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Yield Spreads and Market Reversions

  • Written by Syndicated Publisher No Comments Comments
    June 16, 2014

    Over the last few days, I have been discussing the very wide deviations in price from long term moving averages and other signs of bullish excess.  As of late, even the“bullishly biased” mainstream media has begun to at least question the eerie calm that has overcome the financial markets as volume and volatility have all but disappeared.

    I found it very interesting that several market commentators all made similar statements when asked about the “market calm.” 

    “Where else are investors going to go to get yield.”

    The “chase for yield” was the desired result by the Federal Reserve when they dropped rates to record lows and announced, in 2010, that supporting asset prices to boost consumer confidence had become a “third mandate.” However, they may have gotten more than they bargained for as several Fed officials have now voiced concerns over potential financial instability.  To wit:

    Fed’s Kocherlakota Urges 5 More Years Of Low Interest Rates via Reuters

    Kocherlakota acknowledged that keeping rates low for so long can lead to conditions that signal financial instability, including high asset prices, volatile returns on assets, and frantic levels of merger activity as businesses and individuals strive to take advantage of low interest rates.

    But that is a risk, he suggested, the Fed should be willing to take.

    Fed’s Williams Says Central Banks Need To Realize Investor’s Aren’t Rational via The Wall Street Journal

    “In a world of rational expectations, asset prices adjust and that’s it, but if one allows for limited information, the resulting bull market may cause investors to get ‘carried away’ over time and confuse what is a one-time, perhaps transitory, shift in fundamentals for a new paradigm of rising asset prices.

    This “exuberance” can be clearly seen in bond yields. In normal times, the interest rate paid on a loan is driven by the potential for a default on repayment of the principal. For example, a person with a credit score of 500 is going to pay a substantially higher interest rate on a loan than an individual with a 700+ credit score. The “risk” of a potential repayment default is offset to some degree by a higher interest rate.  If a loan of $100,000 is made with an interest rate of 10% for 30 years, the principal is recouped after the first 10 years.  The real risk is that the loan defaults within the first 1/3 of its term.

    Currently, investors are assigning only 1/2% difference in interest rates between loaning money to a highly credit worthy borrower and one that is only marginally so.  This is shown in the chart below which is the spread between AAA and BAA rated bonds from 1919-present.

    Bond-Yields-AAA-BAA-061214

    There have been precious few times in history that the spread between interest rates have been so low. Importantly, extremely low yield spreads are not a precursor to an extended economic recovery but rather a sign of a mature economic cycle.

    The Federal Reserve officials have very good reason to be concerned about the potential for “financial instability” as extremely low thin yield spreads have also been indicative of both minor and major financial market corrections and crashes.

    Bond-YieldSpread-S&P500-061214

    I have zoomed into the chart above to show just 1960-present in order to provide a bit more clarity.

    Bond-YieldSpread-S&P500-061214-2

    What investors need to be watching for is a “widening” of the spread between yields. The decline in the yield spread shows the rise of investor “complacency.” However, the“lack of fear” is a late-cycle development and not one seen at the beginning of economic upswings. Importantly, when the yield spread begins to rise, it tends to do so rapidly leading to a reversion in asset prices.

    Currently, the ongoing “chase for yield” has led investors to take on much more “credit risk” in portfolios than they most likely realize. When “fear” is introduced into the financial markets, the subsequent “instability” will lead to far greater losses than most individuals are prepared for.

    The chart below is a comparison between “junk bond” yields, the least credit worth borrowers, versus the S&P 500.

    Bond-Yields-JunkBonds-SP500-061214

    Currently, loans are being made to the highest risk borrowers at an effective interest rate of just 5% as compared to the “risk free” rate of 2.6% for a 10-year Government bond.

    We have seen this exuberance before.  In 1999, the old valuation metrics no longer mattered as it was “clicks per page.”  In 2007, there was NO concern over subprime mortgages as the housing boom fostered a new era of financial stability.  Today, it is the Federal Reserve “put” which is unanimously believed to be the backstop to any potential shock that may occur.

    I always have to qualify these missives by stating that my portfolios are still biased to the long side of the markets. When I discuss rising risks in the markets, which is what leads to catastrophic and irreversible destruction of capital, it is always assumed that I am sitting in cash.  This is not the case. I must remain invested while markets are rising or suffer career risk, however knowing when to “fold’em” is what makes the difference to long term investment returns.

    However, having qualified my position, it is important to understand that it is not the DECLINE in interest rates and yield spread that is important, but it is the REVERSAL that must be watched for.  I point out these issues of risk only to make you aware of them as the always bullishly biased media tends to ignore “risks” until it is far too late to matter. It is likely that it will be no different this time.

    “Once more unto the breach, dear friends, once more” – William Shakespeare

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.

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