My family and I move every 20 years or so whether we need to or not, so on Wednesday when the Fed was making its decision to keep interest rates right where they are, I was busy unpacking all the boxes that we’d packed on Tuesday. (I’m sooo looking forward to the day when you can digitize everything you own, upload it all, and then download to your new location. I’d definitely pay $1.99 for an app that did that.)
Anyway, with the benefit of hindsight–and moving- induced exhaustion–I have to say that the nothing that Fed did on Wednesday was actually extremely important as an indicator on a potential September interest rate increase.
While it did nothing on Wednesday to change interest rates, the U.S. central bank said quite a lot about the U.S. economy. The economy, the Fed said, had overcome uncertainties to achieve what looks like a sustainable moderate rate of growth. Job growth has pushed the economy to something close to full employment. And, the Fed added, it sees fewer clouds on the horizon for the U.S. economy.
This isn’t a formula that guarantees an interest rate increase when the Fed next meets on September 21, but this language does clear the way for a possible interest rate increase.
The problem facing the Fed, though, remains the same: After all the stimulus that the Fed has provided for the U.S. economy, where’s the growth?
Inflation is well below the Fed’s target of 2%. The economy shows no signs of breaking out of its low growth rut. Maybe Friday’s first read on second quarter GDP growth will come in at the 2.6% rate that economists were expecting last week, but current forecasts are looking for growth closer to 1.8%, and that would still leave the U.S. economy looking back at growth of less than 2% for the first and second quarters of 2016 and the last quarter of 2015.
Maybe, the Fed has to be wondering now, the speed limit on the U.S. economy has been lowered to 2% instead of 3%. Maybe current growth is about as good as this economy–domestic and global–can deliver. And if that’s the case, what’s the point, exactly, of raising interest rates? To make sure that growth stays well below 3%? To head off nonexistent inflation?
In these circumstances and with this data, the Fed is being asked to figure out not just what is happening but why. Are we in for a long period of slow economic growth because something has changed in the US. and global economy?
The Fed would like to know.
I’m sure investors would like to figure out an answer too–since the answer has major implications for portfolio design and risk taking.
At the moment the Fed funds futures market hasn’t raised the odds for a September move beyond the 18% or so of the days before the Fed meeting.
Update July 12. The yield on 10-year Treasuries rose to 1.52%, the highest level this month (and prices fell). Last week the yield on the 10-year Treasury hit a record low of 1.318%.
The climb in Treasury yields is likely to be temporary, in my opinion. The market is coping with a series of big auctions this week. An auction of three-year Treasuries on Monday attracted the weakest demand in seven year. Today an auction of $20 billion in U.S. Treasuries was the weakest demand since 2009.
The trend toward higher yields and lower bond prices isn’t limited to the United States. The yield on German 10-year bunds rose by 8 basis points to a negative 0.9%. Yields on the French 10-year bond climbed 7 basis points to 0.19%.
And the bond market faces intense competition for cash from a continued rally in U.S. stocks that had taken the Standard & Poor’s 500 stock index to 2154.70, a new all-time record, as of 3 p.m. New York time. The Dow Jones Industrial Average also hit a new all-time high today. When the S&P 500 is climbing 0.82% in a day, the argument for buying 10-year Treasuries yielding 1.52% gets a little weaker.
But the dynamics driving Treasury yields lower (and prices higher) in the longer term remain in place. At 1.52% for a Treasury and a negative 0.9% for a German bund, U.S.bonds have an immense relative yield advantage that’s likely to keep cash flowing into the U.S. bonds. And yields in Europe seem set to go lower. Deutsche Bahn today become the first non-financial company to sell a bond in euros with a negative yield. More than $3.3 trillion in European sovereign debt trades now with a yield below 0%.
Inflation expectations continue to fall. By the Federal Reserve’s preferred measure, inflation is now rising at just 0.9% annually. The bond market is now trading with expectations for just a 1.3% inflation rate in 2021-2026, according to Bloomberg. That’s the lowest level of implied 5-year inflation in Bloomberg data that stretches back to 1999.
Today it looks like the financial markets are holding their collective breath. After encouraging reports on from the ISM Services Survey yesterday and from the ADP private sector jobs survey (172,000 jobs added in June) and the weekly initial claims for unemployment (the lost number of new claims since April) it sure looks like the markets have decided to wait for confirmation of this good news from tomorrow’s official jobs report for June rather than moving up on these early indications. As of 3 p.m. New York time the Standard & Poor’s 500 stock index was down a slight 0.23%.
At least that’s the impression an investor gets looking at the U.S. equity markets.
