US Treasuries: On the cusp of a reversal

Some see the end of the bond bull run amid signs of growth, inflation and a rate

by: Joe Rennison and John Authers
.



One of the longest and most important trends in world finance may be on the cusp of a reversal.

US 10-year Treasury bond yields, used as a benchmark in transactions the world over, have been in decline since inflation came under control in the early 1980s.

But in the past week, yields have risen to their highest in almost three years, while the US jobs market has grown its fastest in more than a decade. With equity markets suggesting that growth and inflation are in store under President Donald Trump, and with the Federal Reserve committed to raising its base rates this week for the third time in a decade, some bond market luminaries are convinced that the great “bull market” is over. From now, they expect interest rates to rise steadily.

“I believe the secular decline in yields is over,” says Henry Kaufman, the Wall Street economist known in the 1970s as Doctor Doom for his accurate forecasts of higher inflation and interest rates. “It will not come back.” His latest book carries the ominous title Tectonic Shifts in Financial Markets.

Bill Gross, co-founder of Pimco and the best known bond investor of recent decades, warned in January that if the level of 2.6 per cent on 10-year yields was breached then “a secular bear bond market has begun”. As that level was touched last week, the Janus Capital bond manager warned the US economy was like a “truckload of nitroglycerine on a bumpy road”, where a mistake could “set off a credit implosion”.

The Treasury market moves in three-decade cycles




Bond yields rose after a period of wartime financial repression and peaked as inflation approached 15 per cent. Then the Federal Reserve under Paul Volcker raised rates, convinced markets inflation was beaten and pushed yields down. After the 2008 financial crisis the Fed held yields down


But there have been many false alarms when the bond market appeared to turn, only for yields to fall again. Last summer they dropped to an all-time low of 1.36 per cent after Britain’s referendum on EU membership. Even now, bond market participants remain unconvinced by the signs of economic growth that have driven US stocks to records, while the overwhelming belief is that rises will be gradual. Out of 56 market analysts polled by Bloomberg, only 13 believe that the 10-year yield will rise even as far as 3 per cent by the end of this year. This would be no higher than it was three years ago, when there was still a widespread fear of deflation.“

We are certainly well off the bottom,” says Tod Nasser, senior vice-president for investment management at Pacific Life. “But it is not a game changer.”

Much is at stake. Higher bond yields would bring relief to pension funds by making it easier for them to finance their payment obligations. But higher yields would make it harder for indebted companies to roll over their debt and inflict losses on bond and credit investors.

The economic case for US rates to rise is clear. Employment is growing. The jobless rate, at 4.7 per cent, has completed its recovery from the crisis (although this has been helped by an increase in the numbers not seeking employment). Wage inflation, at 2.7 per cent, is recovering, although it remains painfully weak compared with the pre-crisis period. Surveys show the confidence of consumers, small businesses and investors at levels not seen since before the crisis.

Fed governors, led by the chair Janet Yellen, have made clear their intent to raise rates this week, and markets now regard this as a certainty. Most significantly, Lael Brainard, the Fed governor most known for her reluctance to raise rates, says the US economy is “at a transition”. This was perceived as a watershed moment. After years when traders refused to believe the Fed’s threats to raise rates, futures markets now suggest that three rate rises this year are probable, while the chance of four rate rises — unthinkable three months ago — is about one in four.

The labour market awaits higher rates



Despite long-term unemployment, the jobs market has more or less recovered from the 2008 crisis and wages have started to rise. This has helped convince the Fed to raise short-term interest rates, which should push up long-term bond yields


But despite all this, 10-year Treasury yields are barely even positive in real terms, as inflation is accelerating. They remain just below Mr Gross’ threshold of 2.6 per cent and do not yet put a brake on growth, or on speculation.

A tension in markets persists. While equity markets are positioned for growth and interest rate increases, bond investors largely remain convinced that interest rates will not go up much, and that any rises will be steady.

Why? First, growth is in question, says Mike Lillard, chief investment officer at Prudential and member of the Treasury Borrowing Advisory Committee that advises the US government on debt management issues. “We remain in a low-growth world,” he says. “And we do not think the Trump administration can change that.”

