Bridgewater Associates: More Will Likely Be Necessary From The Fed - July 2010
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Bridgewater Associates: More Will Likely Be Necessary From The Fed - July 2010

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Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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Bridgewater Associates: More Will Likely Be Necessary From The Fed - July 2010 Document Transcript

  • 1. Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations may be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the US Federal copyright law (T 17, US code). 1 Bridgewater ® Daily Observations 07/29/2010 Bridgewater® Daily Observations July 29, 2010 © 2010 Bridgewater Associates, LP (203) 226-3030 Greg Jensen Jacob Kline Sean Macrae More Will Likely Be Necessary From the Fed: Growth has decelerated quickly over the last few months, and our most recent pulse reading suggests that we are running at about a 1.5% growth rate now (Friday’s GDP report will probably suggest something in the mid 2s, but that is old news, as most of the quarter’s growth occurred in April and early May). As you’ll remember from our Observations in the midst of the spurt when optimism about the economy was peaking, we described that we thought it was transitory for the following reasons (Daily Observations, April 21): “we suspect the growth spurt that we are in the midst of looks more transitory than sustainable. The biggest contributors to recent growth rates in the US are 1) disposable income exceeding private income due to fiscal stimulation, 2) spending growth exceeding income growth because of a reversal of debt liquidation and a decline in savings rates, and 3) production exceeding spending due to a reversal of inventory liquidation. These influences are of a transitory nature and will soon normalize at the same time as fiscal stimulation is scheduled to change to fiscal tightening. When that happens, growth in the economy will depend on income growth and/or credit growth picking up. This hasn’t yet happened, though it might, which is why we are watching these numbers so closely. Over the next few months, the stats will be particularly difficult to dissect as the end of the housing tax credit is likely pulling some activity forward and the surge in census hiring is pushing around the employment stats. Absent a rapid change in income or private sector credit growth, 2nd half growth will likely disappoint growing expectations.” This appears to us to be playing out to script, and the lack of a significant change in private sector credit activity suggests to us that the weakness will be sustained and build. Our forward-looking estimates imply a barely positive growth rate (0.5%-1%), and given the risks around that, we see about a 35% to 40% chance of an outright negative growth reading in the second half. Growth stalling at this very low level of economic activity would be very bad as unused capacity (particularly labor) is already at or near record levels (with devastating long-term cultural and social implications) along with the creeping risk of entering a deflationary spiral. In our view, the evidence is building quickly for significant further reflationary action by the Fed. The short-term market implications of such a move should be even lower long rates, along with a weaker dollar, higher gold and probably higher equities. We are nervous that the Fed, out of an abundance of caution given the political realities around non-traditional monetary policy, will fall behind the curve. While monetization policies are currently viewed as risky, we think the implications of monetary inaction during a deleveraging and deflation are riskier. Monetization should not be viewed like a light switch that works in an all-or-none sort of way; it should be viewed like a spigot that regulates the flow in degrees. It works similar to interest rate cuts or putting your foot on the accelerator of a car. When doing either, you judge the right amount primarily by watching the reactions. When things start to pick up, you start to let off. When things start to slow down, you start to press the pedal harder. The same is true for monetizations. In our view, it is time for the Fed to put its foot back down on the monetization accelerator.
