Are You Seeing the Forest for the Trees?

By March 30, 2015 Blog No Comments

At the beginning of last week, the FTSE Multi-Asset Stock Hedge (MASH) Index bypassed the S&P 500 in year-to-date (YTD) performance. The substantial pullback in stocks that occurred on Wednesday, March 25, 2015, added fuel to the fire. Specifically, the S&P 500 is struggling to keep its head above water, while the MASH index is up 2.4% YTD.

Which components are primarily responsible for the MASH index’s outperformance?  There are 10 components that, historically speaking, effectively hedge against stock risk. Only one—German Bunds—is trailing the S&P 500. (See below.)

1. U.S. Dollar 7.05
2. 25+ Year Zero Coupon U.S. Treasury Bonds 6.06
3. Swiss Franc 3.46
4. 10-20 Year U.S. Treasury Bonds 2.51
5. Inflation-Protected U.S. Treasury Bonds 1.48
6. Gold 1.3
7. Japanese Yen 0.47
8. Japanese Government Bonds 0.34
9. National AMT-Free Municipal Bonds 0.23
10. 10.5+ Year German Bunds (1.04)

There are a couple of clear standouts in the component-by-component analysis. First, longer-maturity U.S. Treasury bonds have been superstars on the back of lower long-term interest rates. Although the Federal Reserve has been clear on the direction that they’d like to take their target (which affects the shortest end of the yield curve), the ongoing theme is one where rates on the long end of the yield curve continue to fall.  Investors with allocations in longer-term treasuries have been handsomely rewarded.

The idea that long-term interest rates have been falling for 15 months has been highly unpopular in the media, yet highly rewarding for our clients here at Pacific Park Financial, Inc. My colleague, Gary Gordon, president of Pacific Park Financial, Inc., not only wrote about investing in those ETFs which would benefit from falling long-term rates, he allocated client dollars to those ETFs back at the start of 2014. Those allocations are part and parcel of the multi-asset stock hedging strategy that MASH represents.

How unpopular was the idea that interest rates would fall, not rise, in 2014? Bloomberg regularly conducts a survey amongst top economists on the direction of interest rates. Their survey revealed that 100% of economists expected interest rates – as determined by the U.S. 10-Year Treasury – would rise from 2.86% at the time of the survey to 3.41% over the next 12 months. The 10-year actually finished at 2.17%, and multi-asset stock hedgers with exposure to 10-20 year treasuries and 25+ treasuries were richly rewarded.

Certainly, the presumption that interest rates would rise in 2014 was logical. After all, the Fed began dropping hints in May of 2013 that they would have to begin weaning the U.S. economy off quantitative easing (a.k.a. buying bonds with electronic dollar credits to hold rates down). And those hints worked! A “taper tantrum” was born such that the 10-Year shot up 140 basis points from 1.63% to a multi-year high of 3.03%. (See the chart below)


Surely, if bond market yields were soaring – and the Federal Reserve planned on tapering its bond buying to depress rates – the U.S. economy was ready to stand on its own two feet, right? After five years of zero percent rates and emergency level QE stimulus? Indeed, nearly every prominent voice began to describe the U.S. economy as “self-sustaining.”

So why on earth did we believe interest rates would fall, not rise, in 2014? Why do we still believe that rates will continue to fall, rather than rise?

For starters, the central bank of the United States primarily affects the short end of a 0-30 year yield curve. It does so by setting a target, intra-bank, overnight lending rate. However, when the Fed raises its target on the “zero” years side of the equation, investors who do not believe the economy is self-sustaining tend to gravitate to securities with a reputation as safe, long-term U.S. treasuries. Whereas the popular belief at the time had been that short-term and long-term yields would rise all along the curve – whereas the feeling was one that the economic picture was brightening – our conviction was that the global and domestic prospects were weakening. It followed that we believed efforts to push short-term rates higher would only encourage investors to seek shelter in longer-maturity yields.

Are we saying that the yield curve would get flatter and flatter? Possibly invert in spots? That a recession might be just around the bend? Yes. You read that correctly.

