Managing tail risk is a constant worry for any investor using leverage, and many others who shouldn’t worry since they’re not levered also fret over the possibility of a market swoon. It’s a real dilemma; low risk assets such as government bonds offer no return at all unless a flight to quality drives prices temporarily higher. Risky assets such as equities are attractively priced as long as (take your pick) (1) housing doesn’t turn down, (2) Spain doesn’t need a bailout, (3) Israel doesn’t bomb Iran. As someone once said, you can have cheap markets and safe markets but not both at the same time.

Buying equity put options can afford some protection but of course the option premiums will eat into the return. Long stock with a put is equivalent to a long call, and buying call options isn’t generally a reliable way to build wealth. We started looking at using a short Euro position last year in combination with risky assets. The logic at the time was that most of the bad things that could derail the market were likely to begin in Europe. While that’s not as obviously the case today, it can still represent an attractive way to combine risky, yield generating assets (such as bank debt) with a market hedge.

The 90 day rolling correlation between the S&P500 and the Euro has moderated from its high levels in the Fall when the Euro crisis dominated the news. However, while day-to-day moves are fairly independent of one another, the Euro reliably drops when stocks are notably weak. Over the past year, the Euro fell 69% of the time when the S&P was down 0.25% or more. Falls of 0.5% or greater saw a weaker Euro 90% of the time.

The U.S. is likely to experience GDP growth of 2.5-3% greater than the Euro-zone this year. The focus on austerity as the solution to Europe’s excessive debt makes a weaker currency in their interests as a way to stimulate some demand for southern European exports. So a short Euro position is probably the path of least resistance barring another crisis, but in addition it provides some tail risk protection for holders of higher yielding assets.

Investors are living in a time of unprecedented openness by the Federal Reserve. Many readers are old enough to recall the days when “Fed-watchers” would seek to divine the central bank’s intentions on monetary policy through its open market operations. If managing reserves, and therefore indirectly the cost of short term financing through the Federal Funds rate, required that the NY Fed conduct a “System RP” and they instead provided somewhat less overnight funding through a “Customer RP”, bond traders would immediately interpret an intention by the Fed to raise interest rates and react accordingly. It was subject to all kinds of communication problems – sometimes the Fed wasn’t trying to say anything, but Wall Street analysts had got their reserve requirement Math wrong and thought they heard a warning of higher rates. Then the Fed might oversupply short term credit the next day, in order to correct the mis-communication. Somehow this obscure back and forth of action by the Fed followed by reaction from the markets was state of the art central bank communication back in the 80s and 90s. It all now seems so quaint and pointless at the same time. The Fed under Alan Greenspan, following custom, deemed plain English unsuited to its purpose. And Greenspan himself took evident pride at his ability to provide long Congressional testimony using tortured erudition that shrouded monetary policy in a fog and left senators befuddled.

Ben Bernanke has continued a new tradition begun in the latter Greenspan years of communicating quite plainly. Opinions are easily formed on this Fed, because their intentions are so clear. There’s no more hiding behind obfuscation. The conduct of monetary policy takes place right out in the open. FOMC minutes are released in a timely fashion; Bernanke holds “town halls” to discuss monetary policy, goes on “60 Minutes” and the Fed now actually tells you, with a fair degree of precision, where they think interest rates will be.

In January, the FOMC released short term interest rate forecasts from all 17 FOMC members. From the published data, it’s possible to construct the Fed’s own yield curve. A long term interest rate is simply the sum of all the short term interest rates from which it’s constructed. Libor rates are visible and can be hedged out to ten years through eurodollar futures. In aggregate they form the ten year swap rate. The ten year swap rate is closely tethered to the ten year treasury yield, which is largely set by the Fed’s Operation Twist and its predecessors, QE 1 and 2.

The chart overlays market forecasts of short term interest rates, derived from recent eurodollar futures prices less the typical 0.3% spread to the Fed Funds rate (the blue bars), and compares it with the FOMC’s own interest rate forecast (the red line). It assumes the FOMC expects to return to its equilibrium 4% interest rate in five years.

