The pastoral, the avalanche, and the earthquake

Mon Mar 4, 2013

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Whitebox's Andrew Redleaf envisions three possible scenarios for 2013.


By Andrew Redleaf

Amidst speculation the long awaited great rotation from bonds into stocks has begun, most commentators appear to be missing the hidden danger. Investor fear and Fed manipulations pushed bond prices to perilous levels; there is no guarantee that the retreat from such prices must be orderly and rational. Instead of a rotation we could easily see a panic in bond markets that rather than lifting the stock market drags it down as well.

Bond holders today own securities that cannot fulfill the function for which they were purchased. The investment function of a bond is stability. By definition assets priced at historic extremes cannot be stable. Treasuries can't pay negative real yields forever; therefore they won't. The Merrill high yield index can't pay six percent forever, therefore it won't. To the extent the future prices of these instruments are unpredictable, they have ceased to function as bonds. Eventually bond investors will recognize this and reject them.

Though bubbles don't need a reason to pop, the government is quite capable of supplying one. Before the election, no matter who won, it still seemed plausible that both sides would agree to something like Simpson Bowles, which not only restrained spending but reformed taxes in (on balance) pro-growth ways. Almost as soon as the votes were counted, those hopes were dashed. Washington clearly is either unwilling or unable to forge pro-growth fiscal--or regulatory--solutions. Economic policy seems likely to be worse over the next four years than at any point in our professional life time, an extraordinary thing to say for any who can remember Nixon or Ford.

Since 2008 bond markets have been governed not by growth but fear, especially fear of another financial markets crisis, here or abroad. At some point, however, other fears become relevant, especially the fear that for a government whose debt is growing faster than the economy, a relatively modest rise in Treasury rates could begin a death spiral that ends in unofficial default.

For almost five years investors have assumed the Fed's ever expanding balance sheet could overwhelm any doubts about the U.S. Treasury. What's to keep investors from waking up one day and remembering the odds against any central bank reversing a market that is determined to sell?

There are three likely scenarios for 2013: We call them the pastoral, the avalanche, and the earthquake.

In the pastoral scenario, which I'd call a 70 percent probability, the current precarious equilibrium holds. The Fed maintains its credibility; there is no credit panic. Instead, we see continued moderate growth and modest, orderly flows of capital from bonds into stocks. The downward pressure exerted on equity prices by rising discount rates likely would be balanced, or even overpowered, by the upward pressure of economic optimism. I believe the S&P could end the year up significantly.

In the best possible version of this scenario GDP would be strong enough and long enough to permanently relieve the opposing fears that are inflating the bond bubble and threatening to pop it. The real risk free rate would slowly turn positive as the Fed eased off its zero rate fanaticism. We would escape the fiscal abyss as we always have before; we'd grow out of it.

In the other two scenarios we are not so lucky.

In the "avalanche" scenario the credit market collapse begins with high yields and reaches downward to investment grade corporates and laterally to equities as investors panic about the economic implications of a credit contraction. If bonds collapse from the upper reaches, Treasuries could remain a "safe haven" for investors, or they too might be abandoned, as investors foresee that a credit contraction would crush GDP and tax revenues and provide cover for even more stimulus spending.

As with a real avalanche, this credit avalanche could be triggered either by a big obvious shock--a recession could do it--or it could be triggered by an event so trivial the world never agrees on what happened. It's not the sudden noise that really causes the avalanche; it's gravity plus a whole lot of snow.

In the "earthquake" scenario; the investors who own the 80% (almost $10 trillion) of U.S. public debt not held by the Fed finally lose faith in Treasuries. The Fed cannot buy enough paper to maintain super-low yields and Treasury rates soar. Spreads, rather than contracting as they normally do when rates rise, actually widen on fear. In self-fulfilling fashion credit markets close, the economy contracts, and equities fall as hard as bonds.

So for investors in 2013 the relevant question is not when the great rotation will begin, but whether perilously priced bond markets will correct calmly or violently?

Disaster is far from inevitable. But Washington is not improving the odds.

Andrew Redleaf is founder and chief investment officer of Whitebox Advisors, a $2.3 billion hedge fund firm in Minneapolis. He will be the keynote speaker at the Absolute Return Spring Symposium.