July 10, 2015

On this week’s WEALTHTRACK, our guest is taking on the Wall Street consensus. The overwhelming sentiment from economists, analysts and strategists is that the great bond bull market, particularly in U.S. Treasuries, is over. Treasuy bonds have been described as extremely overvalued, risky and undesirable. Not so says global bond manager Robert Kessler. He is sticking with his decade long, bullish view on Treasuries and says the Federal Reserve is in “no position to raise interest rates.”

CONSUELO MACK: This week on WEALTHTRACK, rock climbing bond manager Robert Kessler continues to chart his own course and reach for U.S. Treasury bonds, while other investors say they are too risky to own. Why Kessler says Treasuries are the safest route in a treacherous climate, next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. Ever since WEALTHTRACK was launched ten years ago Wall Street has consistently gotten one prediction wrong. How many times have you heard economists, analysts, strategists, columnists and yes even Federal Reserve officials warn us to prepare for rising interest rates?

The overwhelming sentiment has been that the great bond bull market, particularly in U.S. Treasuries was over. Treasury bonds have been described as extremely overvalued, risky and undesirable.

And on occasion they appeared to be right. There have been several periods, some recent when yields have gone higher, or “backed up”, as they say in the bond world.

The one lone and dependably contrarian voice against this anti- Treasury chorus has been a WEALTHTRACK guest since the beginning. He was correct back in 2005. He has been through the years since, and he might prove to be right still.

He is Robert Kessler, Founder and CEO of Kessler Investment Advisors, a manager of fixed- income portfolios with a specialty in U.S. Treasuries, for institutions and high net worth individuals globally. Now for years Kessler and his team have been tracking several indicators that continue to convince them that rates will remain low. One is not widely followed by the public, but it is by Federal Reserve officials. It’s called the “Output Gap” and it measures the difference between the economy’s actual growth and its potential. In this case between real GDP, that’s ex-inflation and the congressional budget office’s measure of potential GDP growth. The gap is currently about 2.5%.

For an economy growing around 2.2% throughout the recovery that slack in the economy is sizable. As the New York Fed wrote recently: “Resource slack by this measure seems larger than that implied by most estimates of the unemployment gap. Historically, inflation tends to be restrained if the economy is operating below potential.”

Restrained it is! Another key piece of evidence cited by Kessler for continued low rates is inflation. As you can see from this chart of a measure of Consumer Price Inflation – in this case the core PCE, or Personal Consumption Expenditure Price Index, excluding food and energy prices, inflation has been running well below the Federal Reserve’s target of 2%.

I began my conversation with Kessler by asking him why, in his opinion, the Fed is in no position to raise interest rates.

ROBERT KESSLER: The Fed would raise interest rates if in fact their mandates were at the levels they should be at, and their mandates are inflation or the stability of rates.


ROBERT KESSLER: Of prices and employment.

CONSUELO MACK: Full employment.

ROBERT KESSLER: Full employment, and employment has gotten a very sticky kind of a basis to it right now because we don’t quite know what full employment looks like when a lot of people are not involved or they’re temporary in the economy. So we kind of leave employment out for a moment and go back to inflation, and since inflation hasn’t reached the target since 2009 almost, it’s very difficult to perceive that the Fed is going to raise rates when, in fact, they’re not even at the mandated area that they want to be at. So when we look at the Fed as to when the Fed will raise, I don’t know, but we do know that until those things actually happen, the Fed probably won’t be raising rates.

CONSUELO MACK: So why is the Fed saying that they are going to raise rates?

ROBERT KESSLER: I don’t think the Fed is exactly saying that they are going to raise rates. What the Fed is really saying is they’re dependent on data.

CONSUELO MACK: It’s data dependent.