The Fed expects to raise short term rates by the end of 2014. They expect them to go up by 0.5% between the end of 2013 and 2014. Quite recently, the market forecast for Libor rates was that they’d increase by 0.3% during this time. Futures markets didn’t expect as sharp an increase as the Fed. Of course, the Fed is only making a forecast, and it’s based on GDP growth, inflation, unemployment and many other variables. Their forecast for these might be too optimistic. But when you ponder for a moment the actions of those bond investors who would accept market interest rates as the basis for their purchases, it’s quite bold to insist that buying bonds at yields below the Fed’s expected break-even is a sound move. They are telling you, if you’ll just listen, that short term rates between now and 2022 will average more than the current yield on a bond maturing at that time. The Fed’s forecast may be wrong, but their forecast is obviously a bit more important than yours or mine.

The long end of the yield curve is similarly fascinating. The FOMC’s long run equilibrium rate is 4%. This is where they believe short term rates will return when the Great Recession of 2008 is a distant memory and the economy is chugging along at whatever rate it can just short of causing inflationary pressures on wages and other inputs. The FOMC doesn’t say exactly when things will be back to “normal”. Of course, we’d all like to know. The chart above assumes five years. But the futures market has a different opinion on when that will be, and the answer is March 2022. This is how far out in to the future it’s necessary to go in order to reach a eurodollar futures contract that yields 4%. Everything prior to that date yields less, because investors in aggregate believe the economy won’t quite be back to normal. Or at least,
that’s what investors are saying by their decisions to invest, or not, at prevailing yields.

If Bernanke testified before Congress that we still have another ten years to go before the “extraordinarily accommodative” monetary policy was no longer needed, there would be outcry. He would probably be fired, or even impeached. Further fiscal stimulus not even imaginable would no doubt be contemplated. Big things would happen.

Except that he wouldn’t say that. Although he hasn’t put a date on normalcy’s return, everything about his actions and those of his colleagues on the FOMC strongly suggests they are not nearly that pessimistic. Futures markets are pricing in ten years because the Fed has put them there through their buying of treasuries. 61% of net U.S. Federal government debt issuance was bought by the Fed last year. The Fed is maintaining bond yields at levels far lower, perhaps 1-2% lower, than the likely break-even on short term rates over the same period.

This should be plain to anybody paying attention to the Fed’s communications. It doesn’t necessarily mean ten year treasuries at 2.2% and related corporate bonds at modestly higher yields are guaranteed to lose money. It may take us more than ten years to reinvigorate the economy, to fully repair all the damage excess debt has wrought over the years. But it is obvious that the Fed thinks today’s bond yields are a poor investment. That is a clearer expression of its opinion from the central bank than many of us are used to, and shows how far we’ve come since the old days of Fed watchers.

We continue to think equities are attractively priced, although obviously not as cheap as they were in the Fall. The Equity Risk Premium, the difference between the earnings yield on the S&P 500 and the yield on ten year treasuries, has narrowed modestly from where it was in September, mostly because the strong rally in stocks has driven multiples higher and earnings yields lower while treasury yields have drifted higher. However, this relationship is still historically wide.

But on interest rates, we believe in siding with the elephant in the room. If last year’s buyer of 61% of treasuries thinks yields are too low, that sounds like a view worth respecting. Investors can own a combination of equities and cash divided according to their risk appetite and outlook. But long term bonds, both government and investment grade corporate, are clearly at yields intended to lose you money. The world’s biggest buyer is telling you so.

One day, probably in the not so distant future, Spencer Jakab of the Wall Street Journal will probably regret suggesting that natural gas prices may go negative, as he did in today’s article “Why Natural-Gas Prices Could Fade to Red”. It’s an attention grabbing headline, but is likely to be better known some time in the future when natural gas has bounced and Mr. Jakab’s piece comes to be remembered as the time when the very last sellers showed up on the scene.

And of course natural gas fundamentals over the near term continue to look extremely poor, with a warm winter reducing the need to restock inventories during the shoulder months. Owning natural gas futures has been a terrible trade for anyone foolish enough to speculate that way, and there’s no near term bounce in sight.

But it’s not clear why anyone would pay to give away natural gas. It can be flared off or simply not produced if prices are unattractive. There’s also growing evidence that its cheap price is drawing utility demand for electricity generation while at the same time depressing demand for coal. In fact, the long term outlook is revealed by Kinder Morgan’s strategy (KMP). Their acquisition of El Paso (EP), expected to close in 2Q12, adds an extensive network of natural gas pipelines to KMP’s existing network as can be seen in the presentation they published when the acquisition was announced. Kinder Morgan expects increased movement of natural gas.

