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.

Eurodollar futures provide quite precise data about the market consensus forecast for interest rates. Since they extend out for ten years, they provide a rich set of information constantly updated about where market participants think 3 month Libor will be every three months.

The FOMC recently started making public the interest rate forecasts of its members. They issued a graphical representation of when FOMC members expect to begin tightening and what each member expects the year-end rate to be through 2014. You can find it here listed as “Projection Materials” for their press conference. For some weeks now I’ve felt that there exists a mild discrepancy between the rate forecasts imbedded in the eurodollar futures curve and the FOMC’s forecasts. For instance, only 6 of 17 FOMC members expect the Fed to begin tightening by 2013, whereas 11 (i.e. a majority) expect so by 2014. So the majority think they’ll be raising rates no later than 2014. Similarly, the median rate forecast of FOMC members at the end of 2013 is 0.25%, but a year later it’s 0.75%. Moreover, if you compare the average forecast rather than the median, rates are expected to move from 0.56% to 1.12% (there are a couple of outliers on the high side). So on balance, it looks as if the FOMC expects short term rates to rise around 0.5% during 2014.

Meanwhile, the spread between the September 2013 and September 2014 eurodollar futures yields is 0.36%. The market is priced for less of a tightening than the FOMC is forecasting.

Now eurodollar futures and the yield curve in general are analyzed probably more closely by more smart people than any other variable in financial markets. In addition, not all FOMC members vote, and it’s not clear what each members’ forecast is (although you can make some reasonable assumptions based on public comments by individual members). Current market pricing is not an oversight, it correctly reflects market expectations. And yet, were you able to sit in on a discussion of the FOMC, or better yet debate interest rate forecasts with them, they would likely tell you that the yield curve out to three years is not pricing in enough of a tightening of short term rates. Of course, the FOMC’s forecast could be wrong; after all, they really don’t know more than anyone else about what the economy will be doing in 2014. One interpretation of market pricing is precisely this – FOMC members are overly optimistic about GDP growth and the economy will still be facing headwinds 2-3 years out.

This may be so, and yet the knowledge that the FOMC thinks the yield curve is too flat would have been considered valuable inside information not so very long ago. Today, it’s public information. And they are of course in a position to make their forecasts come true.

The view that the yield curve is too flat can be most easily expressed through a long eurodollar futures calendar spread (long September 2013 and short September 2014), betting on a wider spread or steeper yield curve between those two points. Not everyone chooses to trade futures, but the rate forecasts revealed explicitly in the eurodollar futures curve are part of the term structure of bonds as well. Although the eurodollar futures market makes plain the precise path of interest rates the market expects, bond yields of different maturities are priced to be largely consistent with the same information. So an investor today who selects five year bonds over shorter maturity two years in exchange for the modest yield pick-up available is effectively rejecting the FOMC’s interest rate forecast as too optimistic on the economy. The FOMC is telling you they think you’re making a mistake.

Disclosure: Author is Long the September 2013/2014 eurodollar calendar spread.

I’ll be presenting on my book, The Hedge Fund Mirage, at the 2012 Factset Symposium Conference in Scottsdale, AZ March 19, and will be playing golf in Scottsdale over the weekend March 17-18.