ROBERT KESSLER: And the data that we’re talking about would be as Mr. Bernanke used to use and other chairmen of the Federal Reserve have commented that they use the PCE deflator, personal consumption expenditures. And whether you look at the headline number which includes energy and food or you look at the numbers that would be historically what we’re looking at, they’re not even close to the two percent the Fed would like to see. So when you look at inflation and you say, “Wait a second. Those numbers aren’t there,” and the Fed is data dependent, it’s kind of natural that the Fed would say, “Well, we’re really looking at these numbers, and we believe we’ll get there,” and they have a magic term for this. It really is magical. It’s transient. The number is transient. We really aren’t at that two percent level, but we will be there, and when we get there we’re going to be raising rates. So the marketplace immediately assumes what that will be and …

CONSUELO MACK: And they read the minutes of the FOMC meetings, and they’re seeing that there’s this debate going on, and they’re seeing that there are a sizable number of Fed officials who are saying that we need to raise rates; that we don’t need them to be this low for this long.

ROBERT KESSLER: But we hear this every year.

CONSUELO MACK: Yes, we have heard it every year.

ROBERT KESSLER: And one of the things you and I have discussed is the question of what is normal, because the Fed likes to say, “We’d like to get back to normal.”

CONSUELO MACK: Right, normal levels of interest rates.

ROBERT KESSLER: I’d like to see everything back at normal too. That means normal wages which right now are running at around two percent, 2.2 percent, and that 2.2 percent has been down there for the last five, six, seven years.

CONSUELO MACK: Right. In this recovery.

ROBERT KESSLER: In this recovery. It’s not at three, and it’s not at four which would be normal. It’s at two, so we’re not there with that, and so what’s normal about QE1, QE2, QE3 or stimulus programs we’ve never seen before, and European stimulus programs we’ve never seen before and Chinese stimulus programs we’ve never seen before?

CONSUELO MACK: To this extent, right.

ROBERT KESSLER: If none of this is normal, then we can’t really talk about, well, I think it’ll be normal in September or October or November or December. So I think what happens is the Federal Reserve and its governors walk around and they say, “This is what we’d like to see. We’d like to see something normal,” but that’s entirely different than the reality of what the numbers really are, and it’s our job at least when we talk to public or when we at least have the ability to talk about investments that we talk about reality, not what we’d like to see.

CONSUELO MACK: And so what’s the reality that you’re seeing? I mean, so aren’t we close enough that it could be reasonable to assume that the data is getting close enough for the Fed to raise rates?

ROBERT KESSLER: I don’t mean to disagree with Wall Street which I tend to do a lot.


ROBERT KESSLER: A lot, but we are now at the absurd level of saying we really are looking at a deflationary environment around the world, and we have proof. China just came out and they said our number one that we look at in terms of wholesale inflation is negative four and a half percent, and the kind of retail side of it is negative more than one percent. Well, China is exporting that number to us, meaning they want to sell goods to us cheaper because that’s what their prices are, and they’re competing with Japan who would like to sell them even cheaper, which is not inflationary. It’s cheaper meaning deflationary, and then you have Europe, Mr. Draghi running their central bank saying, “We need to really stimulate and get our currency down so we can export cheaper than them.” So you have a whole global marketplace trying to export to everyone else lower and lower prices. That hardly sounds like inflation. So we have kind of this vested interest in the United States. We love to talk about inflation, but there really isn’t any.

CONSUELO MACK: Right. And the vested interest, tell me, because as you said you do disagree with Wall Street a lot, and one of the things, a faulty assumption that you’ve mentioned to me is that the Fed needs to raise interest rates to a normal level. So we don’t really know what normal is, or do we? I mean is there a normal level that you see that the Fed or at least Wall Street doesn’t see?

ROBERT KESSLER: I think you look to see why someone’s saying something. You have bankers all over Wall Street telling you we need to raise those rates. Well, why do they say that? They make a lot of money if rates go higher. And if you own those financial stocks, you’re going to do better. Well, I don’t happen to own those financial stocks, and I’m not a believer in JPMorgan and Citicorp and the rest of them. So you have to look and say, well, that’s what they really want. They want you to raise rates.

