In my new book, Bonds Are Not Forever; The Crisis Facing Fixed Income Investors, I make the case that some big trends in the U.S. economy and Finance began shifting following the financial crisis of 2008, the consequences of which will include interest rates insufficient to compensate bond investors for inflation and taxes (hence the Crisis). The last few days have produced two news items of note which illustrate the altered economic and political landscape.

On Thursday, the Wall Street Journal reported that “Embattled J.P. Morgan” would be bulking up its oversight by spending an additional $4 billion and adding 5,000 employees to clean up risk and compliance problems. No doubt the company has been hit by a succession of issues from the huge loss in the office of the CIO to problems with mortgage underwriting standards and commodities trading. They’ve responded by deploying substantial amounts of money and people to resolve these problems and reduce the odds of new ones in the future.

I can imagine the stultifying impact these additional legions of compliance, regulatory and legal experts will have on many aspects of business. I worked at JPMorgan for 23 years and it’s a great company. I know from first hand experience that when additional layers of oversight are added whose job is to basically say “No” to any transaction or new line of business that carries a hint of the risks that have so bedeviled them in the past couple of years, it leads to a pretty frustrating environment. If you choose to make your career protecting a large bank from the sometimes questionable instincts of its revenue-generating employees, “Yes” is a word that carries career risk and limited upside. Many potential transactions and activities will now not occur, because they won’t pass muster with an increasingly vigorous compliance culture or because the weary revenue generators will steer clear of anything that is the least bit questionable. It will certainly make it a less fun place to work, and will hurt the top line while seeking to curb the Legal Expense line. It will make banking at JPMorgan more risk averse, less interesting and presumably more aligned with the public interest. If you hit a bank with enough $500 million fines, they do get the message.

The thing is, senior management will be well aware of the potential impact on revenues of rejecting all but the most anodyne transaction and will no doubt strive to maintain a profitable balance between the competing cultures of “No” and “Yes”. They will be very sensitive to the new trade-off. And yet, they’ve still chosen to go down this road. The bank that most successfully navigated the financial crisis of 2008 has assessed the ongoing regulatory  environment which must increasingly look as if they’re every government lawyer’s favorite target, and have adjusted their posture accordingly. The political mood has shifted against big banks and Big Finance after thirty years during which financial services grew its share of U.S. GDP. This is one manifestation of the altered landscape.

A second story of note is Larry Summers’ withdrawal of consideration for the position of next Fed chairman. Interestingly, it was the lukewarm support from Democrats on the Senate Finance Committee that led to the calculation that Republican votes would be needed even to get the President’s nominee to the full Senate for consideration. Summers is regarded by some as less enthusiastic about increased regulation than they might like, further reflecting the mood for a more tightly controlled banking sector. Listening to Senator Elizabeth Warren discuss the urgent need for ever more banking oversight may not  reflect a balanced view, but it does once again reflect the new reality Finance faces.

Financial markets have this morning provided their input – bond yields are down and stocks are up, reflecting the view that a Fed Chairman Yellen will continue Quantitative Easing and low interest rates for longer than would a Chairman Summers.

Whether or not this is good public policy isn’t really the point – others may debate that. However, what both stories highlight is that a shift towards more banking regulation and dovish monetary policy pushes back the time when bond investors might expect to earn a decent yield on their savings. The market expects a Yellen Fed to continue to promote the interests of borrowers at the expense of savers through very low rates. The JPMorgan story illustrates that what’s good for Finance is clearly less important in Washington than what’s good for everyone else. So bond investors should conduct their affairs accordingly. Current interest rates are unattractive, and it will likely be a long time before bonds are a good deal.

In recent weeks I’ve heard quite a few people comment that they’re looking for “rising rate strategies”. It’s a seductive concept; interest rates are almost assuredly headed higher. The debate about tapering rages on, and clearly the bull market in bonds is over. Serial Quantitative Easing will transform to the Fed’s exit strategy from its $3.5 trillion balance sheet.

Unfortunately, it’s not that simple. Long positions in a bond bull market have several sources of return. In addition to the capital gain that falling rates create, the holder of a leveraged long position further benefits from positive carry in that the cost of funding the position through the repo market is less than the interest rate earned on the bond. There’s also “rolldown”, in that a ten year security held for a year will be priced as a nine year security, and with a positively sloped yield curve the lower nine year rate causes some additional drop in the yield. Three sources of return make a bull market with a positive yield curve a great environment for leveraged investors.

