Bond Market Overview Prerequisite Research

US Bonds OVERVIEW
9th
Perspectives on US Treasury Bonds
Dec 2015, by Daniel J. Want

www.prerequisite.com.au/research
Disclaimer
General Information
Copyright 2015 Prerequisite Capital Management Pty Ltd, Australia. All rights reserved. Past
performance is not indicative of future results. Neither Prerequisite Capital Management Pty Ltd nor
any of its employees, or any person(s) or firm who is represented within this publication shall have
any liability for any direct or consequential loss sustained by anyone who has relied on the
information contained in this publication. At no time does Prerequisite Capital Management Pty Ltd
make specific recommendations for any specific person, and at no time may a reader, caller or
viewer be justified in inferring that any such advice is intended. This publication has been prepared
by Prerequisite Capital Management Pty Ltd on behalf of itself and its affiliated companies solely for
the general information of clients or potential clients of Prerequisite Capital Management Pty
Ltd. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument.
The views expressed are the views of Prerequisite Capital Management Pty Ltd through the period
ending at the date of publication and are subject to change at any time based on market and other
conditions. References to specific securities and issuers are for illustrative purposes only and are not
intended to be, and should not be interpreted as, recommendations to purchase or sell such
securities. Prerequisite Capital Management Pty Ltd (ABN 27 141 060 933) is a Corporate
Authorised Representative of AIW Dealer Services Pty Ltd (ABN 59 153 322 420) AFSL 414256.
Copyright 2015 Prerequisite Capital Management Pty Ltd, Australia. All rights reserved. Past performance is not indicative of future results. The views expressed are the views of Prerequisite Capital Management Pty Ltd through the period ending at the date of
publication and are subject to change at any time based on market and other conditions. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
Context: Positive for the US Bond Market

I.
Deleveraging has hardly started: Both in the developed world and Emerging Markets.
II.
Capital Misallocation & Oversupply: Caused by (a) the cost of capital being held too low for too long, (b) policies that have caused
saving & investment (global current account) imbalances to persist much longer than they naturally would have persisted
III.
Demographic headwinds: Aging populations etc
IV. CAPEX peak and credit conditions tightening: Escalating credit spreads, lending officer surveys show tightening standards for
Commercial loans
V.
Turn in the Earnings Cycle: Profits and margins starting to compress globally and in USA.
VI. Tide going out on Buybacks: Growing recognition of corporate irresponsibility

VII. Global Capital Flows shift: Material regime change in pattern of capital flows last 12 months potentially representing an unwind of the
last 7-15 years, engendering instability especially in Emerging Markets (highly elevated risks of banking crises & other shocks in the
seasons ahead). Global trade also weakening strongly.
VIII. Prevailing expectations towards higher yields: ZEW survey related inflation and interest rate expectations at peak optimism, latestage bear market psychology towards key commodity markets still absent (with vicious supply dynamics still reinforcing to the downside
particularly in energy and industrial metals)
IX. Velocity still falling (both structurally and tactically): broader liquidity still tightening globally (overwhelming liquidity supply)
X.
Speculative Positioning remains substantially negative towards Bonds: stronger commercials persistent in multi-year
accumulation of Treasuries. Late-stage bull market psychology towards multi-decade rise in Bonds still absent (& under-owned)
XI. Geopolitical Escalation and increasing trade barriers growing at the margin.
XII. Fed & Central Banks backed into a corner: trapped by excessive reliance on low interest rate policies (last couple of decades) and
QE (over the last 7 years), unable to unwind such programs due to the extreme fiscal constraints of both the public and private sectors.
US Conditions
Tightening Lending Conditions...
??
US Bond Price
??
Key Takeaways:
NYSE Margin Debt

(people borrowing to
invest in the Stock Market)
Tightening
(i.e. harder to get a loan)
US Lending Conditions
Loosening
??
Credit conditions are

tightening in the US
It appears as though the
cycle is turning down for
the US Stock Market (as
shown by a possible top
in NYSE Margin lending)
Which means we may
possibly be about to see
bond prices go much
higher.
(i.e. easier to get a loan)
The US Share Market