But in the bond market, which I’d argue is more important than the market for stocks right now, there’s considerable turmoil not so far under the surface.
The problem that the bond market is starting to focus upon is a potential shortage of investment-grade government bonds.
That seems strange if you remember that we’ve been told over and over again that the market for U.S. Treasuries is the most liquid and deepest in the world. And there is $13.4 trillion of Treasuries in circulation now.
The problem for Treasuries and 10-year government bonds from the United Kingdom, Japan, and Germany is that because of all those asset purchase programs under various quantitative easing plans, central banks already own a big hunk of the available supply. The Federal Reserve, for example, owns 20% of all Treasuries–about double what the central bank owned before the global financial crisis. The Bank of England owns 25% of that country’s government debt. The Bank of Japan owns 33% of Japanese government debt. And the European Central Bank owns 15% of German debt.
That would seem to leave lots of room for private sector investors such as insurance companies and pension funds–but that available supply shrinks rapidly when you subtract all the government debt out there with negative yields. Unlike banks, which can have a sound reason for parking money at a central bank at a negative yield (it reduces the potential assets at a bank and thus lessens the amount of capital that a bank needs to hold,) pension funds, insurance companies, and other yield investors need to see the highest possible positive return on their bond portfolios. For many of this class of investor, then, U.S. 10-year Treasuries, yielding 1.39% today, are just about the only game in town.
Which is having a noticeable effect on bond market volatility. 1.39% on a 10-year note isn’t a particularly attractive yield to begin with. And it gets even less attractive when you remember that inflation, measured by the Consumer Price Index, is running at 1.02% year over year as of May, and at a rate of 1.57% for 2016 to date. (Which pushes even the nominal 1.39% yield on 10-year Treasuries into negative territory in real terms.)
But the real fear is that the yield is headed lower over the rest of 2016 now that it doesn’t look like the Federal Reserve is going to raise interest rates this year. That means there’s considerable pressure to buy now before yields go any lower–which, of course, generates demand that pushes Treasury prices up and yields down.
This fear also acts to limit any fall in bond prices and rise in yields since that’s a buying opportunity for any investor worried about future yields.
There are two effects likely from this.
First, it will keep bond prices trending higher and bond yields trending lower–especially for U.S. Treasuries.
Second, it increases the odds of a big reaction or overreaction in the bond market to any negative news, such as today’s stories that the European Commission is thinking of levying big fines on Portugal and Italy for missing their budget goals (again.) That news comes at a time when the markets are already worried that Italy’s banks need a big capital infusion from the Italian government. Anything that makes that capital rescue seem more difficult will set nerves already on edge even more on edge.
All this the reason that I added the iShares 7-10 Year Treasury Bond ETF (IEF) to my JubakPicks portfolio.
It’s tempting to lump the post-Brexit crisis with earlier crises such as the global financial crisis or the dot.com bust. And there’s a certain amount of logic in the lumping. If Brexit is to move behind a merely local market event limited to the United Kingdom and, maybe, the Euro Zone, it will do so because of the monetary overhangs created by global central banks in an attempt to head off earlier economic downturns (The expansion of the money supply by the Greenspan put that fed the dot.com boom and then bust) and then the even more massive expansion of the balance sheets at central banks as they attempted to first stabilize the financial system (a generally successful effort), and then to jump start growth by throwing a wave of cash at economies from the United States of China (a generally unsuccessful effort.)
Against that backdrop it’s tempting to see the danger that Brexit might set off another global credit crisis, like that that followed the bankruptcy of Lehman Bros. and the near bankruptcy of American International Group (AIG) and other financial institutions that required government-led or government-arranged bailouts. And I don’t mean to pooh-pooh those fears. Looking at the holdings of hard to sell illiquid assets at, say Deutsche Bank, I think a shudder or two is in order. According to the New York Times, Deutsche Bank was sitting on 32 billion euros in such illiquid assets at the end of 2015, and that amounts, adding to an analysis by Berenberg, another German bank, to 96% of Deutsche Bank’s core capital cushion. And that’s not the end of problems in the banking system. Banks in Italy and Portugal look to be carrying so much bad debt that they will need so kind of government rescue.
These are huge problems. But the reason is that they won’t result in the kind of global credit crisis that some gurus are predicting is that these are exactly the kinds of problems that the world’s central banks know how to fix by injecting capital into banking sectors, by encouraging the formation of bad banks to hold problem loans, by facilitating recapitalization schemes and the necessary agreement by bank creditors to take less–way less, than 100 cents on the euro. Even in China, which has the world’s worst bad debt problem, the People’s Bank knows the drill for successfully kicking the can down the road.
