Where are rates going? Forecast: Volatility
After the stunning swoon in treasuries - the 30 year has plunged over 20% year-to-date - it's only natural to ask, where the heck are bond yields going from here? Even more fundamental, what about the availability of credit? Just for a little historical perspective, let's take a look at where we have been.
Here is a long-term chart of the 3-month treasury yield. Now I know it's no intellectual leap to say WE HAVE TOUCHED ABSOLUTE BOTTOM DRIVEN BY A NEAR DEATH EXPERIENCE AND THERE AIN"T NOWHERE TO GO BUT UP! But let me layer a bit more of the completely intuitive on top of the transparently obvious.
1) Government issuance of new debt is expanding to historically high levels to cover the bank bailouts, stimulus plan(s) and continued pork barrel spending. You can find a great visual for the relative size of the bank bailout program, versus past major U.S. spending initiatives here(View image).
According to a recent Forbes article, the U.S. government has said it will need to borrow $2 trillion, or 14 percent of the country's total economic output, in 2009 alone. Some have been reminding those of us who care that we should not forget that additional borrowing from mortgage giants Fannie Mae and Freddie Mac will contribute to overall U.S. government borrowing being much higher.
2) Bond market "vigilantes" now more likely foreigners than U.S. investors (when Ed Yardeni coined the term back in the early 90s) are worried not just about return on their money (vs. domestic and other alternatives), they also worry about return of their money. Their cooperation in funding our debt will only be bought with higher rates of return. Let me quote one of the larger buyers of our main export:
"Whether to buy more US Treasury bonds, and if so by how much, that should be based on China's need, and based on our requirement to keep the safety of our foreign reserves and their value". Chinese Premier Wen Jiabao
Of course, others are more sanguine about the chance of a buyers' strike in bond land.
"The reserves are so large that they have little alternative but to hold a substantial fraction in U.S. Treasuries and guaranteed paper," said Harvard economist Richard Cooper, referring to the People's Bank of China.
My guess is that, at the margin, the Chinese do anything they can to soak up their FX reserves with something else rather than U.S. bonds. Of course, Urban Digs readers know it's a second derivative world, where change at the margin drives everything (because markets drive economies today and they respond largely to incremental data).
3) With the massive stimulation of the U.S. economy, and little opportunity to deploy that capital into value added investments (those which offer a fundamental competitive advantage in efficiency/productivity or provide for a true unmet need), money will quickly seep into financial and or raw material asset speculation and producer price inflation.
But wait. Why are some very smart investors like Mohamed El-Erian suggesting that inflation will come, but it will come later in the cycle rather than immediately.
As you can see from the chart above, Pimco has some fancy ways of saying that U.S. and global growth will be slower going forward due to damage from the recent downturn, but also from exposure by the downturn of unsustainable trends in industries and economies, which will begin to normalize, in some cases rapidly (restructuring of the U.S. auto industry) and in other cases slowly (deleveraging of the U.S. consumer balance sheet).
I agree with El-Erian that these factors suggest slower growth and less inflation pressure, suggesting that the bond market behaves in a manner befitting a non-inflationary environment. However, this doesn't take into account the risk premium being built into U.S. bonds for credit quality deterioration as impacted by both increased default fear/desire to diversify and massive issuance.
In his most recent commentary El-Erian points out that the bond market implosion that has taken place since his piece on lower inflation pressure is reinforcing deflationary trends:
"The Treasury bond sell-off is now putting pressures on other markets in the economy. We should worry most about housing where borrowing rates are rising notwithstanding the Federal Reserve purchase program. Indeed, according to data released on Thursday, already 12% of U.S. households are facing difficulties meeting their mortgage payments."
My forecast? Volatility. I think that whenever the economy gets weak, China will rush in and buy commodities - which props up emerging markets where they would like to sell more of their widgets - and gets them a supply of cheap materials for making infrastructure they need as well as exports. It also allows them to recycle FX reserves into a productive and in their mind relatively safer use. This will keep commodity prices volatile, but trending higher. To the U.S. consumer this will be felt as pain in food and energy prices.....not measured in the headline inflation numbers. When energy prices get too high....as they are now.....you will see the U.S. economy downshift, pushing the commodity complex back down.
As the U.S. economy slows we will see a flight to the dollar and U.S. bonds, which will tend to feather back the inevitable trend towards higher rates. This may give temporary help to the mortgage market, but at this point the housing recovery may become stymied by generally higher mortgage rates. Without a housing recovery I can't see how general credit availability can improve. Banks will be stuck in the recovery room and the recent round of capital raising will be their easiest. My guess is they horde that capital. Not a prescription for a booming economy and CPI inflation. In my mind the misery of inflation is going to be felt in higher food and energy costs to the consumer and investments in commodities will be relatively safe, as should many emerging markets (suppliers of commodities) largely due to the closed loop of China investment demand.
