Today's Most Dominant Risk Factor

Shannon Zimmerman: It's a very political season, so let's backup a little bit and talk about monetary policy and policy in general. You think of that as a risk exposure. How do you go about analyzing that and having a view into something that can be so remarkably unpredictable?

Vineer Bhansali: It's very interesting. Over the last four years, the policy risk factor has evolved from just being monetary policy to just policy in general. Four years ago you could have looked at what the federal-funds rate was or what the pricing of eurodollar contracts was, and say, what is the Federal Reserve supposed to do? And quantitatively you could have proxied the policy risk factor with, let's say, the fourth or eighth eurodollar futures contract implied rate.

Now, since then rates have come down to zero-bound and they are very low, and the policy that the central banks are using is not just monetary policy, but they're also buying assets like mortgages. They're also out in the public space talking about managing expectations about inflation. So, the evolution of analysis for policy risk factors has had to move into those dimensions. And what we have done is really tried to build a framework within which the policy risk factor can be more broadly interpreted. There also has been a lot of great research from researchers from Stanford and other places who've looked at quantifying the policy risk factor by the mentioning of policy risk in news items. So, doing a Google search, for example. That's a very interesting area of research. And to your question, we believe that the policy risk factor today is probably the most dominant risk factor in terms of both asset-class returns and risk, and really getting it right is of paramount importance for any robust portfolio construction. All assets are being driven by it.

Zimmerman: Is that particularly true of monetary policy in the Fed because I know you talk about policy broadly, and obviously, if you're thinking of health-care bonds, for instance, it's an interesting time, though maybe the question is settled by now. But over the last 12 to 18 months there was a lot of uncertainty around that. Is that the kind of thing that you would factor into your assessment of whether or not to increase your exposure to health-care bonds?

Bhansali: Yes, it would, but it's a little bit more indirect, like you mentioned. To see what health-care reform might do to health-care bonds and health-care equities requires a lot more interpretation. Monetary policy on the other hand is relatively more straightforward. It's not easy, but straightforward because you can know that once the rate-cutting process has been exhausted, the next step for the Federal Reserve is to do outright purchases of securities. And what you have to find is what is the area in which they are likely to deploy their capital, and what is it likely to do to the rest of the market. For example, as TIPS yields become significantly negative, what does it do to things like gold, what does it do to things like index equities, et cetera? And that's an evolving area of research, both for myself and for a lot of the industry.

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Zimmerman: What do you make of that, when Bill Gross was here, not at the most recent Morningstar Investment Conference, but the year before, he was talking about that and he seemed just amazed at the impulse that people had to park their money with the government and to pay for the privilege in terms of negative real yields. That hasn't changed. I think you have to go out to the 20-year period before you start earning real income on your Treasury investments. What do you make of that, and how do you factor that into your analysis now?

Bhansali: I spoke about it at the ETF Conference. Bill's viewpoint and I think our viewpoint, my viewpoint as well as some academics like Ken Rogoff and Carmen Reinhart have written papers on this topic, is that when you are this heavily indebted, the only way the government can pay its debts if they don't explicitly default is by a stealth default, which is basically keeping real yields negative or low, because that way you can keep nominal yields or basically real yields plus inflation. So if you can keep real yields negative and nominal rates low, then inflation can rise without it really looking like rates have gone up very much. And that at the end of the day is somewhat of a financial repression-driven long-term default. Today the broad market index is 65% Treasuries and mortgages. The yield on the Treasury index is below 1%, hence the yield on the broad index is probably 1.7%, 1.6%, and our view, and this comes back to ETFs, our view is that you shouldn't passively buy indexed ETFs if your ultimate purpose is yield because you are not getting it.

Zimmerman: Exactly.

Bhansali: You are basically buying something that's owned by the government. And what you saw in our ETF, the active ETF that Bill runs, is that you can add significant amounts of performance simply by going out of those indexed securities into places where there is real yield and where there are securities that are safe.

Zimmerman: Right. And that kind of anticipates the next question I want to ask you before we come to price momentum. So, you look at the landscape generally, and it seems to be sort of a risky time for bonds. There's the threat of inflation. If mean reversion holds, inflation is going to go higher, not lower than it has been over the last several years, and interest rates surely will go higher. At some point, both of those would be bad for fixed-income investments. How do you tack around that likelihood, and do you consider it a likelihood?

Bhansali: Yeah. So the rates go up because of two reasons: They can go up because of inflation rising, that's a direct impact; and there is also risk premium rising, the fact that people require higher compensation to part with their money. And those are really driven by expectations of long-term policy, expectations of creditworthiness of governments, et cetera. So, we do think in the long end the very, very long bonds are more exposed, the nominal long bonds, are exposed to both risk premiums rising and inflation rising. And that's an area where you have to be very cautious if you tread there.

In the meantime, the short end of the yield curve still gives you relatively a good amount of roll-down. So, if you are inside of maybe three, four, five years and running down to effectively 0% short-term yield, you can pick up. It's not perfectly safe, but you can still pick up some amount of carry. So we think with fixed income, you have to be cautious of the very, very long end. If you want to buy something, you have to buy something that's inflation-protected or buy something that is default-protected against both corporate defaults and God forbid against sovereign default.

Zimmerman: This is just a side note, and again because we are in political season, what is the endgame for U.S. debt? Are we going to inflate our way out that? It seems almost inevitable, and not even what has been engineered in the past; it's been a fairly effective means of doing it. But the political atmosphere has been such that it hasn't been possible really to talk about that when inflation is really remarkably low relative to historical rates.

Bhansali: Yeah, I think if you go back to the academic thinking, there's three or four ways of doing this, and there are three primary ways of dealing with expanding debt. First is explicit default, and I think that's unlikely to happen in the United States and in most developed countries because we have printing press, and we can print as much dollars to pay our obligations as we need. Another way is to actually come out of it through growth. The history is somewhat spotty in terms of how many countries have been able to come out of enormous amounts of debt just through growth. There are some great examples but very few.

And of course the last one is this financial repression, keeping rates really low, inflation expectations effectively rising. And I think that is the way we are heading, and there are consequences. There are consequences having to do with what happens to the U.S. dollar. There are consequences to what happens to our future generations that will be looking to borrow from net creditor countries like China and so on. And I think those consequences need to be tackled not just by monetary policy but by fiscal policy and by really stimulating growth.