A turn in Corporate Profits & Margin Debt...
Key Takeaways:
NYSE Margin Debt
US Annual Profit Growth (EPS)
??
US Profits
Increasing
US Profits
Decreasing
Corporate Profits are

falling for the largest US
Companies.
Falling profits &
tightening lending
conditions increase the
probability that the US
Stock Market cycle is
indeed turning down,
and that NYSE Margin
Debt will likewise fall
from here. (Which is all
usually bullish for
Treasury Bonds)
The US Share Market

The Share Buyback bid is falling away...
Key Takeaways:
S&P 500
(US Share Market)
Proxy of Share Buyback Narrative

(Ratio of Buyback ETF to S&P500... a rising line means that
buybacks are generally being rewarded by the market, a
falling line means that they are being punished)
Share Buyback
programs (where
companies would
repurchase their own
shares) was one of the
biggest sources of
demand for the Share
Market in recent years.
For the last 7 years
companies were
rewarded for doing
buybacks
Now companies are
being punished for
doing buybacks, which
indicates a big source
of demand for stocks
will likely go away
(bearish for stocks,
possibly bullish bonds).
US Conditions
Fixed Investment appears to be stalling...
Key Takeaways:
It appears that CAPEX &
fixed investment in the US
Economy (one of the
biggest drivers of profits
and even employment
within an economy) is
potentially stalling and
about to fall again
This usually is not good for
the economy (& the share
market).
But this is usually very
positive for Treasury Bonds
Global Conditions
Capital Flows are decisively shifting...
Key Takeaways:
These charts show a (very) loose
coincident relationship between
global FX reserve growth and
global economic growth
The contraction in Global FX
Reserves is more indicative of a
regime change in global capital
flows, which increase the nearterm risks of growing instability in
world markets & economies
In the current context, we believe
this bodes well for US Treasury
Bonds, as savings & capital will
tend to move into the least bad
Government Bonds during times
of economic & financial market
weakness.
Inflation Expectations??
ZEW Sentiment Surveys...
Expectations of higher
short-term rates
Key Takeaways:
Expectations of lower
short-term rates
Targeted Fed Policy Rate
US Bond Yield
(interest rates)
Expectations of
falling inflation
Expectations of
rising inflation
These are surveys of

Institutional Analysts and
Economists
They indicate that
everyone is essentially
anticipating that inflation
and interest rates will
move higher
Typically when everyone
is expecting higher
inflation & interest rates,
we actually are close to a
peak and Bond yields are
likely to fall
This is a positive for US
Bond prices
Commodity bear market far from done...

WTI Light Crude Oil Speculative Positioning
Price of WTI
Light Crude Oil
Speculators betting that

the price of oil will increase
Speculators betting that the

price of oil will decrease
Key Takeaways:
The grey line shows the net-positive (or netlong) positions of the Speculative Investment
community towards Oil (black line)
Notice that Speculators have been betting
that the Oil price would increase since 2005
Even though the price of oil has fallen over
$60 a barrel since 2014, Speculators are still
betting heavily on a price increase!
This persistence of bullish bets, despite such
a large fall in price and despite a viciouscircle where producers are refusing to cut oil
supply, means that it is highly unlikely that
the bear market in commodities & the price
of oil is over, there doesnt appear to be any
of the late stage signs of negative
psychology in the market that would suggest
the bear market is complete.
This means that lower oil prices are still likely
ahead, which is deflationary, and usually
bullish Treasury Bonds.
10
Inflation Expectations??
Tactical Velocity still falling...
US Bond Yield
(interest rates)
Proxy: Tactical Velocity

