Our two “top-down” trades that have gone wrong in 2014, have been the yield curve flattening, where we thought rates would continue to move higher into 2014, and the retail / consumer discretionary trade, which we thought would end with the ugly winter of December, 2013 through March, 2014.
The yield curve flattening could be a function of many things including low interest rates in Germany, Japan and Canada, but ultimately I’ve always felt that Treasury’s and bond prices in general are usually (and ultimately) determined by inflation and inflation expectations, which at least here in the US and Europe, seem to be diminishing rapidly, after a brief pop in expectations this Spring.
It doesn t make much sense to hold a fixed-income security yielding 2.5%, when inflation expectations are rising above 2%.
As of last week, here are the government bond yields that Treasuries are competing with:
US 10-year: 2.42%
However what has truck me the last two weeks are the inflation gauges or cost components of key indices that are now coming in lower than expectations:
* The Nonfarm Productivity Index reported last week, showed unit labor costs growing +0.6%, versus the 2% expected. Unit labor costs were WELL below expectations.
* Average hourly earnings in the July payroll report was expected at +0.2%, and instead came in flat.
From my understanding the Fed has always worried more about “demand-pull” wage inflation, than “cost-push” commodity inflation, and Yellen has said there appears to be quite a bit of unutilized slack in the labor force.
However, it is very tough for us to add duration to client accounts with the 10-year Treasury trading at 2.42%.
We’ve split the baby so to speak, by adding some high-yield municipal bond funds, ETF’s and closed-end funds, (both high yield and investment grade muni CEF’s) from which we have gained for clients, both yield, some duration, and what we feel is decent relative value in the fixed-income space.
Im a little worried about Emerging Market debt (either local or dollar) given the dollar’s continued relative weakness. A period of robust dollar strength would help us gauge how Emerging Market funds and ETF’s perform, and correlate.
A trade in the 10-year Treasury through the 2.40% yield level on good volume, and we would be out of the TBF, a frustrating trade for sure this year.
In 2013, our TBF long helped offset some of the stress of the Bernanke Taper, which started in May, 2013, and really helped our fixed income performance in balanced and bond accounts for the year. In 2014, as you would expect, the TBF has been a drag on results, despite the 6 straight strong jobs reports.
So where is the inflation that so many expected 5 – 6 years into a decent, but not robust, US economic and labor force recovery ?
1.) Some say it is demographics;
2.) Some say the consumer is still stretched, which I see in some of my own clients;
3.) Some say the continued productivity gains by personal and corporate technology are holding inflation at bay;
4.) At the consumer or retail level, I have to think the twin retail giants of Amazon (AMZN) and Wal-Mart (WMT) are crushing pricing power throughout US retail. (Here is our Wal-Mart earnings preview from Seeking Alpha); (Long WMT and AMZN)
5.) Some say it is the continued deleveraging of the US economy stemming from the worst deflationary crisis since the Great Depression (i.e. 2008’s meltdown);
As a portfolio manager, there is always one trades every year that eats away at you, and this year it has been the TBF and Whole Foods (WFM, which are actually two trades), both of which could be suffering from similar afflictions.
I think the 10-year Treasury is at a key level in the low 2.40’s. We’ll let the market tell us where it wants to go.
Thanks for reading. Today’s post was just “thinking out loud”.
Trinity Asset Management, Inc. by:
Brian Gilmartin, CFA