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
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
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
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
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
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
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
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.