Image credit Markus Spiske.
Murphy’s law is an epigram that is typically stated: “anything that can go wrong, will go wrong.” We tend to think of good luck or bad luck as just probability personalized, and so prefer a broader interpretation of the law: “anything that can happen, will.”
For the last several years, analysts, market commentators, and speculators alike have been claiming that interests rates must rise at some point, and when that day came, any investor that held long-duration bonds would be in for a world of pain. Artificially repressed interest rates coupled with a fear of duration has, arguably, led to the massive suppression of credit spreads. Ironically, yield chasing made long-dated Treasuries such a great relative valuation bet in 2014 – at least, in retrospect. Nevertheless, the “rates must rise” thesis continues.
It takes less effort to prove something false than it does to prove something true. Before it meant “a very rare event,” this was the very point Nassim Taleb tried to highlight in his book The Black Swan. Proving that all swans are white is very difficult, but it only takes the existence of a single black swan to prove that statement false. To prove something false, you only need a single contradictory example.
With 30 Year U.S. Treasury Bond yielding 2.69%, rates going up does seem like the obvious conclusion. After all, buying at that rate is a vote that short rates will not exceed 2.69% in the next 30 years. That seems like a big bet to make.
Looking abroad, however, we can find our single contradictory example. Germany’s 30-Year Bunds are currently yielding 1.25% and fell as low as 1.05% on Wednesday. A recent Wall Street Journal MoneyBeat Blog post highlights a few reasons why this may be:
- Relative to shorter-dated peers, 30-year rates aren’t actually that low. In fact, there is only a 50 basis point spread between 10-year and 30-year Bunds – a similar spread to the U.S. 10-Year Note and the 30-Year Bond.
- Global inflationary fears have recessed, potentially causing some investors to unwind their bearish bets on long bonds.
- The supply of German bonds in the market will actually shrink in 2015. It is simply economics that if demand remains constant and supply shrinks, price will go up.
- Germany is the Eurozone’s “safe asset”; with the potential threat of Greece’s exit, investor demand may be piqued for safety.
- In the most extreme scenario, if the Eurozone currency bloc falls apart, it is likely that the German currency will rise against its peers, to the benefit of German debt holders.
Now, these may be the very reasons, when translated to a U.S. centric viewpoint, that the 30-Year U.S. Treasury Bond rallied so heavily in 2014. Regardless, the very existence of Germany’s 30-Year rate at 1.25% is the single counter-point we need to the “rates must rise” rally cry. To paraphrase a line from Red Blooded Risk, a book by Aaron Brown, AQR’s Chief Risk Manager: it is of little harm to place a positive probability on a zero-probability event; it can be catastrophic to assume zero-probability for something that can actually happen.
Markets need not do anything we demand of them. They can go up, down, or sideways depending on the competing forces global supply and demand. Forces, we will add, which can be quite fickle in the short-run.
In the interest of keeping our week-to-week commentary short, we will end with just a few thoughts on how this sort of thinking applies to equity market beliefs. It is commonly held that stocks will appreciate over the long run – that time is a great diversifier to short-term market risks. We simply ask: how do Japanese equities fit into this belief model?
Japan’s GDP is nearly unchanged for the last 20 years and the Nikkei 225 has been similarly unchanged for those that bought-and-held over that period. After 20 years, Professor Norihiro Kato suggested that Japan might, perhaps, be the world’s first “post growth” society, focused less on consumerism and growth and more on quality of life. No amount of stimulus will be able to reboot that sort of cultural change.
Where some say “exception,” we argue “contradictory example.” Stocks need not go up forever. After all, anything that can happen will.
In Our Models
This week we saw rebalances in two of our portfolio models.
Our Risk Managed Small-Cap Sectors portfolio rebalanced, with all sectors exhibiting consistency in their momentum signals over the prior four weeks. 2 of the 9 sectors remain fully removed from the portfolio. Despite the weakness in these 2, the remainder of the momentum signals appear robust, with our models estimating that a greater than 10% loss would be required in broad small-cap exposures before short-term Treasuries would be introduced into the portfolio.
Also rebalancing this week is our Target Excess Yield 4% portfolio. Our risk dashboards estimate that the investable universe’s cross-correlation has dropped from 27.13% to 17.94% over the last 21 days while the volatility in short-term junk bonds has risen 17.32%. With the increased availability of diversification, the portfolio continues to ratchet down exposure to short-term junk and enhanced short-duration strategies in favor of broad core bonds, whose volatility profile has remain unchanged.
This week’s negative return in global equity markets continued to push our Risk-Managed Global Sectors portfolio closer to introducing a potential short-term U.S. Treasury position. Currently, 5 of the 11 sectors are exhibiting positive momentum, 3 are exhibiting neutral momentum, and 2 exhibit negative momentum. Our estimates show that if broad global markets fall another 5%, a small short-term U.S. Treasury position would be introduced to buffer downside risk.
We continue to be highly concentrated in our Multi-Asset Income portfolio, with large positions in mortgage REITs, preferreds and corporate bonds. Nevertheless, weighted average correlation in the portfolio sits just below 45%, a reminder that position concentration is not necessarily indicative of internal diversification within a portfolio.