(Real Economy)
Key Takeaways:
The velocity of money is a
representation of how fast
money circulates in an
economy. Basically the
more it circulates (velocity
increasing) the more
economic activity that
money generates which is
usually a good thing. If
velocity is falling then
usually it means economic
activity is falling also which
is not so good usually.
In our present context,
velocity is falling, which
usually means interest
rates will trend lower, and
Bond Prices move higher.
11
Market Liquidity
Capital flows becoming more concentrated...
US Bond Yield
(interest rates)
Key Takeaways:
When conditions improve,
capital tends to disperse
more within the economy
and the capital markets
(rising grey and green lines)
However, when times get
more challenging or
participants are starting to
get worried, capital will tend
not to disperse, but
concentrate into a few key
areas (falling grey and green
lines)
Currently capital is tending
to concentrate within the
economy, which means
interest rates will tend to fall
This is currently positive for
Bond Prices
12
Market Liquidity
The plumbing is problematic...
Key Takeaways:
US 10 Year Bond Yield
US 30 year Bond Swap Rate

spread over 30 Year Bond Yield
From a text book perspective, Swap

rates should be ABOVE Bond Yields
(i.e. positive readings on the red line)
because in theory the US Treasury
Bond should be more risk free than a
swap with a counter-party institution
(i.e. a non-government counter-party)
In practice however, swaps and
treasury bonds are slightly different
financial instruments with different
term structures and uses.
On balance, the negative spreads
indicate problems within the core
funding markets of the US
Anecdotally, the recent fall in spreads
(red line) we believe is a positive sign
for US Bond Prices
13
The US Bond Market

Accumulation Patterning...
Key Takeaways:
??
Strong & persistent Buying by Commercials...
(Speculative Community
selling just as persistently)
The Commercials (green line) are

typically thought to be the strong
hands, the large players who
usually have a better grasp of
things as a general (but tenuous)
rule of thumb.
The Speculators take the opposite
position to the Commercials and
are basically betting on a price
increase or decrease.
For the last two years, the negative
sentiment generally among the
investment community towards
Bonds has been substantial.
We believe the negative sentiment
towards bonds for the last few
years has built a foundation to
potentially take Bond prices much
higher in the not to distant future.
14
The US Bond Market

A multi-year setup for another substantial move higher in price?
IF we have seen the top of the multi-decade bull market in bonds THEN
this will have been the most widely recognised top in all of history...
So, given the context of this entire document, with deflationary risks abounding,
growth reasonably expected to stall/roll over and record corporate profits likely to
prove highly transitory (not to mention the flaw in perceptions concerning Fed policy
effects) it would appear the record shorts in US bond markets and record pessimism
towards the asset class may well be laying the ground work for a significant move up
in bond prices (lower yields)
...PCM Research,
20th
??
January 2014
Key Takeaways:
For the last almost 3 years, we have heard ad-nauseam
that the US Bond Market has topped or topping,
marking the end of the multi-decade bull market in
bonds and presaging the imminent collapse of bonds.
For reasons briefly touched upon in this presentation,
and much further analysis not able to be included
within, we believe the Bond market is not yet about to
top out but rather we could see much more upside
first. In fact, the last two years have most likely
established a great base for a move higher.
US 30 year Bond Yield (inverted)

giving an approximation of Bond Price action (which is the inverse to yield)
15
The US Bond Market

Late-Stage bull market psychology still absent...
It was a period when a large part of the liquid capital of the country attempted to
crowd into the always limited area of riskless investment. The sharp recession of
1937-1938 had destroyed the last hopes of some of the most stubborn optimists
that 1932 was only a traditional crisis and that the United States would, as
always, recover to resume its climb to new heights of prosperityWhen the war
ended, some people thought that the Treasury would not always be offering as
much as 2.5%. Perhaps rates as high as 2.5% would vanish forever.
Sidney Homer, A History of Interest Rates
(writing about the 1946 secular peak in the long-term bond market.)
Hat tip: Lewis M. Johnson writing here: http://www.capitalwealthadvisors.com/news-and-insights/
Key Takeaways:
As stated on the last slide, if we have seen
or were seeing an end to a multi-decade
bull market in Treasury bond prices (multidecade bear market in yields), then this
will have been the most recognised
market top in all of history (almost an
oxymoron with regards to the way
markets actually function).
We do not yet believe we
have seen a top in Bonds, and
submit further an excerpt
from Sidney Homer that
captures the sentiments of
the previous multi-decade top
in Bonds (hat tip: Lewis M.
Johnson, whose work we would
recommend to anyones reading list).
Such sentiment extremes are

more consistent with market
tops, such psychology being
noticeably absent at present.
16
Context: Positive for the US Bond Market