What worries me the second set of problems because neither central banks nor national governments have figure out how to accelerate economic growth and to boost inflation to healthier levels. All the money that central banks have thrown at the growth problem has resulted in some pretty spectacular asset bubbles. It’s important to remember that negative interest rates, as we have in Germany in particular and the EuroZone in general, and in Japan, generate massive gains in bond prices as existing bonds paying a coupon rate of even a pittance such as 0.5% rise in price so that yields will fall into negative territory. On the equity side, it’s harder to see asset bubbles but I would suggest that a Standard & Poor’s 500 stock index that is trading near all time highs when the U.S. economy is growing at just 1.1% (and where earnings growth for the second quarter is again likely to be negative) has a valuation problem.
Which points me to the way in which any post-Brexit crisis will be different. It will be a slow motion crisis driven by a gradual slowdown in economic growth in the United Kingdom, the European Union, Japan, China and the United States–all those great linked economies of the world–that results in a dimming of prospects for corporate earnings growth. The crisis will be interrupted periodically, as it has been in the last two days, by the hope–against the track record of central banks–that this time they will be able to intervene and get this or that economy growing again. And if will intensify, periodically, as the sloshing of central bank cash from one asset class to another, results in an asset bubble here or there that will collapse with much handwringing and the search for new asset bubbles in the making.
The global economy didn’t look all that ducky before Brexit. And nothing about Brexit provides a boost to economic and earnings growth.
The Brexit vote in favor of ending the United Kingdom’s membership in the European Union effectively took Federal Reserve interest rate increase off the table for July, and September, and November. And maybe even December. Remember that the process of exiting the European Union is a long one–and the two-year deadline for a departure doesn’t even get started until a U.K. government asks for an exit. We could still be in the scary, early, nobody knows what’s happening stages of an exit come December. (This post originally appeared on my subscription site JubakAM.com on Saturday June 25.)
And if a Federal Reserve interest rate increase is off the table for that long and global financial markets remain unsettled for that long and growth in the global and U.S. economy is going to be lower than projected just a month or so ago, I think it’s time to rethink exactly how low yields on the 10-year U.S Treasury can go.
The logic here is pretty simple. In an uncertain financial market investors and traders look for safety in assets such as Japanese government bonds, German bunds, and U.S. Treasuries.
As long as the threat of a Federal Reserve interest rate increase was a real danger, putting cash into Japanese government bonds and German bunds had a certain attractiveness over buying U.S. Treasuries. A hike in U.S. interest rates could send the price of existing Treasuries lower. The end of that threat from the Fed for the months ahead removes that disadvantage.
And that allows the big yield advantage of U.S. Treasuries to come to the fore. The yield on a ten-year U.S. Treasury was 1.56% as Friday, June 24. That compares to a negative 0.17% yield on the 10-year German bund and a negative 0.185% yield on the 10-year Japanese government bond.
If you are looking for safety and would actually like to make a little bit of money while you sit on near-cash, what do you think is more attractive right now? Collecting 1.56% in U.S. Treasuries or paying 0.17% or 0.185% to hold German or Japanese government bonds, respectively.
Which is why bond managers are forecasting a new drop in yields for U.S. Treasuries in the months ahead. Do remember that a drop in yield works out to an increase in the price of Treasuries.
The consensus among these Treasury bulls is that the yield on 10-year Treasuries is likely to drop to something like the 1.38% historic low of July 2012 or even further to a new historic low near 1.25%.
What would a drop to 1.38% or 1.25% from today’s 1.56% yield mean to bond prices–and the gains that bond buyers can think about?
If the yields on 10-year Treasuries fall to 1.38%, the price of a $1,000 Treasury bond would rise to $1130.44 for appreciation of 13.4%.
If the 10-year Treasury yield falls to 1.25%, the gain would be 24.8%.
Mind you I wouldn’t count on Treasury yields falling to match the historic low or to bust through that low to 1.25%. But it won’t take a drop all the way to those levels to make this a profitable position, especially when the U.S. and global economy look weak enough to keep returns from equities to very low levels.
You can, of course, buy Treasuries directly in the market or from the U.S. Treasury itself. And there’s no reason not to–the process is very easy. Or you can make it even simpler for a very modest fee by buying an ETF such as the iShares 7 to 10 year Treasury Bond ETF (IEF.) The expense ratio is a low 0.15%. For the year to date total return on this ETF is 7.06%, which certainly beats the 0.32% return for the Standard & Poor’s 500 stock index. Currently the ETF yields 1.58% and it pays dividends monthly.
I’m going to add this ETF to my Jubak Picks 12-18 month portfolio on Monday, June 27.