The Perfect Storm

Green Shoots. I hate that term. I don't know what it is that people love about a lame saying, but once it catches, it's all you hear about. Much like the stock market. When a stock/sector is hot people flock to it until it slowly leaves news headlines and gets revalued at a more normal level. But I digress.

Are we actually seeing a recovery? Lately, a flood of data has shown that the second derivative has inflected meaning that the rate of decline across many metrics has slowed. Even most bears have called for a return to growth in 2010 which means the timing for slower decline should be near. The last few months have provided great insight into where the long term trends should lie.

As the panic subsides, the flee to safety will reverse, money will flow into equities, and upward pressure on rates will ensue. Specifically, U.S. Treasury prices will fall pushing yields up. It's worth noting that I have seen more coverage on this issue lately than ever before which means the idea has caught on. Here is why yields will move up:

1) The U.S. is issuing more bonds than it has since WWII to pay for promises made during this recession.
2) The international community is losing faith in U.S. repayment and calling to move away from the U.S. dollar as a reserve currency.
3) There is a possible recovery looming around the corner.

While all three points listed above can cause yields to rise (economists differ as to which is the cause, some having identified one while refuting another) it is important to understand that the impact is quite different.

Let's work backwards.

The third option provides that a recovery is imminent. If so, rates will naturally rise as they do when money flows into equities and may even be slightly above supply/demand norms due to the possible threat of inflation down the road. This scenario is the least threatening as the open market will find the appropriate price because if speculators over-shoot, higher sustained rates will worsen the recession which would send money right back to the U.S. Treasury. The underlying problem is still the housing market. That is KEY! Higher rates will only make that problem worse. That is why many call for a slow recovery as it will allow for housing to settle, money to flow out of fixed income, and rates to remain low until the recovery does actually come to fruition. The problem here is that the banks are still trying to operate as if nothing has changed. They still price their loans on the 10-year Treasury as if someone is out there eager to buy the newly repackaged mortgage backed securities (other than Bernanke). The system is broken, get it through your heads. The model has to change, maybe even go back to the old days where you write a loan, keep it on your books, and service it. Maybe not, but the banks are sitting idle while their business model is collecting dust and soon will join the dinosaurs at the Smithsonian. And as you will see below, having mortgage rates tied to the 10 year Treasury is dangerous. It defeats all that Bernanke has "accomplished" so far. While this slow recovery, gradual rise in yields, and eventual appreciation in assets may be the most likely scenario, and I hope it is, I fear that the next two are far from impossible.

The first and second options are more ominous than the third (and more conspiracy-theorist friendly). A loss of confidence that the U.S. can repay it's debts down the road (or repay them with a deflated dollar) is a serious concern, but not one that unravels overnight. That concern is exacerbated by the record issuance of new Treasuries. Our deficit is huge, our debt even bigger, and the money supply is through the roof. The catch is that the entire world operates with the U.S. dollar. Everything is priced in dollars and changing that would take years, maybe decades. China has made steps to move away from their reliance on the dollar. They have set up swaps with countries such as Brazil, shortened treasury maturities, stockpiled commodities, and publicly criticized U.S. fiscal/monetary policy. Why? Because they are smart, forward-looking, and fast-acting. Not to mention, they have more U.S. dollars than any other country in the world and may want to protect it a bit. I would too. Watching what China does (not necessarily says) is crucial.

So, here is the million $ question (or maybe trillion $ question these days): What happens if the world stops buying U.S. Treasuries at the same time that the U.S. issues record supply of them? I hereby submit this scenario as "The Perfect Storm." At that point we are no longer operating in a normal market, at least not one the U.S. has ever experienced. Yields move higher and higher while the U.S. continues paying its obligations. Institutions and governments would continue selling Treasuries as confidence of repayment (or, again, repayment with worthless dollars) deteriorates. Even higher yields sends the mortgage mess into a whole new stage, far worse than anyone has predicted. That sends the U.S. into a major depression unless the Fed steps up yet again and bails out the economy. However, in this scenario, confidence in the U.S. Treasury is already lost which means our government's ability to add the extra trillions on to it's balance sheet is only paid for by printing currency ("monetizing the debt" to those that don't like to face the truth). This Perfect Storm becomes a spiral where a depressionary environment is combined with the Treasury market being sold off and yields going through the roof. Never before has the U.S. been doubted as a safe-haven, a place people can invest without risk. The government, despite any promises that all is well, would be printing money at full speed. I even spoke with one analyst who suggested they would manipulate the auctions with fake bidders to keep yields low. Under this scenario, commodity prices (and anything else denominated in U.S. dollars including U.S. assets) would rise just as fast. Inflation would indeed become rampant, maybe even earn the prefix -hyper.

So, how likely is this? I can't say for sure, but likely enough that every investor should be considering it. The last few weeks have demonstrated this very possibility with yields and commodities skyrocketing. Several government authorities have even come out and reassured the public that they have full confidence in the U.S. Hmmmm, didn't Mozilo, Fuld, Killinger, Thain, Thompson, etc say the exact same thing right before they handed their assets to the government? And if all these foreign countries had full confidence in the U.S. would they really need to state it publicly? And why would China and others be preparing for the exact opposite of what they are stating? In my opinion, those are all questions that warrant serious concern. My best guess is the market will behave as it always has. Yields rise until an equilibrium between recovery prospects and further deterioration is found. Then that equilibrium shifts as the market moves slowly towards recovery. In fact, the last two days saw the aforementioned sectors retrace just a bit. However, you better believe that we have a heavy weighting in commodity based stocks/ETF's for our clients. What we are experiencing is unprecedented, and just because something has never happened before, doesn't mean it can't happen now.