CONSUELO MACK: But looking at the data, Robert, at Kessler Investment Advisors, where should Fed funds be, and where should the 10-year Treasuy rate be looking at the data that you look at?

ROBERT KESSLER: Now you get into the complicated question of should we be looking at the Taylor Rule which is a methodology that John Taylor came out with that has validity, but all of these numbers really require that you put the proper input into them, and most people decide to put the input that they want.

CONSUELO MACK: So when you put the input in, though, what numbers are you getting?

ROBERT KESSLER: Then we would come out with minus one and a half to a half of one percent.

CONSUELO MACK: In the Fed funds rate.

ROBERT KESSLER: In the Fed funds rate. How could you possibly think in a world that everyone is trying to stimulate enough to move things along that we want to raise rates? We have so many countries now for the first time. We talk about normal. So many countries with negative interest rates.

CONSUELO MACK: Negative rates. Right. Exactly, and the sovereign debt of France and Germany.

ROBERT KESSLER: And a lot of people make fun of it. I mean we have bond gurus that argue this is the craziest thing. Of course it’s the craziest thing. On the other hand, it’s there. Rates don’t go negative unless there’s a reason for that, and the answer is which is the problem right now in the whole global economy. There’s too much supply and very little demand, and everyone wants to sell something to someone who really doesn’t need it, and that’s that excess supply. It’s excess factories. It’s excess real estate in China. It’s excess everything in Europe, and I’ll skip the Greek situation because whatever way it gets resolved, Greece will still have the same problems.

CONSUELO MACK: Too much debt.

ROBERT KESSLER: Too much debt.

CONSUELO MACK: Too many obligations.

ROBERT KESSLER: It’s interesting to people who should be watching. The best thing to own when there’s too much debt and deflation is cash because cash takes on greater and greater value, and debt gets worse and worse and worse. That’s why people want inflation. Wow. If I can get the price of my house up, who cares about the debt? And if I can get the value of anything up, commodities, interest …

CONSUELO MACK: You inflate your way out of debt.

ROBERT KESSLER: An interesting thing about commodities which we noticed the other day, the industrial commodities …those are the five, I’ll use industrial commodities in terms of metals.


ROBERT KESSLER: Copper, aluminum, all those things that we need to use. They’re making five-year lows. If things were getting better, why are they making lows? And they’re not the only ones. The CRB index which uses agricultural products as well, they’re making lows too, or they’re bouncing around on their lows. So the argument that, in fact, things are really getting better, we need to raise rates because of inflation, where? And this whole complicated process revolves back then to Wall Street, and Wall Street says, “We need to raise rates, because if I tell you we’re going to raise rates because things are getting better, you’ll buy more stocks.”

CONSUELO MACK: The end of the bull market in Treasuries which many in Wall Street, most in Wall Street have been saying now for as long as I can remember, certainly the last six years at least. You have been saying the opposite. So why isn’t it the end of the bull market in Treasuries?

ROBERT KESSLER: This end of the bull market is almost on the absurdity now because every two years Bill Gross, Jeffrey Gundlach, someone comes out and says it’s the end of the bull market, and then of course we make another new low in the Treasury market. There’s no such thing as a bull market or a bear market in Treasuries. Treasuries are simply something that are guaranteed by the United States government. You don’t need to buy a 10-year or a 30- year Treasury. Treasuries represent cash, and there’s absolutely no logical reason why you don’t own some Treasuries, and the best way to own them depends on really what your horizon is in owning them. That’s all.

CONSUELO MACK: So since 2000, S&P 500 4.4 percent annualized returns, 30-year U.S. Treasury 7.6 percent annualized returns. The last six years, the S&P 500 was 22.3 percent annualized returns. Over the last 40 years I remember looking at the statistic, and Treasuries have outperformed stocks by a very wide margin. We never should have invested in stocks. We should have been in Treasuries. It was a bull market.

