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Counting Cards

Originally posted on October 20, 2013.


There has been many an article written about the similarities between gambling (largely poker) and investing. The important macro self-disciplines for each are common denominators - the importance of risk management, decision making under uncertainty, position (bet) sizing, and the list goes on and on. Of course we have investment world notables such as David Einhorn living a bit of the dual life as an example of this linkage.

Whenever I walk into a casino, the same thought always initially pops into my mind. Don't these folks realize the statistical odds they are facing in the various games being played? Don't they understand the odds are heavily stacked in favor of the house and against them, especially if longevity of play is involved? The correct answer is, "of course not", or casinos would be deserted. Certainly for most, it's not about the odds, but rather entertainment. There is a price for entertainment and at least in a casino the patron ultimately sets the price! The price being the amount of cash they are willing to part with.

In like manner, we do know there are a number of folks more than well aware of the odds presented by the casino gambling experience. Folks such as former mathematics professor turned hedge fund manager, Ed Thorp, successfully beat the supposed gambling establishment at its own game by developing a system for counting cards in blackjack. Counting cards enabled Thorp to gain a statistical edge and changed the house-assumed odds of the game in his favor. And yes, it also bought him banishment for life from physical casino facilities. There is zero room for a level statistical playing field in the gaming industry.

So why talk about statistical odds and counting cards? We know that the Fed is set to taper their bond purchases dead ahead. I personally believe that once they start, there will be no re-firing up the printing presses regardless of economic outcomes. Reactionary financial market outcomes may be another story, but even then I believe the Fed wants out, period. So now it's all a matter of pacing and magnitude of position reduction until the Fed polishes off its final free drink and leaves the gaming table for an extended period.

What I hope is meaningful is a bit of card counting in terms of the Treasury market, which is extremely important given what we've already seen in the movement of US Treasury yields post May. For now, I've seen many a suggestion that the Fed will first start the tapering with a reduction in Treasury purchases while they leave the magnitude of MBS purchases intact. We'll just have to see come September 19. I've also seen many a pundit characterize the recent Treasury market selloff as one of the worst in history. Unfortunately, what I do not see is a discussion of context. Historical Treasury market corrections were never preceded by the type of monetary intervention we have been treated to in the current cycle. So history may be quite the imperfect guide and comparator.

Can a look at the complexion and character of US Treasury owners over the last quarter century help us in counting the cards of the current cycle? Who, or whom, have been the key provocateurs of price support? How has the ownership structure of Treasuries changed over time? Assuming the Fed will be done purchasing Treasuries by perhaps mid-2014, just who will pick up the slack? How many current and large Treasury owners have already played the bulk of their "face cards", with perhaps little left to play further? Perhaps counting the cards of the moment can help us anticipate the odds of a number of potential future outcomes in the Treasury market.

So let's start with an historical retrospective of Treasury ownership itself. The following table is populated with data derived from the Fed Flow of Funds report. We're looking at the major holders of Treasury securities across time and how their ownership percentages have changed. Quite the story.

Percent Ownership of US Treasuries 1990 versus 2000 versus 2010 Table

I'll keep the comments brief as none of this should be "new news". As we look back over the last few decades, it is clear that the foreign sector and the mutual fund complex have played the bulk of the face cards in their hands. You can see that these numbers are as of 1Q 2013 period end, prior to the beginning of turbulence in US Treasury prices. We also know that since that time we've seen record outflows in the US mutual bond fund complex. Is it reasonable to speculate that perhaps mutual fund holdings of Treasuries as a percentage of the total outstanding has peaked at a high unseen for at least a quarter century? Very reasonable. Although no one knows what lies ahead, it's hard to see Treasury mutual fund flows accelerating any time soon after the price jolt we've seen in recent months. The US public just does not have a history of "chasing" deflating assets, quite the opposite.

