“People are nervous about the long term outlook, and they should be.”
-Paul Volcker
I had a great day of meetings in New York City yesterday. It’s always additive to get the City’s pulse on risk management matters. The biggest risk that I found myself talking about was one that I haven’t spent enough time writing about – the risk associated with the world’s largest current bubble imploding – short term US Treasuries.
This morning, on the heels of a very disappointing earnings report out of one of America’s largest growth engines (Google), yields on 2-year US Treasuries are trading down to 0.58%. The inverse of this yield equates to the highest prices for short term US Treasury Debt EVER.
Ever, as we like to say at Hedgeye, is a very long time. Particularly when considering bubbles and the tail risks they incubate, it’s critical to never accept ever as forever.
I could go off this morning on the credit quality of US Treasuries, but Jim Grant has done a much better job than anyone else on this topic and I’ll point you to his most recent “prospectus” for US Treasury bonds as required reading. His conclusions weren’t bullish.
Back to the tail risks embedded in the lowest Fed Funds and Treasury yields ever, I’ve started to frame this up using 3 D’s – The Disguise, The Dare, and The Delay.
What risks are implied when the US government is setting unsustainable and unreasonable expectations that rates will stay at ZERO percent forever?
- The Disguise – considering an ever forever disguises financial risk and unintended consequences.
- The Dare – both the Fed and Treasury are effectively daring you to get out there and lever yourself up with either “cheap” liabilities or chase “higher yielding” asset classes than the “risk free” rate of zero percent.
- The Delay – bad actors who are bad stewards of capital get their bad capital allocation decisions (losses) socialized and this delays much needed restructuring of their balance sheets.
When US interest rates push higher – and they will when you least expect them to – you are going to see a 3D version of massive global asset management blowups. This time, no one can say “no one saw this coming.”
Getting the timing right on this is what it is – difficult. That’s why we call this a tail risk. There is a less than a 3% probability of US Treasuries imploding today, or next week. But… every day that 2-year yields hit their lowest level ever, creates a higher probability over the intermediate to long term that Treasury rates go up.
In terms of immediate term leading indicators for interest rate risk, I think the best one for a country’s fiscal and balance sheet health is its currency. Watching the US Dollar hit lower-immediate-term lows yesterday hopefully got President Obama’s attention.
The US Dollar Index is down for the 6th consecutive week and has lost -6.7% of its value since the beginning of June. For the world’s alleged “reserve” fiat currency, that’s a lot and we, as your Risk Manager, think you should be paying acute attention to this.
As a reminder, our Q3 Macro Theme of American Austerity submits a very straightforward thesis – the US Dollar is going to become what the Euro has been for the last 3-6 months as both the US and the world come to grips with the reality that both the US deficit and debt to GDP ratios are going to look a lot like Spain’s in 2011.
Put another way, assuming that the US Dollar is going to be an American entitlement that we can use and abuse as the world’s reserve currency forever, and that short term US Treasury Bonds will trade at their highest prices ever and forever, is no longer reasonable.
My immediate term support and resistance levels for the SP500 are now 1077 and 1121, respectively. We shorted the US Dollar on June 7th via the UUP etf and remain bearish on both the US’s fiscal position and its balance sheet health.
We’ll be doing a full slide presentation and conference call on American Sovereign Debt and the implications of the aforementioned tail risk that’s mounting on the short end of the Treasury curve in a few weeks.
Have a great weekend and best of luck out there today,
KM
Keith R. McCullough
Chief Executive Officer