ROBERT KESSLER: This is an argument that shouldn’t be made. You shouldn’t be comparing Treasuries to the S&P index. It becomes a little bit …

CONSUELO MACK: Except if you’re looking at appreciation, it sure has worked.

ROBERT KESSLER: Treasuries represent a part of a portfolio that is absolutely 100 percent secure. It also represents a part of a portfolio that’s a hedge against terrible things that always happen. Believe me. They will keep happening, and Treasuries represent that, and at the same time as you point out, there are periods of time that Treasuries really outperform as an investment. Those are three good reasons, all of which…

CONSUELO MACK: Especially if interest rates start at whatever, 18 percent and go down to …

ROBERT KESSLER: So Treasuries shouldn’t be either/or. Treasuries are a part of the approach to investing that virtually every major institution really has. It’s just that it’s not convenient for Wall Street to want to sell something that really appears to be … well, what the heck. I give you a very good example. Usually people who buy long-term Treasuries or Zero Coupon Treasuries which we’ve talked about on this show, once they put it into their portfolio, they tend not to do anything with it.

CONSUELO MACK: They just forget about them and wait until maturity.

ROBERT KESSLER: They just forget about it. Now that is not a good idea if you’re selling someone stocks. You don’t want someone to put it over there and not turn it over. We like to think we keep things long term.

CONSUELO MACK: Longer term.

ROBERT KESSLER: We are long-term players when we advise on portfolios, so surely some place in your portfolio you want a riskless entity. Riskless because you’re not saying it’s an investment. It comes under the savings, and the traditional way to look at savings is you want the money back. You’re not interested in how much you make, and so there is a part of your portfolio for that purpose.

CONSUELO MACK: But shouldn’t we distinguish between let’s say a one or a two-year Treasury note as savings that you’re going to get your money back in one and two years between a 30-year Treasury bond which has tremendous … they call it duration … long duration, tremendous interest rate risk.

ROBERT KESSLER: Sure, and if you ..

CONSUELO MACK: Because many people don’t hold something for 30 years and just waited for it to mature. I mean that is considered to be a fixed-income investment.

ROBERT KESSLER: But you have no hesitancy or someone has no hesitancy to recommend a stock which is not 30 years. It’s 1,000 years. You don’t buy a stock and say, “Oh my god. It’s going to pay off in two years.” You own it indefinitely until you sell it.

CONSUELO MACK: But realistically an investment time horizon for a bond is … most people don’t hold anything for 30 years, at least eight.

ROBERT KESSLER: Most people don’t own stocks for an indefinite period of time.

CONSUELO MACK: No, they don’t.

ROBERT KESSLER: And so I think when you look at the 30-year Treasury, it’s simply because it has more opportunity if you believe rates are going to either stay where they are, or they’re going to drop.

CONSUELO MACK: Right, and you do believe that. And for instance I was looking at a prediction that you made, and I think it was that the 30-year Treasury, you think the yield’s going to drop to two percent or below, and the 10-year at one percent or below. I mean that’s just completely contrary to what everyone else on Wall Street is saying.

ROBERT KESSLER: You know you have Switzerland with negative rates, a reputable country. You have Germany, 0.85 their 10-year Treasury. You have rates all around the world that are dropping because of the deflationary events we’re looking at. Why would one assume that at two and a half or three and a half percent or three and a quarter percent for the 30-year Treasury that it’s not dropping to two? And the only reason you’re, “Oh, no. It can’t drop to two,” is because everyone’s telling you it can’t.

CONSUELO MACK: And the premise is that the U.S. economy, it recovered sooner. It is a stronger recovery than the one that’s happened in Europe. Not true?

ROBERT KESSLER: The U.S. economy, which we all agree, is by all measures recovering at the slowest pace it has ever done since any period of time.

CONSUELO MACK: But it’s still faster than what’s happened in Europe for instance, and Japan.