More broadly, many argue that there has been a shift in the US economy. With productivity low and the economy less exposed to oil shocks, long-term rates as high as 16 per cent, which occurred during the 1970s and 1980s, are unlikely to be repeated. “We will not come back to that,” says Mr Kaufman.

Other structural factors also weigh on rates. The percentage of the US population aged 65 and over rose to 15 per cent in 2015 from 9 per cent in 1960. This will increase further, crimping growth and potentially raising the demand for bonds. (As people retire, they tend to sell equities and buy bonds.) “Society is ageing,” says William Irving, a bond manager at Fidelity Asset Management. “The proportion of old people is at an all-time extreme and that has contributed to slow growth and lower rates.”

Foreign buying declines



Meanwhile, foreigners’ purchases of Treasuries appear to be tailing off as foreign central banks worry that US bonds have become too expensive. China and Japan, the biggest foreign holders of US government debt, have reduced their holdings


Meanwhile, those of working age are producing less. Growth can be described as the sum of a rising workforce and higher productivity. While jobs have increased to the point where the Fed can claim the US is at full employment, productivity has stagnated. Year-on-year growth in output per hour worked remains at 1 per cent, according to data from the Bureau of Labor Statistics.

“The only way rates could be sustainably higher is to overcome secular stagnation and that requires a recovery in productivity,” says Dominic Konstam, global head of interest rates research at Deutsche Bank.

A further problem comes from the overhang of US debt. Prolonged low interest rates have prompted companies to issue debt and made it easier for junk-rated borrowers to persuade yield-hungry investors to offer them financing. Outstanding corporate bond levels have risen from $5.4tn to $8.5tn since 2008, according to the Securities Industry and Financial Markets Association.

This poses a risk for the future. If interest rates rose markedly, companies would lose access to financing, while an increase in the risk of default would damage the returns for their investors. Scott Mather, chief investment officer for US core strategies at Pimco, says: “The concept of a debt overhang is a real one and is one of the reasons we find it difficult to believe we will get back to old levels of growth.”

Quantitative easing — the large asset purchases pursued by central banks since the crisis — is also an issue. Although the Fed is no longer buying bonds, which pushes prices up and yields down, it still has a sizeable portfolio under management and is reinvesting the coupon payments it receives.

The Fed was the first central bank to halt QE



The Fed has stopped increasing its portfolio of US bonds, which should decrease downward pressure on yields. But it has not yet started to sell them — a move that could send up rates sharply — while other big central banks are still expanding their balance sheets


Many believe that the Fed could start to sell its bonds, but Mr Kaufman questions its ability to do this on any great scale. “I don’t think the Fed can do this in massive ways. At best it can do it gingerly. We would have to enter a period of significant increases in inflation for the Fed to consider doing it.”

The European Central Bank and Bank of Japan are still deep into their asset purchase schemes, although Mario Draghi, the president of the ECB, hinted on Thursday that the programme may not last beyond this year as he declared victory in the battle against deflation.

“You still have a massive amount of QE going on from the Bank of Japan and ECB,” says Mr Mather. “That certainly pulls down the equilibrium level of global yields.”

For now, QE in Europe intensifies foreign demand for US debt, where yields are higher for bonds of equivalent maturities. The gap in the yield Treasuries offer compared with German Bunds is the largest it has been since 1989, before German reunification, while the spread over UK gilt yields is its widest in history. This gives foreign investors a huge incentive to buy US Treasuries.

This may not last. China’s central bank has begun to sell off its inventory of more than $1tn in Treasury bonds. Japan, the biggest holder of Treasuries, has also been selling. But political risks, such as a populist victory in one of this year’s parliamentary elections in Germany, France or the Netherlands, could prompt investors to seek a haven in the US.

Higher US yields attract buyers from abroad




The extra yield on US bonds compared with other developed countries’ bonds is at a record. This creates an incentive for foreigners, especially in Germany and Japan where rates are negligible, to buy Treasuries. This keeps yields lower while raising the dollar


And in the US, equities rallied on the assumption Mr Trump could win a significant corporate tax cut this year, followed by a big infrastructure package. These moves would push up bond yields. But with the administration entering what could be a drawn-out process to replace former President Barack Obama’s Affordable Care Act before it can start on tax reform, doubts have begun to surface.