If the labor force continues to shrink, wage growth continues to decelerate, if corporate earnings continue to weaken, the market will demand the safety of long-term U.S. treasuries. There’s nothing the Fed can do to stop it. In fact, the Federal Reserve might even make things worse. They know that a rapid rise on the short end of the yield curve could, conceivably, push the U.S. economy into recession. That’s why all of the talk about rising rates amounts to little more than chatter.

From our perspective, a strong showing for bonds could be a theme that lasts for years to come. Consider that an equivalent yield on a German 10-year bund—let alone a Spanish bond (yes, the sovereign debt of beleaguered Spain)—is less than the U.S. 10-year. Where should a safety-seeking investor go if not the U.S.?

In truth, our conviction regarding lower interest rates, not higher ones, is not particularly hard to grasp. Take a look at the chart of the 10-year going back to the early 1980s. Can you spot the trend?


If you think that falling interest rates since the early 1980s will somehow reverse direction, then you’ll need to take into account one more trend: government spending. Decade after decade, government spending has gone up. In fact, where interest rates have fallen by roughly 88% since the early-80s, the U.S. debt as a function of economic output (GDP) has more than doubled!


Why is it important to talk about government spending? Well, take a look at the chart below. If you take the data back as far as it will go – back to 1926 – interest rates are inversely correlated to government debt. When government spending decreases, interest rates go up. When government spending increases, interest rates go down.


In essence, interest rates will not bottom out until and unless our government debt peaks like it did in the 1940s. The way the U.S. is spending today – with reckless abandon – there is little probability that government spending will be curtailed to bring our debt-to-GDP ratio back down to more sustainable levels. It follows that interest rates will not make genuine moves higher as long as public debt (accounts payable) exceeds economic output via our GDP (accounts receivable).

Think about it. If your monthly credit card bill is higher than your monthly income, what do you do? Any effort to pay off your debt goes from futile to hopeless. Unlike the average Joe, Uncle Sam has the power to tax its citizens to potentially increase short-term revenue, although that approach can ultimately limit economic output. That leaves one last hope for the U.S. government—the Federal Reserve. The Fed can create money out of thin air to purchase bonds and push down interest rates (its “credit card APR”). In fact, the Federal Reserve’s dirtiest little secret is that interest rates NEED to be kept low in order for the U.S. government to service its monstrous obligations.

Bloomberg’s annual surveys of top economists notwithstanding, investors need to see the forest for the trees. Longer-term interest rates are more likely to fall than rise. And that’s a trend we’ve been telling investors about for 15 months now.

The other half of the MASH story is the U.S. dollar. It’s not hard to see why the almighty greenback has shot to the moon since hitting near-historic lows in May of 2014.

As the chart below shows, the U.S. Federal Reserve began slowing down its third round of quantitative easing (a.k.a. QE3) on a monthly basis back on December of 2013. The Fed finished the tapering process by October of 2014. In a manner of speaking, the U.S. finally curtailed its electronic money printing endeavor.

Shortly thereafter, Japan and Europe began their own quantitative easing parties. First, Japan dropped its bombshell to electronically print yen for the purpose of purchasing its country’s bonds and stocks. Then in January of this year, Europe unveiled its mammoth electronic euro printing at an estimated €1 trillion (up from an anticipated €600-700 billion).


The net effect of Japan and Europe—and a whole host of other sovereign central banks now engaged in currency devaluing policies around the globe—have caused the dollar to soar against those global currencies. Alas, the currency wars could wind up being the proverbial straw that broke the stock market camel’s back.

Could a significantly stronger dollar cripple U.S. corporate profits? It is already happening, with first quarter earnings estimates turning negative for the first time since 2009. With median stock P/E ratios and median stock P/S ratios at their highest levels in recorded history – with stocks more expensive than they’ve ever been before – what is your plan for protecting against a severe bear?

Please click here to learn more about the MASH index.


Disclosure Statement: Pacific Park Financial, Inc. is a Registered Investment Adviser with the SEC. Pacific Park Financial, Inc. and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising on this website. is created independently of any advertising relationship.

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