ROBERT KESSLER: And by that same definition it sells at a much higher rate. The assumption that most people are making is we know the rates are going up. So why would you own that? Now I’m not making that assumption obviously, but why not just make the assumption that if the rates aren’t going up and there’s absolutely nothing but a deflationary environment that we’re looking at all over the world, since when does the United States decouple, get away from every other country in the world? Are we so much of an island that we …? And the answer is, we were the first to put this big stimulus plan into effect. So we recovered a little bit better.

The trouble is when you take away the stimulus, we suddenly find out we’re not recovering much at all, and we call it the Output Gap, and the Output Gap right now in the United States is about two and a half percent, and what’s interesting about that is if we continue to grow at two percent where we are right now, it will take us into about 2022 or 2023 before we catch up and then you can raise some rates. If we grow at three percent, that would be better. About 2018. Oh, but we’re not growing at three percent.

The world has a serious problem. It’s our job it seems to me, without being disingenuous, and I think it is disingenuous to sit here and tell people things are better than they really are. It’s nice that they appear to be getting a little bit better, but even wage growth which you and I briefly mentioned …

CONSUELO MACK: That anecdotally we’re seeing the minimum wage raised in certain states. We’re seeing Wal-Mart raising it’s minimum wage.

ROBERT KESSLER: We are growing on a wage growth, any way you look at it, at about 2.2, 2.3 percent.

CONSUELO MACK: Annualized.

ROBERT KESSLER: Annualized, and we should be looking at close to four. So we’re not at four. We’re at 2.2. That’s not any kind of wage growth. Yeah, it’s better than one, but it’s really nothing, and so when we hear that Wal-Mart may be raising the minimum wage or Seattle is … on a meaningful basis to the United States, to the country, you’re looking at 30 years of wages going down. We’re finally getting a number maybe that’s hardly acceptable but slightly going up. Is that good? Yes, of course it’s good. Am I optimistic about the future of China and about the future of the United States? Of course I am.

CONSUELO MACK: Eventually.

ROBERT KESSLER: It’s a timing question. CONSUELO MACK: So here we are almost at the end of our conversation on

WEALTHTRACK, but we are at a position where you don’t think the Fed is in a position because of the slow growth and the disinflation we’re seeing to raise interest rates any time soon despite all the expectations. That the economy is going to be slower than most people think, and the recovery is going to continue to be very tepid. And what about the stock market which we’ve had a six-year bull market?


CONSUELO MACK: How vulnerable is that?

ROBERT KESSLER: The object of me sitting here is not telling you how to play risky assets. The object is to sit here and say there is a lot of risk in the world at the moment.

CONSUELO MACK: And therefore, for a one …

ROBERT KESSLER: Therefore, get cash. Cash is a big deal right now because cash may be worth 30 or 40 percent. How do you get 30 or 40 percent out of cash? The market is going to drop. When it does, and it will, 30 or 40 percent, then you can use some of that cash to buy things. We as investors never are prepared for that.

CONSUELO MACK: And so the One Investment for a long-term diversified portfolio would be to hold some cash. Is that right?

ROBERT KESSLER: I like cash, and every year I always tell you buy long-term U.S. government Treasuries. I would continue to say that, but I think cash is more important, and I think that’s the one thing you’re hearing not to do. Everything Wall Street tells you right now is you don’t want any cash because the alternatives are you don’t get paid anything on cash. You don’t need to get paid anything.

CONSUELO MACK: They don’t get paid anything on cash.

ROBERT KESSLER: You as an investor sit with the cash and you get no money. You have no interest on it, and the answer is, yeah, but you’ll be able to buy everything at some point cheaper, and that’s really important. Last but not least, in a deflationary environment as I just described from China, Europe and the rest of the world, in a deflationary environment cash is more and more and more valuable, and especially now. So I think it’s worthwhile certainly to look at that and say, “Do I have enough cash if the market does what it always will do?”

CONSUELO MACK: Robert Kessler, always a treat to have you on WEALTHTRACK.


CONSUELO MACK: And always thought-provoking as well. Thanks.

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