  • 2. 2 Bridgewater ® Daily Observations 07/29/2010 Low Yields Are Still Attractive In this Environment: US ten-year yields now stand at 3%. Bunds are offering 2.7%, gilts are offering 3.5%, and JGBs are at 1%. At these low yields, developed sovereign bonds can seem like a lousy investment. On the other hand, we know Japanese bonds were counter-intuitively a great investment after yields fell this low in the ‘90s, and almost everyone got that one wrong. The reality is that the excess return of bonds can still be very attractive at low absolute yields when the yield on cash is as low or lower for a sustained period of time. And because excess return can be leveraged (buying longer duration, using futures, etc.), bond returns can be as or more attractive at these yield levels than stock returns. Because a sustained low return on cash also tends to occur during deflationary economic contractions, the favorable excess return on bonds tends to coincide with lower than normal returns on stocks, making bonds far preferable to stocks during most periods when bond yields are below 3%. To get a sense of the history, we pulled every period in the past 100 years when a country’s bond yields fell below 3% and then observed the subsequent return of bonds and stocks over various time frames. Contrary to intuition, when bond yields fell below 3%, the subsequent risk-adjusted return of bonds was about 20% better than that of stocks during the period, and this was more than twice as good as bonds’ typical historical return. The average Sharpe ratio of bonds when yields began the period below 3% was 0.54, while the Sharpe ratio of equities during the same periods was 0.46. The average Sharpe ratio of bonds during all periods over the past 100 years was 0.24. Bonds Stocks Bonds Stocks United States (1934 - 1956) 270 2.3% 14% 0.70 0.69 United Kingdom (1934 - 1937) 27 3.4% 15% 0.34 1.61 Canada (1937 - 1939) 32 5.2% -6% 0.49 -0.39 Canada (1944 - 1950) 81 3.2% 15% 0.53 1.22 Australia (1941) 2 23.0% -3% - - United Kingdom (1945 - 1947) 32 4.6% 7% 0.58 0.60 Japan (1994- present) 181 2.2% -1% 0.60 -0.05 Switzerland (1998 - present) 150 2.0% 1% 0.52 0.05 Singapore (2002 - present) 93 1.7% 11% 0.32 0.53 Taiwan (2002 - present) 92 2.1% 6% 0.45 0.27 United States (2008 - present) 20 1.8% 22% 0.20 0.87 Hong Kong (2008 - present) 21 3.1% 30% 0.45 1.16 Sweden (2008 - present) 20 1.7% 11% 0.31 0.64 Germany (2008- present) 19 2.8% 15% 0.59 0.69 France (5/2010 - present) 2 -2% 44% - - Netherlands (5/2010 - present) 2 0.1% 53% - - Average of All Cases 2.5% 8.3% 0.54 0.46 Bond and Stock Performance When Yields Fall Below 3% Duration of Yields < 3% (months) Excess Returns, Annualized Sharpe Ratios As the table above illustrates, there have been a number of new cases in which a country’s bond yields have fallen below 3%. Yields in the US, Hong Kong, Sweden, and Germany all fell below 3% in 2008, and in the past few months (during the height of the European debt crisis), France, and the Netherlands also saw their yields fall below 3% as well.
  • 3. 3 Bridgewater ® Daily Observations 07/29/2010 As shown below, relative to most investors’ professional memory, yields over the past few years have basically been at their lowest levels ever. 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 USA 10-Yr Yld Average To a degree, our notion of ‘attractive yields’ is distorted by the late 1970s and early 1980s. The chart below shows UK ‘consol’ (a perpetual bond) yields going back to 1700. The average yield over the longer history was 4.6% compared to a 4.5% yield today on perpetuities. As you can also see, double-digit government borrowing rates are a once in 300-year aberration. So in a very long-run perspective, today’s yields not low. Of course, a significant difference between today’s monetary system and that the one that existed over the history of the UK (and the rest of the world) is the modern use of fiat money, with the obvious risks that creates. 0% 2% 4% 6% 8% 10% 12% 14% 16% 1700 1720 1740 1760 1780 1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 GBR Gov't Bond Yield Below we look at conditions for a few countries that have experienced protracted periods with sub-3% bond yields: the US in the 1930s, 40s and early 50s, and Japan and Switzerland from the 1990s to present. We compare these conditions to the US today. They are all a bit different, though low bond yields persisted in all three circumstances through some combination of significant excess capacity and/or savings that kept inflation and credit demand low.
