Maybe the most important chart we can think of right now relating to our concerns over Treasuries lies below. And yes, it’s as much a symbol as it is about substance. Hopefully it helps put a bit of an exclamation point behind this discussion. We’re looking at the 30-year US Treasury bond from 1980 to present. As you can see, we’ve tried our best to draw in what we consider to be a critical multi-decade trend line. What is absolutely clear is that the multi-decade series of rising lows and rising price highs has been broken in recent years. For now, we’re testing an approximate triple top price area. Triple tops can be quite the powerful formations, either when broken to the upside or having failed. We’ll see what happens. But as we look a good bit further down the road, when this trend ultimately breaks (and we believe it will due to the ever growing awareness of the true nature of inflation) it’s going to be party over for monetary policy effectiveness for perhaps a good while to come. Are we looking at the last asset bubble of substance when we look at the current Treasury curve? Although we wish we had the answer, we do know one thing. We better all keep watching as this may ultimately turn out to be one of the most important investment guideposts of the next few years.
Beforewe leave you, one last view of live in the institutional world webelieve is important. Certainly we're all aware of the crowded theaterexample when asset classes go bad. Only one door out and everybodywanting to go through it at the same time. Absolutely classic as ananalogy for financial market action resulting from nothing more thanthe repetition of human behavior. Well, we see the current Treasurymarket as being this analogy in reverse. Everyone has been trying toget into the theater through a very small door, and of course they allwant in at the same time. Let's face it, how else would we see twoyear Treasury yields last week kiss the 1.8% range, virtuallyguaranteeing a big time negative real rate of return? C'mon, buyingTreasuries two years out at recent levels has nothing to do withfundamental investing or acknowledgement of basic economics. But itdoes have everything to do with the most basic of all human behaviorand emotions - fear. Fear coupled with relative lack of AAA creditsupply, or even the perception of lack of supply, can do very strangethings to prices over very short spaces of time.
Anyway, in the chart below we're looking at the behavior of bond mutual fund managers in the aggregate, and what we personally see at the moment is quite the anomaly. The top portion of the chart is cash as a percentage of total assets in the bond mutual fund complex over time. The bottom portion is self explanatory - the price of the 30 year UST over the same period.
With the lines and all of the shaded red bars we've drawn in, there are more than a number of messages here. First, and very simplistically, the longer term trend decline in cash as a percentage of total assets in the mutual bond fund complex mirrors the upward trajectory of thirty year US Treasury price from the early 1980's through to the early part of this decade. Easy to understand as the initial part of the period was characterized by meaningful pessimism regarding bonds, as was expressed in the very high level of cash holdings at that time, in aggregate post the horrendous performance of bonds in the inflation laden 1970's. But as bond prices rose during the decade of the '80's, pessimism regarding bonds as investments faded and mutual fund cash was put to work. Typical behavioral pattern of the institutional investment community that has been repeated time and again. Over this two decade period (1980's and 1990's) we notice yet another phenomenon as we look at the red bars we've drawn in. Every time Treasuries rose meaningfully in price over shorter periods of time (cyclical upturns within a longer term secular upward price move), cash as a percentage of total assets in the bond fund complex fell materially. Every time. As is the case with almost any longer term asset class movement, mutual fund managers chase price performance. You've seen it a million times.
But as we enter the current decade, mutual bond fund manger behavior starts to change relative to character exhibited during the prior two decades. Look at the red bars we've drawn in for the current decade. As the price of Treasury bonds rose on a cyclical basis in this decade, cash as a percentage of bond mutual fund assets actually rose in spike fashion. Just the opposite of what transpired in the '80's and '90's. Bond fund managers reversed prior behavior and began to sell bond market rallies. This occurred from mid '02 through early 2003, at the exact time the Fed was getting toward 1% on the Fed Funds rate. It also occurred from mid '04 through mid '05, as the Fed reversed course off of generation lows in the Funds rate and began to tighten nominal yields in literally baby step fashion. Why the change in bond fund manager behavior? At least from our standpoint, we believe it was the recognition of two things. First, nominal yields during these periods were very low, which means bond price performance relative to interest rate movements could easily overshadow coupon yield in terms of total bond fund performance. At low nominal yields and recognizing that interest rates run in cycles over time, bond fund managers were responding to higher price risk academically inherent in bond investments during a period of low nominal coupon yields. The second reason we believe risk became a heightened concern within the bond fund complex early this decade was the recognition of the length of the in place secular bond bull market environment up to this point. The bull is indeed quite the senior citizen from an asset class standpoint. And we all know that asset class bull markets do not grow to the sky indefinitely.
Let's fast forward to very recent experience. Since mid-2005, cash as a percentage of total assets in the bond fund complex has dropped from just under 10% to just under 4%. Quite the contraction in cash assets. Moreover, and really over the last six to twelve months, we've seen more than a fair amount of money flow into the bond fund complex as equity returns have become more volatile. Now we see that with the recent spike upward in Treasury prices, bond fund managers did not increase cash holdings as they have done consistently in other like occurrences this decade to date. Importantly, as we stand back and again look at the character of current investment environment in the Treasury market, we see anomalistic recent buying within the context of: 1) lack of alternative AAA rated fixed income vehicles, 2) negative real rates of return along virtually the entirety of the Treasury curve, 3) buying based on safe haven status as opposed to economic return potential, and 4) cash in the mutual bond fund complex remains quite low relative to historical experience.
So as we look ahead, we believe now is the time to at least start thinking about the possibilities for financial market and real economic outcomes if and when this panic behavioral trade in the US Treasury market reverses. We already know that at that point it does become the crowded theater with one small exit door. For at least as far as the message and data of history is concerned, it may very well be that at some point the US bond mutual fund complex is trying its best to squeeze out of the same door with so many institutions who first panicked to get in. Aren't the actions and thinking of crowds amazing...to watch from a distance, of course? Indeed they are.