Interestingly, pension fund ownership of Treasuries as a percentage of the whole has been remarkably stable over time, dipping in the recent period as yields hit generational lows. The mantra has been that pension funds starved for guaranteed rate of return would be a natural buyer. Given assumed actuarial return assumptions of the moment, that could be true, but certainly not at current nominal Treasury yield levels that don't even come close to these assumed return levels. It's going to take higher interest rates to bring pension capital to the Treasury market.

Banks and Insurance companies appear to have been very rational in their portfolio management of Treasury holdings over time, cutting back as yield levels fell over multi-decade periods. With mark-to-market capital rules in the banking industry, are these folks really going to attempt to catch the proverbial falling knife and risk possible perceptual hits to the capital account? Same deal with insurance companies. They are not in the business of making it on the policy premium side of the P&L and losing it investing. Moreover, even in a much higher rate environment in 2000, banks and insurance company holdings of Treasuries were one-fifth of the magnitude of the foreign sector. At least over the last decade plus, they never held enough face cards to meaningfully influence the game.

Perceptually, households have decreased their direct ownership of Treasuries as yield levels have fallen over the decades. But we also know that household ownership of bond mutual funds grew significantly from 2009 to early this year. As mentioned, these flows have reversed in relatively violent fashion in recent months for very obvious reasons.

The thought that the Fed owns all the Treasuries right now is absurd. What is not absurd is that the Fed has been the largest single buyer of Treasuries in recent years. The whole flow versus stock argument. For now, at the margin the Fed is the most important player at the table, but they are set to lower their position sizing and ultimately leave the table entirely. What does that suggest about the size of future winning pots when a whale leaves the game?

I've saved the foreign sector for last for very obvious reasons. Talk about the 800 pound gorilla in the room. I personally believe there are two sides to the story here. First, we know the accumulation of Treasury securities by the foreign sector has been largely attributable to China and Japan over the last few decades. The driver was simply mercantilist economics - the financing of the Asian export juggernaut. We also know that export machine is slowing. Over the first six months of 2013, Chinese ownership of Treasuries increased $55 billion while Japanese ownership decreased by $28 billion, almost a wash. The Fed has bought more Treasuries on a net basis in one month than these two have bought in six. Given the internal issues faced by both China and Japan, have they simply run out of face cards to play at the Treasury table?

Alternatively, and we have not yet seen this, we need to be aware of the potential for global capital flows to at least help support Treasuries, but not for economic reasons (such as the mercantilist economics theme). The big question for not just Treasuries, but really the US financial markets broadly, is whether global capital will move increasingly to the US dollar out of fear. Fear of currency debasement (just look at the emerging market currencies), fear of capital confiscation (just look at the bail-in mechanism in Europe), etc. IF global capital concentrates in the US dollar, we may see increasing flows to US equities, real estate and fixed income vehicles that may help forestall higher Treasury yields for a time. Again, we're not there yet.

Are we facing some type of Treasury market implosion ahead? Of course not. There will be a buyer, that's not a major issue. The key issue is price. Price will adjust to accommodate supply and demand dynamics. As we try to count the cards revealing the character and complexion of current Treasury holders, I think it's very fair to suggest the major holders of the moment have played the bulk of the face cards in their hands. We're seeing a reversal in bond fund complex ownership (16%). We know foreign sector accumulation of Treasuries is slowing meaningfully on a rate of change basis (48%). And we know the Fed needs to end the QE experiment as results have not been forthcoming (15%). Collectively we are looking at behavioral change among the cast of characters that owns just shy of 80% of currently outstanding marketable Treasuries.

As in blackjack, when the bulk of the face cards have been played, the odds of "winning" with successive hands decreases. Ed Thorp would suggest we reduce position (bet) sizing. Of course one way to bring more players and new capital to the table is to increase the payout rate. In the case of the Treasury analogy, that's yield. This is where we have been for the last three plus months. Is this where we continue to head looking forward based simply on counting cards?


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