The Widowmaker

There was a strange back and forth recently on Twitter after John Aziz pointed out Nassim Taleb's wrong call on treasury yields back in 2010, having said that every human should short US treasuries, and that it was a no-brainer. Taleb is a brilliant thinker, so how did he and other intelligent people get it wrong on sovereign debt? 

One of the hardest concepts to understand in finance is why seemingly insolvent governments can keep funding themselves almost for free. It doesn't seem right, or at least it doesn't fit with expectations. Taleb might have looked at the Euro debt crisis and subsequently painted all sovereigns with a broad brush, but I can't be sure of his process. I know I struggled for about 2 years to really understand why countries like Japan and the US had not collapsed from insolvency - looking at all the different angles, learning the basic operational and legal framework of the Federal Reserve. As counter-intuitive as it felt, in the end I couldn't see how the US would ever need to default, or any other country with its own currency (as the legal and operational constructs are similar).

The fact that this is so counter-intuitive is probably an essential feature of why government bond markets do not face the wrath of bond vigilantes. What I mean by this is that, if everyone understood that the government was not at risk of insolvency, there would be less accountability for wasteful spending - possibly even reckless spending would occur, which would itself put the government bond market at risk of losing credibility and an inflationary episode.

Because most people assume the government's finances resemble our own personal balance sheets, there is a genuine repulsion to high debt levels, and those in government normally try their best to reduce spending when possible, thereby retaining credibility enough that markets never seriously doubt the smooth functioning of this particular market.

This counter-intuitive nature is also probably responsible for so many senior analysts believing that when the Fed scales back its bond purchases, treasury yields will rise - which is of course backwards, because QE has never lowered yields in the first place. The implicit assumption is that the US government is spending beyond its means, and can only do this because the Fed is keeping rates low by buying debt - this is, funnily enough, also backwards even though it sounds correct. If the Fed were to remove its stimulus programs today, far from causing a flight out of treasuries, this would actually cause a flight in to the safety of treasuries, leading to drastically lower yields -  possibly even negative yields for shorter maturity instruments. We have seen this in action since the Fed tapered its bond purchases - yields have stopped rising and have even fallen since the announcement.

To get this backwards, one needs to assume that the natural path for interest rates is up, and that the Fed is keeping them down against what is 'natural'. This tends to play in to a lot of natural resentment felt towards central banks and private banks, so it is often unquestioned. Far more likely is that, because all the factors that caused falling long rates and inflation for decades are still in place, and there are powerful new factors since the GFC that have amplified this; de-leveraging; low demand for credit; high supply of savings; falling inflation or even deflation; Chinese investment in overcapacity - the natural path for interest rates is still down.

This is normal in an era that can be classified as a Balance Sheet Recession (or Great Depression/Great Recession), where the private sector is trying to repair impaired balance sheets and so demand for new loans is anemic. There have been at least 3 of these periods in recent history, and the previous 2 did not see interest rates turn around for decades. The Great Depression is particularly insightful, because even when inflation picked up during World War 2, yields still did not rise (more regarding this later on monetary policy) - again, The Widow-maker was a terrible trade, despite conditions that should have made it successful:

A long term history of interest rates and stock prices. Due to a incompelte data I've had to cobble together several data sets; 10 year UST's; Long term government bonds; High grade railway bonds; Dow Jones Industrial Index; Railway shares. Thus, this is not perfectly accurate, but the series are close enough substitutes to give a reasonable representation.

Understanding of what makes the widow-maker trade such an unrewarding trade involves, among other things:

1. Interest rate cycles.
2. Credit and savings demand.
3. Monetary policy.
4. Asset prices and bubbles.
5. Inflationary vs. dis-inflationary periods.
6. Legal framework, central bank balance sheet construction, and what separates Euro countries from other developed nations.
7. Public and private debt levels.
8. Global balance of payments imbalances (think US and China, or Germany and Greece), and the savings glut/great moderation.

I will need to break this explanation up in to parts, as it is a long one, but well worth the time as interest rates affect valuations across all asset classes. Also, yield movements make a lot more sense when you stop looking at them backwards!