Deficits and Interest Rates.

The following graph (via Business Insider) shows the yield on the 10 Year Treasury (blue) relative to the Total Public Debt (red):

I point this out now as the calls for reigning in government spending are getting louder.  It seems the primary reason why spending hawks do not want any more monetary stimulus is that it could move interest rates higher.  However, as the graph shows, and as the article points out, there is no connection between spending and interest rates.

I have an idea of why this is happening – deleveraging (see here, here, and here).  Basically as people begin to save more and pay off debt they spend less.  The decrease in spending affects the whole economy as individuals, financial institutions, and companies begin to save and hold cash.  Not wanting to take on risk, the cash is invested in Treasuries.  Thus, lower yields.

I have advocated for more fiscal stimulus numerous times.  While I do think longer-term – after the deleveraging cycle winds down – federal spending needs to be cut down, doing so now would make things worse.  In the words of Richard Koo:

“The insistence that fiscal consolidation is necessary in the longer term is like the doctor who, faced with a patient who has just been admitted to the intensive care ward, repeatedly questions the patient about his ability to afford the treatment. This is both lacking in decency and irresponsible.

If the patient loses heart after learning the cost of the treatment, he may end up spending even longer in the hospital, leading to a larger final bill. Completely ignoring the policy duration effect of fiscal policy and constantly insisting on longer-term fiscal consolidation was what prolonged Japan’s recession.”

Spreads and Equities

I commented last week on the value of credit spreads – credit stress, economic conditions, as a possible buy indicator.  This week I came across some graphs that indicate some correlation with the equity market.

The first is the TED spread.  I mentioned this in the last post, but the TED spread is an indicator of credit risk essentially reflecting the difference in yield between short-term corporate borrowers and Treasury Bills.  The higher the spread,  is the greater the risk in the credit markets. 

The graph here (via Infectious Greed) shows the inverted TED spread versus the S&P 500.  If you look at the graph, as the TED spread moves higher equities in general move lower. 

Another graph that caught my eye shows the High Yield spread (High Yield Bonds over Treasuries) versus the S&P 500.  Again, as the spread moves higher equities in general move lower.

Now looking at both graphs you can see the TED and HY spreads are trending wider.  Is this bearish for equities?  Not necessarily as these spreads appear to coincide with stocks (i.e. one is not leading the other). 

Thus, when the spread and stocks diverge from their past correlations (as both of the aforementioned do now) it is a decent indication that one of those markets is due for a correction – one way or the other.  

Commodities No Longer a Diversifier

One graph that caught my eye this week was how commodities are now highly correlated with equities.  You can find that graph here.

The graph in that link indicates that correlation levels have tended to move in cycles since 1970.  While there have been times where commodities have been negatively correlated (stocks move up, commodities move down or vice versa) and non-correlated (stocks move up and commodities may move up or down or vice versa), right now commodities and equities have never had a higher correlation.

This is likely not news to some of you.   Without any sort of data it just seems to me whenever I hear oil moving one way that stocks seem to move that same way.  This creates a problem for those investors who purchased commodities as a way to hedge against equities.  Thus, if commodities are used in that manner, it’s probably time to get a new hedge. 

That said there are still reasons to have a commodity allocation in your portfolio.  They can be used for the following:

• Inflation hedge
• Dollar hedge
• Capitalize on long-term demographic/economic/geological trends

In short, if you have commodities in your portfolio make sure you know why.  If the answer is solely to hedge against an equity allocation it would be sound to re-evaluate that position.  

How the Credit Spread Works

A credit spread is the difference between the yield on one bond and another.  For this post, I am going to focus on the spread between risky bonds and government bonds with similar maturity. 

A widening spread is when the difference in yield between the two bonds (risky bond yield vs. government bond yield) increases.  A narrowing spread is when the difference in yield between the two bonds decreases. 

So what do widening and narrowing spreads tell you?

• Credit Stress:  Certain spreads (TED, German bunds vs. European Peripherals, Treasuries vs. HY, etc.) can indicate there are problems in the credit market.  Widening spreads tend to be a good indicator of this.  On flip side, narrowing spreads indicates the credit market is becoming more functional.
• Economic Conditions:  Widening spreads between Treasuries and Corporates may forecast that an economic slowdown is on the horizon.  On flip side, narrowing spreads may forecast an uptick in the economy is coming.
• Time to Buy?  This gets tricky, but as a spread widens so does the buying opportunity.  Bond yields and prices move in opposite directions.  So if the yield on risky bonds increases relative to the yield on government bonds the price of the risky bonds falls.  The lower the price the better the value.  On the flip side, narrowing spreads might indicate certain bonds are now pricey.

There are some caveats when it comes to buying on a wide spread, namely that spreads can continue to rise and/or the spread can stay the same, but the yields of both bonds rise. 

Regardless of whether or not spreads can provide buy or sell signs, they are certainly a good indicator that deserve attention. 

Occupy Wall Street –Hippies Hipsters, Union Members, Socialists, get all the press attention

By now most have witnessed the large protests, which started on Wall Street have spread around the world.  Hippies, hipsters, union workers, socialists, and other angry people are present to voice their displeasure over the current system.

I have to admit, when first glancing at the videos and pictures I start to think “how fun  it must be to disregard hygiene for weeks and participate in drum circles”.  I also am amused by the irony of those who protest the establishment while Skyping from an iPhone 4 in J. Crew khakis.

 

Having said that, many in the crowd are ordinary, college educated, working Americans.  I would wager a few, maybe many have worked hard their whole lives only to have their savings evaporate and their jobs lost.  The system failed them. 

Just a guess however, but I would think the ratio of wacko people to sensible people is similar to that of a Tea Party rally.  But regardless of who is protesting, isn’t the message more important?  Here is a video from Yahoo’s Aaron Trask:

At the end of the video he makes the following points about “those who mock the protesters, what are they defending”: 

• Crony capitalism
• Bank bailouts
• Rising income inequality
• The slow death of the American dream

Taking a stand against any of those issues doesn’t seem even remotely close to unreasonable, just as those at Tea Party rallies, who are mocked by the left, have valid points on bureaucratic corruption and/or incompetence. 

My non-partisan point is that when it comes to massive protests or rallies the crazies will get all the attention, but they do bring up sensible positions that MUST be addressed if we will continue to prosper as a nation.