By the same token, bond returns in recent years have been very strong.

Rising rates present a significant challenge for investors. The past four years’ return on the Dow Jones Corporate Bond Index (all investment grade bonds) is 18%, 9%, 9% and 12% respectively (from 2009-2012). Since each year has provided investors with a return substantially above prevailing interest rates, a significant portion has come from capital gains through bond yields falling and the rolldown effect described above. Clearly, since yields are now rising, capital losses will eat into interest income and it’ll be challenging for investors to break even. So far this year the Dow Jones Corporate Bond Index is -3.7%.

But just because bonds are likely to be a poor investment doesn’t mean they’re a good short. It’s a tempting proposition, but being short means that positive carry becomes negative carry and rolldown also works against you (since a shorted bond will roll down the still positive yield curve to a lower yield over time, notwithstanding the effect of generally high rates).

Here’s an example. Suppose an investor shorts a $1million ten year security with a 4% yield, and expects to hold the position for a year. Short term rates at 0% mean that the short will pay away the 4% coupon on the bond with no meaningful offsetting credit from cash (since cash rates are so low). This will cost $40,000. The slope of the yield curve is around 0.20% per year, so the ten year security’s market yield can be expected to fall by approximately this amount over the course of a year, absent any overall shift in rates. This will cause a further loss of about $15,000 to the short.

The net result is that yields need to rise to around 4.55% over a year for the short position to be profitable. Anything less, and the combination of negative carry and rolldown will render the position unprofitable.

This is the significant hurdle facing any strategy that seeks to profit from rising rates. They’re already expected to rise, so profiting from a forecast of rising rates requires that they rise more than is already priced in to the yield curve. If rates move irregularly higher, it’ll be very hard to profit from that. A better approach is to look for investment strategies across all asset classes that ought to be robust during a rising rate environment, but that don’t require rising rates to work.

http://video.foxbusiness.com/v/2652189553001/time-to-dump-bonds/?playlist_id=1071839331001

I’d never heard of Keith McCullough until today when we noticed that Kinder Morgan (KMI), a stock we own, was down 4%. MLPs are weak but KMI and its cousins KMP and KMR are certainly leading the way. The driver appears to be a bearish report on Kinder Morgan to be released to clients of Hedgeye next week. We like KMI for its 4% yield, long history of stable growth and management guidance of 12% dividend growth. KMI owns the IDR’s for Kinder Morgan Partners (KMP) which we also own, and around 50% of distributable cashflow from KMP now goes to KMI. In effect, KMI is a hedge fund manager charging 2 and 50. It seems like a decent investment.

Keith McCullough has in the past made some bold calls. In 2010 he apparently advised clients that France and Italy would both crash as the Euro crisis unfolded, and also at around the same time recommended that they sell all U.S. stocks. I must confess that we didn’t read about those forecasts as the time because we weren’t then (and aren’t now) subscribers. In fact we didn’t hear about them at all until reading about Kevin McCullough today.

Two spectacularly wrong calls don’t tell you anything about whether the KMI call will be right or wrong (and in any case there may have been hundreds of correct calls since 2010). We still like KMI, although we haven’t read Hedgeye’s report. We bought a little more today. He obviously has the ability to cause short term moves in stocks, so we’ll be watching what he has to say (though not as a subscriber).

In writing this month’s letter (just published earlier today) I researched the source of the quote, “If you torture the data long enough, it will always confess.” It was attributed to Ronald Coase, listed on Wikipedia as “Born 1911”. Because his dates did not include an end date for his life, it somewhat improbably suggested he was still alive at the age of 102. However, not wanting to assume Mr. Coase’s demise prematurely, I did not describe him as “the late Ronald Coase”.

I just read in the NY Times that he passed away in Chicago yesterday, at the age of 102. I’m glad I assumed nothing less.