And KMP is expecting increased exports of coal as domestic demand wanes.

Meanwhile, investing in companies drilling for natural gas hasn’t been nearly as painful as being long the commodity itself. Range Resources (RRC) for example, over the past twelve months has matched the return on the S&P500 (although it’s been more volatile). In round numbers, 5 TCFE (Trillion Cubic Feet Equivalent) of proved reserves provides a solid base for its $9BN market cap (if they earn $1 per MCF that’s worth $5BN) and they have ten times that in potential reserves. Their manageable debt (less than $2BN net of cash, or 45% of their total balance sheet capitalization) and low production costs means that the equity holders are unlikely to lose the company to the debt holders. Their increased production of NGLs (natural gas liquids) generates cashflow from an area with more buoyant demand. Owning operating assets, or equity in operating companies such s RRC is far better than going long the futures.

So remember today’s WSJ story – although Mr. Jakab does point out that in the long run low natural gas prices will create their own demand and likely selfr-correct, the article’s headline will almost assuredly be worth revisiting at some point in the future.

I have been invited to give the Keynote Address at this industry gathering in June. I am looking forward to the opportunity to meet with hedge fund industry professionals and discuss how investors can achieve better results than they have in the past.

My thanks to Hank Greenberg for revealing an example of what’s wrong with some areas of Finance. The VelocityShares Daily 2X VIX Short-Term ETN (TVIX) is an exchange-traded note issued by Credit Suisse. Its travails and those of its investors are well covered elsewhere. It’s been a bust, as befits a vehicle designed to provide leveraged exposure to movements in the VIX (an index of S&P500 volatility). The idea that taking positions in the VIX has any utility to begin with is emblematic of the misplaced focus on using leverage to increase returns and then hedge temporary adverse market moves. It doesn’t help move savings to productive types of capital formation, but is instead part of a big casino.

But that is a point for another day. I am reading from the TVIX prospectus, as pointed out by Mr. Greenberg, the stunning disclosure language:

“The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.”

Now this is legal. The SEC apparently pointed out to Mr. Greenberg that they don’t approve the investment merits of securities issued. But what about Credit Suisse? How do they get comfortable issuing a security to the public that they believe will go to zero? Where’s the judgment? What is the point? If you sell a two-legged stool to customers with a warning that they’ll fall off, does that absolve you of responsibility? If you’re a private banking client of Credit Suisse and have entrusted your wealth to them, are you supposed to ignore this window into their values?

Credit Suisse has not broken the law. TVIX represents one element of their activities in the strange world of finance. It is part of their brand. They should be judged accordingly.

Today’s story in the NY Times about Marc Cohodes recounts a poignant tale of the fall of a formerly highly regarded hedge fund manager. I wrote about Marc Cohodes in my book, The Hedge Fund Mirage. A perennial bear and manager of a short-selling hedge fund, 2008 should have been the year he made a spectacular amount of money. Instead, as the NYTimes tells and as I wrote in my book, triumph quickly turned to disaster as the stocks he was short inexplicably rose strongly when everything not nailed down was being thrown overboard by panicked investors.

Copper River, his hedge fund, closed down. Reflecting what must be Marc’s complete disillusionment with all things finance, he is pictured tending to the chickens he raises on a chicken farm in northern California. It’s a sobering career shift, one of the more improbable stories to come out of 2008.

March 2022. That is the point at which, according to eurodollar futures prices, three month Libor will reach the heady yield of 4%. Ten years from now until money market yields are restored to “equilibrium” as defined by the FOMC in their rate forecast issued for their January 24-25 meeting earlier this year (reproduced below). The time to reach equilibrium is not defined in their forecast, so plausibly their forecast could be consistent with market interest rates. But I suspect that if asked whether it’ll take ten years for conditions to return to normal, Ben Bernanke would sound somewhat more optimistic than that. Or put another way, if during one of his testimonies before Congress he suggested that we have another ten years of digging to get out of the economic hole we dug in ’07-’08, many Congressmen might take the view that this is far too long.

