Grant's Interest Rate Observer

Gone are the days

Today marks an even 30 years from the stock market crash of 1987. The leading features of that event are well worn in finance lore, from the strong bid through spring and summer, to the accelerating downward reversal in the preceding days that cascaded into a 22.6% swoon in the Dow Jones Industrial average on that “Black Monday,” to the prominent role of so-called portfolio insurance (a widely adopted hedging strategy that by all accounts led to indiscriminate selling in equity futures and aggravated the downdraft).
The state of the late-80’s bond market generally takes a backseat in the financial history books as stocks were plunged into chaotic freefall before their eventual recovery.  The (perhaps) still-ongoing bond bull market began in 1981 – however that was far from clear at the moment in late 1987.

The 10-year Treasury yield reached an astounding 15.8% on September 30, 1981 and re-tested 14% three years later, despite a contraction in CPI inflation from near-15% in early 1980 to 4% in 1984 on its way to 1.1% at year-end 1986.  A strong bond rally in 1985 and early 1986 stalled by the end of that year, and by the summer of 1987 borrowing costs were again rising sharply:  The 10-year yield zipped higher through September and early October to reach 10.2% on October 15, four days before the crash.

Grant’s, which displayed no particular clairvoyance on the coming rout in stocks, did spot what turned out to be a compelling opportunity in the debts of Uncle Sam. The October 5, 1987 analysis titled “In praise of compound interest” took inventory of that morale-busting bond market selloff and resultant opportunities:

The down side of 10% is vividly clear to anyone who has recently purchased bonds at the heretofore historically high yields of 8%, 9% or 9 ½%.  Financial perspective is not a market timing device, and it’s possible that the market will slice through 10% as it did through 9%. It will be hard to retain one’s faith in the magic of compound interest if rates climb back up to 15%. However, as a bullish friend observes, at yields of 10%, one may lose 10% of one’s principal over the next 12 months while still breaking even. The same cannot be said for Merck common.

It is easy, in the current demoralized market, to hate bonds, but 10% is not to be despised.

It bears mention that the double-digit 10-year yields on offer through mid-1987 coincided with CPI inflation that peaked at 4.5% in October, good for a real yield in excess of 5%.  Today’s 10-year obligation of the U.S. government bestows a 2.3% nominal yield, against a backdrop of modest but visible inflationary pickup.  Year-on-year CPI growth, which averaged virtually nothing in 2015 and 1.3% in the twelve months of 2016, has jumped to an average reading of 2.1% this year through September,  leaving the real yield on the 10-year Treasury at mere basis points.  Wage growth, according to average hourly earnings compiled by the Bureau of Labor Statistics, has accelerated in each of the last five years to average more than 2.6% so far this year compared to sub-1.9% in 2012.

Paul Volcker crushed inflation, while Janet Yellen and her overseas counterparts are determined to unleash it.  More than likely, a sequel to “In praise of compound interest” won’t be appearing in the pages of Grant’s any time soon.

Give me price discovery, but not yet

With apologies to the philosopher Augustine of Hippo, his timeless musing on human nature has found modern application from different constituencies.  Bloomberg today relayed data from real estate appraiser Miller Samuel, Inc. and brokerage Douglas Elliman Real Estate, which shows a 31% year-on-year drop in Greenwich, CT luxury home listings in the third quarter. Would-be sellers hoping for higher prices tomorrow, rather than accepting the market-clearing ones today, drive the supply reduction.

Meanwhile, Simon Potter, the head of markets at the Federal Reserve Bank of New York, struck a similar chord in a 5,907 word speech (but who’s counting) discussing the Fed’s imminent tapering of its Treasury and Mortgage Backed Securities (MBS) portfolio, at the European Money and Finance Forum on October 11 in New York.

I am confident that the FOMC’s plan will reduce the size of the portfolio in a gradual and predictable, ‘no surprises’ manner. . . We cannot and should not prevent Treasury and MBS prices from reacting to relevant economic and financial developments . . . In fact, we actively want asset prices to respond appropriately and fully to economic and financial news.

That said, we do seek to mitigate the risk that our operational actions contribute to unnecessary surprise, disruption, or volatility.

What volatility?