  • 4. 4 Bridgewater ® Daily Observations 07/29/2010 The United States (1934 – 1956) In our Deleveraging Studies we have written extensively about the US experience in the 1930s, and we will not add much more than a cursory overview here. The short story is that policy makers maintained the dollar’s fixed exchange rate to gold rather than stimulating the economy, meaning monetary conditions tightened even as the economy cratered. As the charts below show, growth initially contracted by 10% in the teeth of the depression and then bounced erratically after the 1933 bank holiday and through the war economy. Despite intermittent periods of strong growth, bond yields remained low due to a combination of surplus capacity (double-digit unemployment peaking at 25%) that kept inflation close to zero, weak demand for capital, and debt liquidation in the 1930s, and, in the 1940s, a booming trade surplus and restrictions on non-defense borrowing. -15% -10% -5% 0% 5% 10% 15% 20% 25% 25 30 35 40 45 50 55 60 USA Real GDP Y/Y 0% 5% 10% 15% 20% 25% 30% 25 30 35 40 45 50 55 60 USA Unemployment Rate -20% -10% 0% 10% 20% 30% 25 30 35 40 45 50 55 60 USA CPI Inflation -1% 0% 1% 2% 3% 4% 5% 6% 7% 25 30 35 40 45 50 55 60 USA Trade Balance % GDP Yields only rose above 3% in 1956, twenty-four years after falling below 3%. In the heyday of the post-war boom, growth in the US and abroad was vibrant, consumer credit and corporate capital spending were rebounding, there was a baby boom, the trade surplus was turning into a deficit, and pressure was picking up on the dollar relative to gold. At the time, debt-to-GDP ratios were a fraction of their level today (as the second chart below shows, they had continued to decline into the early
  • 5. 5 Bridgewater ® Daily Observations 07/29/2010 1950s), meaning consumers had ample room to lever up their balance sheets. It was only then that price pressures began to emerge. 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 USA 10yr Bond Yield Treasury yields stayed below 3% for 2+ decades 10-yr Treasury ylds below 3% for first time in 50+ years 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 110% 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 10 Usa HH Debt % NGDP deleveraging continued until the early 1950's. Japan (1994 – present) For a more detailed examination of Japan see the BDO of 5/25/2005, The End of the Debt Deflation Cycle in Japan. As the charts below show, growth fell to zero and bounced around zero for about 10 years. Unemployment rose and inflation fell below zero, creating a self-reinforcing negative cycle of weak demand, debt liquidation and falling asset prices. Throughout, the current account surplus remained broadly positive, exacerbating the deflationary pressure, despite real currency weakness.
  • 6. 6 Bridgewater ® Daily Observations 07/29/2010 Like the U.S. in the 30’s and 40’s, growth in Japan bounced numerous times but never pulled bond yields higher because of the strength of the secularly deflationary debt liquidation forces. -12% -7% -2% 3% 8% 90 92 94 96 98 00 02 04 06 08 10 JPN Real GDP Y/Y 1% 2% 3% 4% 5% 6% 90 92 94 96 98 00 02 04 06 08 10 JPN Unemployment Rate -3% -2% -1% 0% 1% 2% 3% 4% 5% 90 92 94 96 98 00 02 04 06 08 10 JPN CPI Inflation 0% 1% 2% 3% 4% 5% 6% 7% 90 92 94 96 98 00 02 04 06 08 10 JPN CA Balance % GDP These conditions basically remain in place today. What has surprised just about everyone is how long yields have remained low. It has now been 15 years since yields fell below 3%. 0% 2% 4% 6% 8% 10% 12% 14% 16% 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 Japan 10 Year Bond Yield
