Convincingly Irrational

October 9, 2014

To make sense of the markets, it may be ever more important to dissect what we may call convincingly irrational behavior by policy makers. To make sense of stocks, bonds and currencies, you might need to discern some of the madness that’s unfolding in front of our eyes. We assume no responsibility if you turn mad yourself in reading this analysis.


As most of us love a bull market, not everyone will agree that the markets are embroiled in what former Fed Chair Greenspan referred to as “irrational exuberance.” The exuberance we are facing these days I call complacency: investors may be lured into seemingly docile assets, not realizing just how risky they are. This misallocation is fostered by our central banks whose ultra-low monetary policy encourages risk taking. In the stock market, it manifests itself through higher valuations on the backdrop of low volatility, a common measure of risk. But of course the markets are still a risky place; and anything might shake investors back into reality. When that happens, all those that thought the stock market is safe might be running for the exit (no pun intended) in a heartbeat. Hence, we’ve played party poopers and cautioned of a potential crash in the market. In fact, the party pooper might be the Fed in its attempt to engineer an exit. In our analysis, asset prices need to be re-priced (lower) should the Fed attempt an exit.


We find a great number of investors agreeing that bond prices might be irrational. As of this writing 10 year U.S. Treasuries yield 2.36%. How is this possible if the Fed is serious about an exit? Some argue that we are much closer to full employment than Fed Chair Yellen thinks (and thus leaving us vulnerable to inflation); notably, as loads of baby boomers turn 65 years old, they are eligible for Medicare, providing a major incentive to leave the labor force (and thus contributing to a low labor participation rate). But others argue against it, pointing out that the labor participation rate is low amongst young people; and that the labor force is far from maxed out, as the Affordable Care Act has created a large number of under-employed (businesses have an incentive to move full-time employees to part-time employees to avoid being required to offer healthcare).

So why are long-term rates so low? Is it one of the following:

• The market doesn’t believe there will be an exit anytime soon?

• “Easy money” by the Bank of Japan and European Central Bank depress US yields?

• The global economy is not doing well?

• Forget about the 10-year bond; look at the 2-year Treasury note that’s been inching up (a bit, at least)?

• The longer-term growth potential is lower than it used to be?

• The U.S. issuing much less debt in the short-term (although deficits are projected to rise again, both from increased spending on entitlements, as well as higher cost of servicing the federal debt)

We obviously don’t have a crystal ball either. However, our assessment is that a key driver to the low longer-term rates is that the market has lost faith in the longer-term growth potential. This could be due to excessive disincentives to generate growth, be that regulatory burden for industrial projects; ‘macro-prudential’ supervision to hold banks back from extending credit; be that Medicare and disability insurance (those receiving benefits have less of an incentive to work).

And while policies that hold back growth could be reverted, the high government and consumer debt levels may also make it difficult to raise rates. This is exacerbated by the fact that much of this so-called recovery has been based on asset price inflation. If indeed, as we believe, asset prices have to be re-priced lower as rates rise, the economic headwinds might be severe. In fact, we don’t think we can achieve positive real interest rates before the economy falters once again. We would go as far as questioning whether we will get positive real interest rates over an extended period over the next 10 years. It’s the key reason why we like gold, which pays no interest and, as such, may be more attractive than anything that has a negative real return.

When I discussed this view with a current FOMC member the other day, I was told that this cannot be the outcome, as it cannot provide a stable equilibrium; economic theory suggests we either get the Japanese experience or an inflationary one, but we cannot churn along with slightly negative real interest rates forever. My reaction was: I never said this would be stable.

Complacency may also be a way to describe the bond market. After all, central banks have caused anything from Portuguese bonds to US junk bonds to provide only meager yields. Should the Fed try to engineer an exit, these yields ought to rise should risk premia expand once again.

If all of this sounds academic, let’s just say that my own conclusion is I wouldn’t touch bonds with a 10-foot pole.


Last quarter, the greenback appeared to rise relentlessly. The reason? U.S. interest rates will be so much higher than those in the rest of the world. Indeed, it’s not just the pundits saying so, it’s what the market is pricing in. Never mind the analysis above that the Fed exit might be elusive; never mind the fact that real interest rates are more negative in the U.S. than in the Eurozone; never mind that even if the Fed Funds rate were to move up to 1.75% at the end of 2015 (the market prices in much lower rates), real interest rates in the U.S. would – in our assessment – still be below those in the Eurozone. Never mind that when “everyone” knows the dollar will rise that it just might not happen.

So what is happening? It turns out Mr. Draghi, the head of the European Central Bank (ECB) has become what I would deem “convincingly irrational.” In September, Draghi threw the kitchen sink at the market, announcing more refinancing operations (“TLTROs”), that he will proceed with an Asset-Backed Securities (ABS) purchase program, and that the ECB will buy covered bonds. There are just a few problems with these:

• Demand for TLTROs has been lackluster at best;

• In the Eurozone, there is no ABS market to speak of;

• There is a covered bond market in the Eurozone, but there’s nothing wrong with it.

Since then he has provided some vague guidance on how the plumbing on his kitchen sink is supposed to be working. The Bundesbank is not happy as it appears the ECB is willing to put junk into the sink, i.e., buy risky securities. As background, let’s keep in mind that yields in the Eurozone have plummeted. As an example, Spain, which paid almost seven percent on ten-year bonds not long ago, pays less than two percent now. If that’s not a stimulus, what is? The key reasons the Eurozone economy is stuck include:

• Lukewarm credit demand;

• Inhibited banks; and

• Russian sanctions

Incidentally, monetary policy cannot really help with any of these. We have argued that Russia may have greater impact on the Euro than the ECB; that’s because sanctions against Russia destroy confidence in those Eurozone countries that have done reasonably well. Already some are talking about a potential recession in Germany.

The biggest obstacle may well be banks, as too many banks still have legacy debt on their books tying up their balance sheets. It may well be that Draghi is thinking of buying this ‘junk’ – thereby playing the role of a ‘bad bank’; if so, it may get these banks to lend more. Never mind that this violates principles the ECB was founded on. Mr. Draghi has indicated that all he is interested in is to get inflation back up to 2%, as it’s been drifting lower of late. Notably, he has argued that there is no “quid pro quo” with governments – it’s their job to pursue structural reform, while it’s his job to get inflation to be at the right level. With due respect, unless pigs can fly, cleaning up bank balance sheets is the role of the banks and governments, not the central bank. But as the ECB is becoming the chief bank regulator, it might pursue an interpretation of its mandate that has any ‘Bundesbanker’ scream “nein.” Think of it as a Faustian pact, as the ECB might indeed be able to unleash some credit potential by buying loans of low credit quality.

But why does any of this matter for the euro? When someone throws a kitchen sink at you, you duck. Similarly, euro bulls stepped aside, allowing euro bears to give the currency a beating. To understand whether it will last, let’s keep in mind that signaling for central banks might be more effective than action. The announcements of QE in the U.S. moved the markets more than their implementation. Drawing from the U.S. experience, we consider it very likely that the implementation of Draghi’s new alphabet soup may be far less effective than the announcement of the various programs.

Odds are that the refinancing operations will be ramped up; that in itself may be a positive for the euro as past refinancing operations have shown. We doubt the ABS program will be very large, but may well help to further compress risk premia in the Eurozone; the same applies to buying covered bonds.

Ultimately, the question is when the euro bulls come out of hibernation. It turns out that bulls don’t hibernate, so don’t count them out for too long. An encouraging sign that the euro might have found at least a temporary bottom is that the currency has been rallying on bad economic data coming out of Germany. Please join us for our Webinar on Tuesday, October 21, for how we have navigated the euro.

The yen has had a horrible quarter, too. To see where Japan is headed, just consider that the stadium Japan wants to build for the Olympics is likely to cost about US$1.7 billion; that’s relevant because it shows that Japan will do anything to boost growth.

Investing when everything’s up 

So how does one invest in this environment? Prudent rebalancing dictates to take some chips off the table when equity prices are higher. One does not need to share the negative view on the markets that we do to sell some stocks, except of course that “buying the dips” has been a profitable strategy in recent years. At a recent conference, I heard a presentation arguing that the older an investor gets, the more they should allocate to equities. I pointed out that the academic papers he was referring to as backup for his theory were each published ahead of a major market top.

But where does one rebalance to? Our analysis suggests bonds may not be the right place. Having said that, a rebalancing into bonds has worked quite well in the past, including over the past year.

And as we have seen, with Mr. Draghi acting ‘convincingly irrational,’ it’s difficult to recommend blindly fleeing the greenback for the euro. Should investors embrace gold instead? Gold performed even worse than the euro versus the dollar in the third quarter, although significantly outshines the euro year-to-date (last year, the euro far outperformed gold). Talking about gold, it has held on quite well in euro and yen terms. So it’s not gold that’s out of favor on a global scale, it’s just that the greenback has had a major rally. Is it sustainable? There are three reasons I don’t think a dollar rally is sustainable:

• Contrary to conventional wisdom, a rising interest rate environment has historically not benefited the dollar. That’s because foreigners buy lots of US bonds; these bonds tend to be less attractive as interest rates rise. Having said that, we would be the first to admit that this is not a ‘normal’ environment.

• Conventional wisdom suggests the dollar rises in a “risk-off” environment, such as when the stock market plunges. It turns out these correlations are not stable; in the last quarter, the dollar rose on a rising stock market. Conversely, as the market has had a rough ride in the first couple of days of the month, the dollar has tended to fall with a falling stock market. If our negative view of the market proves correct, it may well weaken rather than strengthen the greenback.

• Lots of “good news” is priced into the dollar. Conversely, lots of bad news is priced into the euro. As it happens all too often, the best money is not necessarily made where the grass appears the greenest.

We wouldn’t want to encourage anyone to buy anything blindly – especially not when policy makers around the world continue to be what we call convincingly irrational. Should the world – both politically and from an investor’s point of view – become less stable, it may be prudent to consider allocating risk rather than investments. What we mean with that is that risk management might be ever more important. We have long argued that there may be no such thing as a safe asset anymore and investors may want to take a diversified approach to something as mundane as cash. Should we be right and asset prices globally get re-priced, it won’t be easy.


The reason we like currencies is because they provide an avenue not only to produce uncorrelated returns, but also to manage risk. Learn more by joining us for our Webinar on Tuesday, October 21.

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Spanish Conquistadores invaded the Inca Empire in 1528 to steal their silver and gold.