pessimistic, given what I see unfolding.

I have liquidated virtually 100% of my equity holdings and this occurred back in 2016 and 2017. I’ve always been early. I’ve deployed capital into 2-3 year Treasury bonds since I do not want to have any credit risk exposure in this distorted economic environment. As for risk assets, I’ve been acquiring rare, fully paid-for hard assets. I expect the latter to probably get hit in the coming recession but then they may well perform better in the ensuing monetary inflation. At least I don’t have to worry about managements leveraging their respective company balance sheets by buying back stock at elevated prices because the math works with these ultralow interest rates.

I am deeply sympathetic to a lot of this stuff on an intellectual level, but considerably more wary on a practical level. Below are my comments, edited slightly from my original email for clarity…

At a high level I basically agree with all of this.

Quibbles:

The portfolio changes he describes are too extreme, in my view. I do think the US market has conditioned us to be overly complacent about equity risk over the last 30 years. But there is a huge potential opportunity cost to sitting in cash. I think there are much better ways to manage the kinds of risks we face in this environment such as vol targeting and/or trend following overlays. The problem with the permabearish approach he describes is that there is nothing to help him get back into the market if he ends up being wrong. He will just sit in cash tilting at windmills forever with the permabear crowd.

PV30YR

Regarding negative rates, the idea of owning negative yielding debt is not necessarily irrational if you believe rates will get more negative. The reason is that there is a non-linear relationship between price and yields (see below). For some reason we are taught all about duration in basic bond math but not convexity (convexity is the curvature). The greater the change in yields and the longer the duration of your bond, the more convexity comes into play.

Even with a negative coupon, you can potentially earn a positive return DEPENDING ON THE FUTURE PATH OF INTEREST RATES. If your view is that nominal yields are headed for -3%, -4%, -5% then it is perfectly rational to own negative yielding debt as from a price perspective you are potentially looking at equity-like returns. Who said fixed income had to be boring?

PVNeg30YR

On top of that, it is possible for the owner of, say, negative yielding German Bunds to earn a positive yield by owning the bonds long and then swapping back to dollars using a currency swap or currency forwards.

That’s not to say I think negative nominal rates will achieve the policy objectives central banks have set out to achieve. In fact, I believe it’s just the opposite and the post-GFC and Japanese experiences provide empirical evidence in support of that view. But I do quibble with comments about owning negative yielding debt being “completely irrational” as I think folks making this argument are either forgetting their basic bond math or are ignorant of it. There is an important difference between merely being wrong about the future path of interest rates and being completely irrational.

5 thoughts on “The Modern Bear Trap

  1. Yes, buying a bond with a negative interest rate (NIR) can be a “good investment” should rates become more negative. The trick, however, is to sell the bond prior to maturity to realize the capital gain. Otherwise, you’re assured a loss of principal! What’s sounds risky to me is buying NIR securities knowing there’s $17 TRILLION of sell orders likely to hit the market prior to the bonds’ maturity date. Remember, holders of cash and bonds with positive interest rates do NOT have to sell prior to maturity to lock in a positive return. In contrast, holders of bonds with negative rates do!! So, ok to dance with the crowd if you think interest rates are going more negative, but make sure you’re dancing close to the door.

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