MARGINOT TOOL KIT

How does one explain U S. Treasury bonds in the face of Fed tapering still yielding around 2.5% and the looming risk of higher interest rates somewhere on the horizon?

One explanation might be simply this: Fear premiums have subjugated risk premiums. In plain English, the fear of missing out supersedes the fear of losing out. If bond yields, for example, drop from, say, 2.5% to 1.5% that's the fear of losing out and it is also a bet on more of the same, meaning the "new neutral" or possibly more deflation ahead that people like those at Pimco are selling.

The absence of risk premium is a clear statement of "We'll worry about that later, but for now..." In our recent post Fed Policy Danger we quoted noted investor Stanley Druckenmiller's comment about Fed policy being too focused on the now and too little concerned about its policy impact down the road.

Back in 1980-81 you could walk into any bank or savings and loan firm (if any were still around after the S & L industry tanked) and purchase a one-year CD yielding 14%. Thirty year Treasuries were yielding around 15% in those days. The long running bull market in stocks that's apparently still going didn't officially start until August 1982.

Now the pundits will cite, as they almost always do, their that-was-then-this-is now argument. So be it. But the truth is almost no one saw the big equity bull market coming. And most certainly not the Fed or the bureaucrats in Washington.

Much of the new neutral argument centers on a macro call. That can be a form of extrapolation of the weakest kind because it leaves little or no margin for surprises. Druckenmiller's comment, at least in our mind, is suggesting exactly what we're talking about.

Despite all the Fed's claims about its tool chest still being adequate one could suggest that after WWI hoards believed the 1930s constructed Maginot Line would be adequate.

The French established the fortification to provide time for their army to mobilize in the event of attack, allowing French forces to move into Belgium for a decisive confrontation with Germany. The success of static, defensive combat in World War I was a key influence on French thinking. Military experts extolled the Maginot Line as a work of genius, believing it would prevent any further invasions from the east.

While the fortification system did prevent a direct attack, it was strategically ineffective, as the Germans invaded through Belgium, outflanking the Maginot Line. The German army ran through the Ardennes forest and the Low Countries, completely sweeping by the line, defeating the French army and conquering France in about six weeks.^[1] 

As such, reference to the Maginot Line is used to recall a strategy or object that people hope will prove effective but instead fails miserably. It is also the best known symbol of the adage that "generals always fight the last war, especially if they have won it".^[2]

For the sake of history there was second line--Alpine Line--facing Italy. In our humble view, too few investors today are considering the possibility that for all its reassurances, Fed policies could turn out to be their Maginot Tool Kit.
 t. man hatter
 (2) Wikipedia