In what will hopefully become the new normal for websites, the Huffington Post last week announced they would no longer be allowing anonymous comments on their website. This is a completely sensible move and one that will add civility (their main objective) as well as raise the quality of comments that are made. How is anyone supposed to properly evaluate a comment or opinion if it’s expressed without disclosing the commenter’s identity? It’s a basic element of public discourse and debate that who is saying something is relevant to what they are saying. The individual’s qualifications to hold an opinion as well as any potential for conflict of interest or inconsistency with past statements are all valid information for the reader. Many argue (always anonymously) that they are prevented from posting their identity because of restrictions imposed by their employer (in which case maybe they should just respect those restrictions). Others claim fear of harassment of some form. But an opinion uttered anonymously is not worth the time it takes to read. Anonymous comments are simply an indulgence to the commenter. I always ignore anonymous comments on anything I write, and only respond to those with a true identity attached. This is the standard that should prevail in the civilized areas of the internet. If you disagree, please don’t bother commenting anonymously.

I was struck by an article today on how much Japan will spend next year servicing its debt. In its next fiscal year the Japanese Ministry of Finance (MOF) expects to spend ¥25.3 Trillion on interest. That’s about $260 Billion, or just over 4% of its GDP. By contrast, the U.S. spends just over 2% of its GDP servicing its Federal debt (although that’s only about half of our total indebtedness; America too has its debt problems).

The big question around Japan’s fiscal outlook is, at what point does this become unsustainable? When does the burden of financing the debt require more debt, in a type of fiscal Rubicon? It’s hard to say definitively. By most historical measures Japan’s situation is already beyond repair. However, a crisis has so far been avoided. This is in large part due to the fact that their debt is domestically owned. Japan is borrowing a lot of money but it is doing so from itself.

It does lend support to the theme of a weakening Yen though. Higher domestic inflation and a negative real return for the savers who own Japanese bonds probably represents the best chance for a drama-free resolution. Shorting the Yen continues to be a trade with lots of optionality – as well as being aligned with stated government policy it may benefit from any number of other macro-economic developments including faster U.S. GDP growth, unfavorable interest rate differentials and perhaps higher energy prices due to growing turmoil in the Middle East.

In recent weeks much has been written and said about who President Obama should select as the next Fed Chairman. Supporters of Larry Summers and Janet Yellen are said to be each pressing the case for their candidate from behind the scenes. For a position that is supposed to float above politics, it is surprisingly political.

So without regurgitating what’s already been said, let me offer a couple of observations. Larry Summers is routinely praised for his intellect. CNBC this morning described him as a “brilliant economist”, a breathless term that many might regard as an oxymoron or at least not wholly complimentary. Although I’ve never met Larry Summers, his high IQ is so often cited by others that one is left with the uneasy feeling that he uses every interaction with people to make sure his brilliance is on display and not missed. Modesty is an adjective rarely in the same zip code as Mr. Summers. That may not disqualify him, since politics and business are both full of people unburdened by much self doubt. Nonetheless, the future is generally uncertain and the next captain of monetary policy might be expected to retain some humility with respect to the brilliance of their own views.

Janet Yellen’s qualifications are that she’s already Vice Chair of the Fed’s Board of Governors. Since 2008 the Fed has been engaged in the most enormous monetary experiment labeled QE and the purchase of more than $3 trillion of bonds. Curiously, CNBC labeled Dr. Yellen’s “ownership” of current policy as a negative. Since the Fed will presumably be navigating an exit from QE during the term of the next Fed chairman, it would seem less disruptive to have the steering performed by someone who helped get us in there in the first place. You can almost hear Fed Chairman Larry Summers, at the first sign of market trouble, proclaiming that had he been in the job since 2008 his intellect would have kept us out of the current situation.

As with many ideas in investing, while we all have opinions on what should be, more interesting is assessing how they will probably be and investing accordingly. My views on the next Fed chairman won’t alter the outcome of that decision. However, exiting QE will represent an enormous communication challenge for either of these candidates. Janet Yellen will be inevitably labeled a dove on monetary policy, and bond investors will likely assume a tightening of short term rates is even farther away than the approximate date of 2015 indicated by the FOMC’s blue dots. The Fed will be either late or very late in restoring rates to neutral. It’s a long time ago now, but I remember in 1987 how the incoming Fed chairman Alan Greenspan was immediately faced with a bond buyers’ strike. Yields rose as investors fretted that nobody could adequately fill the shoes of Paul Volcker, the vanquisher of the inflation dragon. Greenspan was felt to be a poor second act.