Key Takeaways:
In the context of this entire presentation (and an invitation for you to contact us should you wish to discuss any of the
macroeconomic issues in greater depth), we would submit to you that the US Treasury Bond Market is potentially set up
for a substantial move higher over the next year or two.
The key risk is that the Bond markets collectively start to punish Government Policies, however, we believe there is still
some way to go before such issues begin to gain traction. In fact, in order for Governments to take the more extreme
policy actions required to cause Bond markets to revolt, it is highly likely that we would need to see a significant move
higher in bond prices (amidst an environment of deflationary shock(s)) before policy-makers would have the tacit
approval to escalate their policy experiments beyond the thresholds necessary to upset Bond markets and overwhelm
the generally deflationary/low-or-no-growth conditions.
Due to regime change dynamics that are starting to force an unwind of the last 7-15 years worth of conditions, and some
of the issues touched upon in this presentation, we believe that investors around the world are likely to experience an
increasing amount of disorientation in the seasons to come. Such will require, almost demand, a slightly more active
approach to portfolio management as the changes in capital flows are likely to be quite paradoxical (& sustained) at
times, and we would anticipate some larger swings in Velocity and increasing volatilities as well. In fact, it is primarily
with regards to global velocity measures that we would submit will be one of the key metrics to monitor in order to
confirm (or pre-empt) any possible turn down in the Treasury Bond markets.
17
About Us
Who is PCM?
PCM is privately owned by four Australian families with a combined 77 years

experience within the investment and financial services industry.
PCM manages investment portfolios, provides research and is a trusted advisor
within a variety of contexts. We work with private individuals, financial advisors,
companies and professional investment managers in order to help them achieve
better investment results within a dynamically evolving world.
PCM was founded primarily as an investment solution for our own family &
friends, knowing that if we could design something that was compelling
enough for us to be fully invested in, then others would like what we do too.
As such, we subscribe as much as possible to the way the Romans would build
their bridges for the first load-bearing test of the newly made bridge, the bridgebuilders and their families would stand under the bridge that they had just
constructed as a testament to the work that they had just performed.
18
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PCM Portfolios on Linear (growth of a typical $500,000 account)
CORE Portfolio
$560,000
$540,000
$520,000
Totally transparent SMA

direct-securities structure.
$500,000
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Dec-14
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(only index funds, ETFs and direct securities)
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No Derivatives
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Hedge Funds or Managed Funds
S&P/ASX 200 (Total Return)
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PCM 60/40 Portfolio (60% Core, 40% Strategic)
Nov-13
Conservative but more Proactive Mandate

Only ASX & NYSE listed securities
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International Exposure
Strategic Opportunities Portfolio
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Sep-13
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Only ASX listed securities
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Domestic focus (Australia)
Jul-13
Daily, Since inception to 30th November 2015
19
Portfolio Overview...
The PCM Solution
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Significantly less volatility than equities
Returns generated whilst maintaining large cash holdings (30% allocation since
inception)
Long-only, big, liquid, exchange traded direct-securities no leverage, no derivatives,
no exotic or inverse ETFs, no opacity.
TRANSPARENT: Totally transparent SMA direct-securities structure. Direct securities

also enables portability.
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SIMPLE: Simple Investment Methodology that is easy to explain to Advisors and Retail
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INCENTIVE ALIGNED: PCM designed these portfolios first and foremost

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20
For they shall be like a tree planted by the waters,