So the bond market disagrees with this outlook. Bond investors believe we are ten years away from full recovery, while the government believes or hopes that this is far too pessimistic. Forecasts can differ, but meanwhile I keep returning to the fascinating optics of the Federal Reserve imposing on the market (through Operation Twist and its predecessors) long term interest rates that reflect market forecasts they themselves find too pessimistic. The only way to reconcile the Fed’s actions with its forecast is to acknowledge that its bond purchases are uneconomic – indeed, they are intended to be so. As the logic goes, maintaining stimulative interest rate policies is the best way to assure that ultimate recovery and an improved labor market both transpire.

It’s rare that a central bank provides so much information about its thinking. An easy way to square the circle would be for the FOMC to produce rate forecasts that are consistent with the yields at which they’re buying bonds. It would ensure consistency between their actions and their forecasts, but to their credit the Fed is promoting far greater transparency than they did under Greenspan. Consequently, presuming that the FOMC doesn’t seriously believe it’ll be ten years before a return to equilibrium interest rates, they are investing at yields too low for any commercially driven bond buyer. This is not even a guess; the Fed is telling you so! The Fed doesn’t need to make profitable investments, and they likely expect to hold what they own until maturity. But if you could catch Bernanke at an unguarded moment, perhaps over a glass of wine with no press nearby, he would surely acknowledge this incongruity and justify it based on the Fed’s twin mandate of promoting full employment consistent with stable inflation. The Fed is doing what they’re supposed to. And they are explaining it as plainly as anyone could hope.  Today’s bond buyer needs to be a very definitely not-hold-to-maturity type to make a profitable investment in ten year treasuries at 2.3% (or corporate bonds tethered through credit spreads to this return-free yield). If it turns out badly because the Fed starts raising rates with a view to reaching their longer run objective before 2022, it’s because the investor didn’t become a trader quickly enough.

Jeffrey Lacker, President of the Richmond Fed, thinks rates may need to rise as soon as next year. He is presumably one of the dots in the chart reproduced below, and no doubt one of the more hawkish. How fascinating to be able to ask him what he thinks of current interest rates. In fact, he’s already told you.

Although treasury yields have risen around 30 bps over the past couple of weeks, yields have not yet reached what the Federal Reserve itself might call equilibrium. The FOMC rate forecasts that the Fed published earlier this year reveal an intriguing inconsistency between the Fed’s actions and its own market forecasts. Operation Twist and its predecessors are intended to drive down long term borrowing costs, to the benefit of those who can access those markets (qualified homebuyers through mortgages, investment grade corporations and of course the Federal government itself).  This along with concerns about Europe have pushed yields lower.

The Fed published rate forecasts from each FOMC member earlier in the year. Their interest rate forecasts are at odds with the term structure of interest rates, which the Fed of course is heavily influencing. The FOMC expects the long run, equilibrium Fed Funds rate to be around 4%. Although they don’t say when the rate will reach that equilibrium level, it seems reasonable to suppose that their forecast horizon wouldn’t be longer than five years. And yet, the 5 year forward treasury rate in five years (derived from the five and ten year treasury yields) is around 3.5% (it was close to 3% before yields began rising recently). The market forecast for short term rates in five years is 0.5% lower than the FOMC’s forecast.

It’s not a huge difference, but what’s interesting is that the Fed’s Operation Twist, by forcing long term yields down, is at odds with their own rate forecasts. By their own admission they don’t believe long term bonds at current yields are a good investment. Their own actions, based on their own forecasts, are not designed to be profitable for them or for anyone following them.

Corporate bond issuance has been running at record levels so far this year, spurred by corporations wishing to lock in low rates. Retail investors have happily taken the other side. The question is, since the Fed is clearly a non-economic buyer and is forcing yields down to levels that their own rate forecasts show to be unprofitable, should this be made more explicit to the retail investors that are buying at current levels? If the government is consciously seeking to make some investment uneconomic, shouldn’t they just say that in plain English? This isn’t critical of Operation Twist or earlier efforts by the Fed to maintain low long term rates – such moves have so far probably been good.

But when retail investors hiding in fixed income start to see losses on their holdings, they might wish the Fed had told them more clearly the risks they were facing. Long term bonds are still a poor investment.

On CNBC’s website today:

http://www.cnbc.com/id/46759372

This interview about my book The Hedge Fund Mirage was broadcast on the BBC World Service earlier this morning. It also includes an interview with a hedge fund manager brave enough to go on and defend his industry.