“Intentions are worth something but activity is worth more,” says Mr Nasser.

Investors say political doubts kept 10-year yields moving sideways for the first two months of 2017. “Bond markets have accommodated a good deal of what we can anticipate and now we need to see detail,” says David Ader, chief macro strategist of Informa. “We just don’t know yet. And in the past few years, realisation has proved disappointing.”

With so many factors pushing down on longer dated yields, it is easy to understand the cosy consensus that rises in rates will be very gradual. To rise significantly above 3 per cent, which would put pressure on the stock market’s gains, the market will need to be surprised.

That could happen if, for instance, the Fed moves quicker than expected or if global central banks start to reverse QE. In 1994, Fed governor Alan Greenspan was widely expected to raise rates. But when the pace of the rate increases was faster than expected, a disorderly spike in yields ensued. That pushed up the value of the dollar and the price of corporate credit, leading to the bankruptcy of Orange County and the Mexican peso crisis.

Even Albert Edwards, the bearish strategist for Société Générale in London, sees parallels to 1994, though ultimately he thinks that bond yields will be driven lower because of continuing deflation. In 1994, “it was excess leverage that broke the market”, he says. The same is true now, and yields could easily spike as the Fed tightens. “Despite remaining a secular bond bull, I think we are in for a rough ride, especially with equity markets at record highs.”

A final danger is complacency. William O’Donnell, fixed-income strategist at Citigroup, says the problems of demographics and productivity are not new and “have not sneaked up on anyone”. He points to a speech Ben Bernanke, the former Fed chairman, made in 2012, explaining how QE kept yields down. QE is now ending.

“It is simple logic. If what Bernanke said was true then, you have to assume the reverse is true now,” Mr O’Donnell says. “It increases the risk that we are stepping closer to a ‘sell everything’ market after nine years of a ‘buy everything’ market. I think there is a lot of dry tinder out there.”

Trumpcare: Different Plan, Same Problems

By: Peter Schiff



With his widely followed, and positively reviewed, address to Congress last week, President Trump showed how easy it could be to unite Washington around a big-budget centrist agenda on health care, immigration, taxes, infrastructure and the military. But the continued accusations surrounding his campaign’s alleged Russian connections, and the President’s conspiratorial responses, have insured that the battle lines have only hardened. However, anyone with even a casual concern with ballooning government debt should take notice just how easily both parties in Washington would agree to vastly expand the gushing red ink if a political truce can be brokered. Those fears should galvanize around the newly-issued Republican replacement for Obamacare. If such a monstrous bill could successfully navigate Congress, we would find ourselves stuck deeper in a deficit deluge than we can possibly imagine.

Obamacare attempted to rewrite the laws of economics by preventing insurance companies from charging high-risk customers more than low-risk customers. But to make this work without bankrupting the companies, all agreed that the young and healthy would need to be forced to buy insurance. The flaw that doomed the law was that the penalties for not buying were too low to actually motivate healthy people to buy. Consumers were charged just a few hundred dollars per year to forego insurance that would have cost many thousands. Given that they could always decide to get insurance in the future, at no added cost, the choice was a no-brainer. Without these healthy people keeping costs down, insurance premiums have risen alarmingly.

Ironically, the Supreme Court noticed this flaw as well. In sustaining the Law’s constitutionality, Justice Roberts argued that the relative lightness of the penalties was insufficient to compel anyone to buy insurance and, as a result, he considered them to be a “tax” that could be voluntarily avoided rather than a coercive penalty to force commercial activity. (Presumably had the tax been high enough to actually work, it would have rendered Obamacare unconstitutional – see my 2012 commentary).

However, the Republican replacement plan, which removes all taxes on individuals who don’t buy insurance, and all penalties on employers who do not provide insurance to their employees, will actually make the problem far worse.

The only reason healthy people buy health insurance is that they know that if they wait until they get really sick no insurance company will sell them a policy. The same principal holds true for all insurance products. You can’t buy auto insurance after you get into an accident. You can’t buy life insurance at a reasonable cost after your doctor has given you six months to live.