Which spreads out its roots by the river,
And will not fear when heat comes;
But its leaf will be green,
And will not be anxious in the year of drought,
Nor will cease from yielding fruit.
Jeremiah (627BC 586BC)
21
Disclaimer
General Information
Contact: Darren Brind (CEO)
darren@prerequisite.com.au
+614 98 671 505
I would highly recommend the team at PCM to anyone

who is seeking professional financial advice and peace of
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transparency, integrity and discretion in all my years I
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family orientated) as those at PCM.
Douglas Raisin, Business Owner & Client, QLD
Copyright 2015 Prerequisite Capital Management Pty Ltd, Australia. All rights
reserved. Past performance is not indicative of future results. Neither Prerequisite Capital
Management Pty Ltd nor any of its employees, or any person(s) or firm who is
represented within this publication shall have any liability for any direct or consequential
loss sustained by anyone who has relied on the information contained in this publication.
At no time does Prerequisite Capital Management Pty Ltd make specific
recommendations for any specific person, and at no time may a reader, caller or viewer be
justified in inferring that any such advice is intended. This publication has been prepared
by Prerequisite Capital Management Pty Ltd on behalf of itself and its affiliated companies
solely for the general information of clients or potential clients of Prerequisite Capital
Management Pty Ltd. It is not intended as an offer or solicitation for the purchase or sale
of any financial instrument. The views expressed are the views of Prerequisite Capital
Management Pty Ltd through the period ending at the date of publication and are subject
to change at any time based on market and other conditions. References to specific
securities and issuers are for illustrative purposes only and are not intended to be, and
should not be interpreted as, recommendations to purchase or sell such securities.
Prerequisite Capital Management Pty Ltd (ABN 27 141 060 933) is a Corporate
Authorised Representative of AIW Dealer Services Pty Ltd (ABN 59 153 322 420)
AFSL 414256.
22

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US Bonds OVERVIEW

Perspectives on US Treasury Bonds

Dec 2015, by Daniel J. Want

Context: Positive for the US Bond Market

Demographic headwinds: Aging populations etc

VI. Tide going out on Buybacks: Growing recognition of corporate irresponsibility

NYSE Margin Debt

Credit conditions are

(i.e. easier to get a loan)

The US Share Market

NYSE Margin Debt

US Annual Profit Growth (EPS)

Corporate Profits are

The US Share Market

Proxy of Share Buyback Narrative

Targeted Fed Policy Rate

These are surveys of

Commodity bear market far from done...

Speculators betting that

Speculators betting that the

Proxy: Tactical Velocity

US 30 year Bond Swap Rate

From a text book perspective, Swap

The US Bond Market

Strong & persistent Buying by Commercials...

The Commercials (green line) are

The US Bond Market

US 30 year Bond Yield (inverted)

The US Bond Market

Such sentiment extremes are

Context: Positive for the US Bond Market

PCM is privately owned by four Australian families with a combined 77 years

Totally transparent SMA

(only index funds, ETFs and direct securities)

S&P/ASX 200 (Total Return)

PCM 60/40 Portfolio (60% Core, 40% Strategic)

Conservative but more Proactive Mandate

Strategic Opportunities Portfolio

Strategic Opportunities Portfolio

Conservative Capital Preservation Mandate

Daily, Since inception to 30th November 2015

TRANSPARENT: Totally transparent SMA direct-securities structure. Direct securities

CONSISTENT RETURNS: Monthly returns are more consistently positive than

INCENTIVE ALIGNED: PCM designed these portfolios first and foremost

EASY, AUTOMATED ADMIN: the platform-based SMA solution

LOW TURNOVER: PCMs portfolios are low-touch (with a portfolio

LIQUIDITY UNCONSTRAINED: The investment strategy underpinning

INFLATION & CURRENCY RISK AWARE: Some protection against

SMA FLEXIBILITY: Although PCM has its preferred SMA platform

INFORMATIVE: PCM are able to provide an abundant amount of

For they shall be like a tree planted by the waters,

I would highly recommend the team at PCM to anyone

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