As Fed chairman, Larry Summers will be unpredictable. No doubt his prodigious intellect will at some point lead the less intellectually gifted ROTW (Rest of the World) to misinterpret his statements. In either outcome, bond investors will be grappling with less certainty than they were used to. The role of Fed chairman changed in 1975, 1987 and 2006. We’ll soon get only the fourth change in 39 years. It’ll be a big deal. Bond investors probably deserve a little more risk premium in the yields they accept as we head into the next transfer of power.

If you stop to think about it there are several analogies for the Fed’s “tapering”, under which they gradually relax the support which has been underpinning the bond market. Maybe it’s the parent who creeps out of the young child’s bedroom at night believing they’re finally asleep, only to be halted by renewed cries from the little one. Maybe it’s Jenga, a game played with wooden blocks where players alternate turns of removing one without causing the structure to collapse. Or perhaps the magician who dramatically whips the tablecloth smartly off the table while leaving the place settings unmoved.

Whatever imagery does it for you, somewhere within the investment horizon of most people the Fed will make their move. Which is why a Bloomberg article on Bridgewater’s $80BN All Weather fund caught my attention earlier today. It seems that in recent weeks Ray Dalio substantially reduced their exposure to Fixed Income. Apparently not in reaction to the weak bond market of the second quarter, but instead as a result of many months of analysis which concluded bonds were no longer as attractive in a portfolio that’s expected to generate positive, uncorrelated returns most of the time.

The classic justification for holding bonds is the diversification they provide to a heavy weighting in equities. It’s worked more often than not, but we may just be heading into a period of time that will test conventional wisdom. To start with, yields on high grade and government bonds are unattractive on a buy and hold basis. It’ll be hard to finish ahead of taxes and inflation with yields of 2-3%. The idea that bonds will rally during times of equity market stress, thus mitigating the inevitable mark to market swings of a conventionally allocated portfolio only seems to justify bonds if you’d actually sell them when they’re bid up through a flight to quality. Few investors do, and the ownership of bonds for the temporary sugar high that turmoil may bring seems less interesting when the long term prospects are poor. Watch for creative explanations from financial advisors to defend clients’ bond holdings in the future.

But the other side of things is that stocks and bonds may at times be highly correlated on the downside. If the Fed’s attempts to at least slow the growth of its $3.5 trillion balance sheet awake the sleeping child, or perhaps even result in a smashed dinner set all over the floor, weaker stocks may be accompanied if not even caused by weaker bonds. The flight to quality may not work.

We believe the most likely outcome is one of very measured, non-threatening reductions in Quantitative Easing and a further very long interval until short term rates rise. This is what the Fed has told us to expect. But that’s just a forecast, and we could be wrong. However, if we do find ourselves in a substantially weaker equity market caused by the Fed’s lack of manual dexterity, we at least won’t have compounded the error by owning bonds as well.

This morning I noticed an article on Seeking Alpha by Alan Ginsburg making the case for shorting Joseph A Banks (JOSB). The writer makes a good case that the company’s financial statements are untrue and that a conflict-driven management team has at times “looted” the company. We have no position in JOSB and no plans to take one. I was simply reminded of Marc Cohodes, a passionate short seller (they usually are) who in early 2008 made the case at a presentation I attended that JOSB was a sham and was going to collapse. Marc was similarly convincing and had evidently done his homework. Sadly, though, in 2008 his short positions blew up on him during Lehman’s bankruptcy (you may recall a temporary ban on shorting financials at that time which caused a brief but sharp rally). It should have been his year, of all years. But it wasn’t.

Early last year I noted that Marc Cohodes had turned his back on Wall Street to run a chicken farm. It was one of the less likely outcomes of the 2008 Crash. We certainly wouldn’t own JOSB, and we don’t short individual stocks so my only involvement with JOSB will be to occasionally buy a pair of socks there. I haven’t so far been seduced by the “Buy One, Get Two Free” pitch for their suits. But if they do eventually collapse and Alan Ginsburg is right, someone else was on to the story already, if rather too early.