The fact that your car is already wrecked, or your arteries already clogged, are pre-existing conditions that no insurance company would be expected to ignore.

Allowing voters the low-cost option to buy health insurance after they actually need it is very popular. It’s like promising motorists they can stop paying their monthly auto insurance premium and just buy a policy after they have an accident. If the government were to require this, all auto insurance companies would quickly go out of business (unless they were bailed out by the government).

Obama’s solution was to use the penalties to force healthy people to buy insurance before they actually needed it. As the years wore on, the relatively low cost of the subsidized exchange plans and the availability of those plans to anyone proved popular. However, the mandates and penalties, as well as skyrocketing premiums for non-subsidized policies, were clearly unpopular.

The Republicans have taken the “brave” political approach of keeping the parts that are popular (subsidized access, pre-existing conditions waivers, expansion of children’s coverage until age 26) and jettisoning those that are not (the mandates and the penalties). The new plan pretends to offer a replacement to the Obamacare penalties by allowing insurance companies to charge a 30% increase to the premium for those who come back into the system after having previously allowed their coverage to lapse. But the problem here is that the premium increase is far too small to force anyone healthy to buy insurance. In fact, it is so low that any healthy person currently insured may decide to drop coverage.

The effect of this law, were it actually enacted, would be the death of the health insurance industry. As the law removes the requirement that larger employers provide insurance, I believe that big companies would look to self-insure employees for routine care. For example, employer and employees could pay into a common risk pool that would set their own deductibles and co-pays. For employees who incur medical charges in excess of the cost of an actual policy, the pool could provide funds to pay for outside insurance at the increased 30% premium. As a result insurance costs would be encountered only if there is a need.

Self-employed individuals would only buy insurance if the total cost was less than the tax credit provided by the new plan. If they can’t find such coverage, they would likely buy a new form of insurance that this law may create: A policy that would pay for health insurance premiums if the user ever got sick enough to need them. Such insurance would be very cheap, as the maximum exposure to the insurance company is only 130% of the premium for a standard health insurance policy. 

In the end, the only people buying health insurance would be those who can buy it for free using their tax credits and really sick people for whom insurance premiums are cheaper than their medical bills. But as insurance companies lose money on the latter group, they will be forced to raise their premiums on the former. This puts us right back in the box we are stuck in with Obamacare.

As premiums soar well above the amount of the tax credits, more people will drop out. Unless the amount of the tax credits rises substantially, which will cost a fortune, all health insurance companies will eventually go out of business. The end result will be socialized medicine, only it will be Trump not Obama that gets the blame. It seems to me that this would be a political loser for the conservative cause. I would rather we go down in flames with Obamacare as then, at least, we will have a chance at a free market solution that could actually work.

The government has a very poor track record with containing the cost of a service when it gives consumers money to buy it. Think student aid and college tuition. Plus the plan is constructed in a way that makes it ripe for potential abuse. Whenever the government is giving away money, people always game the system to get it. Think about the wide-spread fraud in welfare, food stamps, disability, and even cell phone credits. Trumpcare will be no different. Many people will buy catastrophic plans with extremely high deductibles just so they can pocket the difference between the tax credits and the costs of the plans. If they actually incur a medical condition that results in a high out-of-pocket expense, they can just switch their coverage to one with a much lower deductible. Such a switch may even be possible without the 30% premium for lapsed coverage.

If Trump and the Republican leadership can push this monstrosity through, despite the obvious mathematical shortcomings, look for them to make similar efforts on infrastructure and defense spending. All this adds up to uncounted trillions in new debt, and a giant step closer to the utter bankruptcy of the nation. But the real danger lies in the possibility that the law is voted down by conservative Republicans and Trump turns instead to Democrats.

In contrast to the former mission statement of the Republican Party, Trump believes that government solutions can work as long as they are “smart.” The opening weeks of the Trump presidency were dominated by combative rhetoric, conservative and pro-business appointments, and nationalistic executive orders. And while this approach sent Democrats and the media into convulsions, it solidified the loyalty of Trump’s political base, and allows him to pivot toward the center if he wants. If he could peel off some “Red State” Democrats, he would be in a position to enact some of the biggest spending increases that the country has ever seen, even if fiscally conservative Republicans bolt.