  • 7. 7 Bridgewater ® Daily Observations 07/29/2010 Switzerland (1998 – present) Switzerland is a different case. Switzerland experienced an export-driven growth boom – largely in financial services – with the current account widening out to 15% of GDP by 2006. This was a disinflationary force that made goods prices fall even as the domestic labor market tightened significantly. The combination of low inflation and an excess of capital kept bond yields low and has led to continued outperformance of bonds relative to stocks even though growth has been solid. Once again, a few lurches in growth have not been enough to elevate bond yields due to the structural disinflationary forces, and yields have remained below 3% for all but a few months in 2008. -4% -2% 0% 2% 4% 96 98 00 02 04 06 08 10 CHE Real GDP Y/Y 0% 1% 2% 3% 4% 5% 6% 96 98 00 02 04 06 08 10 CHE Unemployment Rate -0.5% 0.0% 0.5% 1.0% 1.5% 2.0% 96 98 00 02 04 06 08 10 CHE Core Inflation -10% -5% 0% 5% 10% 15% 20% 96 98 00 02 04 06 08 10 CHE CA Balance % GDP 1% 2% 3% 4% 5% 6% 7% 8% 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 Sw itzerland 10 Year Bond Yield
  • 8. 8 Bridgewater ® Daily Observations 07/29/2010 Current Conditions in the US Growth in the US has now rolled over and, as we described at the top of this Observations, would make us very concerned if we were at the Fed. The following chart shows growth has now declined below average leves, and without a quick reversal this suggests to us further deterioration in employment and capacity utilization. -8% -6% -4% -2% 0% 2% 4% 6% Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 USA 3mo Coincident Last 3mo Print: 1.5% Core inflation continues to fall, and at 1% is at its weakest level since the early 1960s. 0% 2% 4% 6% 8% 10% 12% 14% 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11 Usa Core Inflation (% yoy)
  • 9. 9 Bridgewater ® Daily Observations 07/29/2010 Looking ahead, we expect US growth to slow even further to about 0.8% in the second half, with the fourth quarter getting the brunt of the likely slowdown related to less fiscal stimulation. Fading Federal Fiscal Stimulus -0.4% State Cut Backs (direct and tax hikes) -0.9% Mediocre Private Sector Income Growth 0.5% Lower Savings Rate 0.4% Inventory Effects 0.0% Business Fixed Investment 0.5% Exports / Net Trade 0.3% Federal Spending 0.3% Housing Construction 0.1% Total Growth (2H 2010) 0.8% Major Cross Currents for Growth - 2H 2010 (expressed as contributions to GDP Growth) The Fed would typically respond to such weak conditions by providing further easing, but because the short rate is already zero, it cannot ease through that lever. Our estimate is that the Fed would want to ease about 150 bps given current conditions and past behavior. -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% 72 73 74 75 77 78 79 80 82 83 84 85 87 88 89 90 92 93 94 95 97 98 99 00 02 03 04 05 07 08 09 10 Actual Change in Short Rates (12mo) Estimated action based on past Fed behavior and how conditions transpired Pressures on Monetary Policy (ignoring zero rate bound) 150bps additional easing w ould be expected So, while rates are certainly low in a historical context, they are not low enough to stimulate private sector activity (which would drive up rates). With time, the Fed will likely act by doing even more to improve debt burdens (e.g., via further asset purchases). We have reached a dangerous point as US growth is decelerating quickly, and the longer the deceleration is not met by a policy response, the deeper it will likely be.
  • 10. Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, LP and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Additionally, Bridgewater's actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research utilizes data and information from public, private, and internal sources. External sources include the International Energy Agency, International Monetary Fund, National Bureau of Economic Research, Organization for Economic Co-operation and Development, U.S. Department of Commerce, World Bureau of Metal Statistics as well as information companies such as Bloomberg Finance L.P., CEIC Data Company Ltd., Emerging Portfolio Fund Research, Inc., Global Financial Data, Inc., Global Trade Information Services, Inc., Markit Economics Limited, Mergent, Inc., MSCI, RP Data Ltd., Standard and Poor’s, Thomson Reuters, TrimTabs Investment Research, Inc. and Wood Mackenzie Limited. While we consider information from external sources to be reliable, we do not assume responsibility for its accuracy. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues.