August 21, 2011

Perspective From Dubai: Predicting An American Bond Bubble (Guest Post)

By Andrew Butter

I’m a little slow, but perhaps someone can tell me what happened to the crowd who were jumping up and down screaming that US Treasuries were a bubble when the yield was 3.7%? If that was a bubble in 2009 and 2010 then 2.0% has to be an UBER-BUBBLE.

The valuation model presented here started out in February 2010 in response to all the noise being generated by the Treasury Bubble Crowd; what the model said (then) was that yields would go down, which they did until Ben started buying under QE-2 and then they went up until Bill Gross sold at the top of the market at precisely the point this model said yields were going to go down to 3%, which they did.


So far so good, so how does that work? When you build a valuation model you feel more confident if you can get to a similar answer by at least two independent routes, typically those are income capitalization and depreciated replacement costs, but there are other ways, I always try for a minimum of two, at least when someone is paying me.

In this case the first line of reasoning was based on the idea that you can define the “fundamental” of something bubbling, or what people who do valuations (at least in line with International Valuation Standards) call “other than market value”, from the square root of the top multiplied by the bottom.


The green line on the chart is a valuation estimate. That’s what I do, valuation; to me it makes no difference if it’s twenty-year old jack up barge, a Costa Coffee franchise, or someone’s left-foot, the principles are the same.

That’s nothing to do with economics by the way; valuation is an estimate of what you can sell something for in certain defined circumstances, that’s it. It’s a prediction of what might happen in the future, nothing else; and what many people don’t understand about valuation, is that when the circumstances change, the value changes too; the acid test is were you in the ball-park.

The credit crunch was all about valuation, the valuations got messed up and so everyone paid 35% more for houses than they should have (or pulled out “equity” based on that), and banks used that as collateral, and the rest was just inevitable. Perhaps as part of its role as a “regulator” the Fed might consider mandating that valuations used to work out capital adequacy of banks are done using International Valuation Standards, instead of the Voodoo Valuation Standards used by the rating agencies? Just a thought, for next time America is considering shooting herself in the foot, not that I care, I’m not American.

The second line of attack was looking for a nominally independent driver; a good place to start on that sort of investigation is nominal GDP:


That didn’t surprise; the analysis on the chart basically says that you can predict the yield on US Treasuries from the moving average of the past four years of nominal GDP growth, there is nothing particularly new there; plenty of other people know that, although that’s the first time I saw anyone doing a simple regression.

But there is not a lot of what International Valuation Standards calls “market-derived-data”, (from USA at least) about what happens if nominal GDP starts going negative, but in any case that’s a four year leading indicator, which I call a driver, in the sense that I suspect nominal GDP “drives” yields.

So that brings us to now and what that valuation model says is that a 2% yield on US Treasuries is not “correct” right now and was probably a result of some sort of mania.

The reason for the mania could be because of “X” or “Y, although personally I’m not very interested in what particular drug the deadbeats are using, from the point of view of valuation, the reason is irrelevant.  At some point, probably quite soon (a few months), it’s likely that the 10-Year will head up back towards 3%, like it did after the last mini-bubble caused by traders front-running the Fed in anticipation of QE-2.

GDP (Nominal):

One thing is that when they get released (in November 2011), it looks likely that the Q3 numbers for nominal GDP in USA (covering July through September), will let’s say “disappoint”.

There are four (valuation) predictions there, lets see if they pan out, like the last ones did? But see – I put numbers on my predictions, how many “gurus” do that?

The Year of the Rabbit

2011 is the Year of the Rabbit, and when I did my predictions back in January for the Chinese new-years which starts on 4th February, on the subject of US Treasuries I remarked:
If ever nominal GDP in USA starts to take off, US Treasuries will too, I’ve got the 10-Year pegged for 3% in March (now it’s 3.4%), plenty of people think I’m wrong. I say there was a bit of a bubble after the rumour got out that there would be QE-2 and the dealers played with Ben like a cat with a mouse by front-running the price, here’s a tip Ben, if you want to spend $600 billion on something, don’t tell everyone first.
I’m not too ashamed about that although I gotta admit I did get the timing of the return to 3% totally wrong (by about four months).

My implicit assumption then was that nominal GDP would grow by 3% minimum, that was based on looking it up in the back-page of The Economist, how much of that was going to be inflation or “real” is of course irrelevant to valuation.

This is the first time I’ve attempted to “do” GDP, although I did notice that Nouriel Roubini
The first half of 2011 showed a slowdown of growth – if not outright contraction – in most advanced economies. Optimists said this was a temporary soft patch. This delusion has been dashed. Even before last week’s panic, the US and other advanced economies were odds-on for a second severe recession.

America’s recent data have been lousy: there has been little job creation, weak growth and flat consumption and manufacturing production. Housing remains depressed. Consumer, business and investor confidence has been falling, and will now fall further…

Until last year policymakers could always produce a new rabbit from their hat to trigger asset reflation and economic recovery. Zero policy rates, QE1, QE2, credit easing, fiscal stimulus, ring-fencing, liquidity provision to the tune of trillions of dollars and bailing out banks and financial institutions – all have been tried. But now we have run out of rabbits to reveal.
I’ll go along with that, apart from the bit about rabbits, if you run out of rabbits to pull out of the hat in the Year of the Rabbit, all hope is lost!!

I don’t think things are THAT bad, and in any case, perhaps there is a silver lining, perhaps the realization is slowly starting to sink in to the minds of the corrupt morons in US Congress that you can’t create economic growth by getting the Fed to play with the base rate, and build bubbles, whilst denying any responsibility?

I've outlined some suggestions such as imposing wealth and gasoline taxes, and cut military spending to put Americans back to work.  Do that and America will balance her budget in 2012 and unemployment will go down to 7% by end 2012 (U-3). It’s either that or QE-3 and there is no evidence that third-time-lucky will cut it this time around, any more than the previous versions.

Meanwhile, personally, I’m just sitting on the dock of the bay, offshore, watching the tide come in. I love nature, sunsets blow me away, and I’m looking forward to the spectacle of America doing the suicide thing…should be spectacular…from a distance.

About the Author - Andrew Butter is Managing Partner of ABMC, an investment advisory firm, based in Dubai that he set up in 1999, and has been involved advising on large scale real estate investments, primarily in Dubai.  (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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