If those conservatives defeat the new health care bill, Trump could look to partner with Democrats in a heartbeat. Of course, to get that support, he would have to make the current bill even more generous. Let’s hope that his self-inflicted wounds continue to prevent such an unholy Alliance.

Housing Bubble Déjà Vu

Mark Roe
. 

Beware the Ides of March

by Jeff Thomas

Food for thought

In praise of quinoa

The spread of exotic grains is evidence that globalisation Works
. 

PEOPLE are funny about food. Throughout history they have mocked others for eating strange things. In 1755 Samuel Johnson’s dictionary defined oats as “a grain, which in England is generally given to horses, but in Scotland supports the people”. Nineteenth-century Japanese nationalists dismissed Western culture as bata kusai, or “stinking of butter”. Unkind people today deride Brits as “limeys”, Mexicans as “beaners” and French people as “frogs”. And food-related insults often have a political tinge. George Orwell complained that socialism was unpopular because it attracted “every fruit-juice drinker, nudist, sandal-wearer [and] sex-maniac…in England”. In many countries today, politicians who wish to imply that their rivals have lost touch with ordinary voters sneer that they are latte-drinkers, muesli-munchers or partial to quinoa.

This South American grain gets a particularly bad rap. To its fans, it is a superfood. To its detractors, it is like the erotic sci-fi murals found in Saddam Hussein’s palaces—pretentious and tasteless. An advertisement for Big Macs once riffed on this prejudice. “Foodies and gastronauts kindly avert your eyes. You can’t get juiciness like this from soy or quinoa,” it said, adding that “while [a Big Mac] is massive, its ego is not.” Even those who love quinoa sometimes fret that scarfing it may not be ethical. What if rising hipster demand pushes the price up, forcing Andeans to eat less of their beloved grain? Or what if the price falls, making Andean farmers poorer? A headline from Mother Jones, a left-wing magazine, perfectly captured the confusion of well-meaning Western foodies: “Quinoa: good, evil or just really complicated?”

 

This newspaper takes no view as to whether quinoa tastes nice. But its spread is a symptom of a happy trend. More and more people are chomping unfamiliar grains (see article). Rich Westerners are eating less wheat and more of the cereals that people in poor countries traditionally grow, such as millet, sorghum, teff and yes, quinoa. Middle-class Asians are eating more wheat, in the form of noodles or bread, instead of rice. West Africans are eating 25% more rice per head than in 2006; millet consumption has fallen by the same share.

All this is to be celebrated, for it is a symptom of rising prosperity and expanding choice. The spread of better farming techniques has raised yields, helping humanity feed itself despite a rising population. Rapid urbanisation means that fewer people grow their own grain, and more have the cash to try new varieties. Globalisation has allowed food and farming techniques to cross borders, meaning that people on every continent can experience new flavours and textures. Migration and tourism have broadened people’s culinary horizons: Chinese visitors to France return home craving baguettes; Americans who live near Ethiopian immigrants learn to love injera (a soft teff flatbread that doubles as an edible plate).

Food for thought

 

The globalisation and modernisation of agriculture have contributed to a stunning reduction in hunger. Between 1990 and 2015, the proportion of children under five who were malnourished fell from 25% to 14%. People who are still underfed are less severely so: their average shortfall in calories fell from 170 a day to 88 by 2016. And between 1990 and 2012 the proportion of their income that poor people worldwide had to spend on food fell from 79% to 54%. As for those quinoa farmers, don’t worry. A study by Marc Bellemare of the University of Minnesota found that Peruvian households became better-off because of the quinoa boom, even if they didn’t grow the stuff, because newly prosperous quinoa farmers bought more goods and services from their neighbours.

 

Granted, rising prosperity has allowed an increasing number of people to become unhealthily fat. But the solution to that is not to make them poorer, which is what the backlash against globalisation will do if it succeeds. Rather than sniping snootily about Donald Trump’s taste for well-done steaks slathered with ketchup, liberals should worry about the administration’s plans to erect trade barriers and possibly start a trade war. That would make the world poorer and hungrier.