Hold on to your hat!
.
Posted by monte
Thu Jun 11th, 2009 12:21 AM
Please explain what perpetuates the "closed loop of China investment demand" as China begins to choke on its overcapacity in the face of declining demand from its principal export markets. I think you are giving too much weight to the sustainability of the Chinese planned economy model that is doomed to suffer under the weight of inefficient allocation of its excess capital. I agree with you up to this point. I would however place greater emphasis on a global deflationary outcome as energy and commodity inflation ultimately give way to reduced Chinese demand.
Posted by MeekSheep
Thu Jun 11th, 2009 08:01 AM
If China does not buy US debt their monetary policy of fixing the reminbi to a certain percentage of the dollar will falter, thus making their exports more expensive. If they make their exports more expensive their economy will falter. To prevent their economy from faltering they need to buy US debt. Is that close? It's what I keep hearing.
Posted by JK
Thu Jun 11th, 2009 09:04 AM
Jeff, always love your commentary, but I have a simple question for you. How do you see this effecting mortgage rates in the next few months and do you think the Government will step in to prevent rates from going too high and negatively impacting the housing market?
Posted by LP
Thu Jun 11th, 2009 09:59 AM
I think in case of China they made it very clear that they don't want to depend on exports and are expanding their domestic consumption dramatically. As this happens I see China reducing their US Treasury Bill holdings or at the very least freezing it at their current levels. As for run-away inflation I think it's a very distinct possibility but I agree with El-Erian - it will come in a year or 2 given current and rising unemployment levels and production under-utilization.
Posted by jeff
Thu Jun 11th, 2009 08:51 PM
Folks, Thanks for the comments. I was out today, sorry for the late response. China is a closed loop because (like Japan at the beginning of their decade of stagnation) they are not highly leveraged at the federal level and can stimulate their internal growth for a long time from government reserves. At the consumer level and they can use consumer savings to fuel domestic consumption and growth as well. The Japanese are now leveraged at the Government level, but their consumers still have tons of savings, which has become a problem, as they have failed to get their consumers to stimulate new growth, while the rest of the world has continued to lend to them, because the government could always tax the people to pay back debt. The U.S. has nobody but corporations to tax in order to pay back its debt, while its consumers are maxxed out. Outside of a currency crisis, which is possible, but I give less than a 50% chance of happening, mortgage rates are going to go up until they cause a double dip in the economy at which point they will round trip back down (though maybe not back to the lows of this recent cycle). I also failed to mention how the dollar plays into all this. The dollar weakens as Russia, China, India diversify away from our bonds, this causes food and energy prices in the U.S. to climb, killing the consumer. As our consumer rolls over it hurts commodity prices, which in turn hurts India, China and Russia and makes investors want to buy our bonds instead of their stock markets. Another cyclical force that will be interweaving with what I have described above. That's why outside of a currency crisis, I see cycles of food and energy, but not CPI inflation, followed by deflationary bouts, with a bias upward. In terms of the China bubble, ultimately I think it will be a historic implosion...like Japan....but it still has more time to run and who knows, maybe they will get smart and figure out how not to fly off the tracks. I just have to believe that the over-capacity and mal-investment resulting from super-heated periods of growth, will eventually catch up with them.
Posted by Buy Seattle Condo
Fri Jun 12th, 2009 01:32 AM
The world’s key challenges cannot be met by governments, business or civil society alone In a world characterized by complexity, fragility and ever greater synchronicity, strategic insights cannot be passively acquired. They are best developed through continuous interaction with peers and with the most knowledgeable people in the field.
Posted by Thisson
Fri Jun 12th, 2009 03:18 PM
Jeff,
It's much more complex than that. I don't buy into the theory that savings is bad for an economy compared to consumption.
GDP = Output of an Economy = Total of C+I+G+X [Consumption+ Savings/Investment + Government Spending+ (Exports-Imports)]. Shifting consumption to savings/investment has no detrimental impact on the net output of an economy; it simply reflects the reallocation of that output. The effect of that shift on GDP going forward depends upon whether savings were invested efficiently (increasing capacity), or wasted on malinvestment.
Moreover, intuitively it makes sense that a less developed economy has more unexploited opportunities for saving and investing than a more developed economy.
Finally, the dollar is not going to weaken as a result of China/India diversifying away from US gov't securities. Instead, interest rate yields will go up (already happening). Currency crisis for the dollar is not on the table, as we are in the beginning of a deflationary crisis, not an inflationary one.
I will give you near term price increases to Food and Energy - simply because demand is relatively inelastic for those; at least in the near term.
Posted by In Debt We Trust
Sat Jun 13th, 2009 06:24 PM
Can someone please explain this to me:
http://www.propertyfundsworld.com/articles/detail.jsp?content_id=335687
Posted by In Debt We Trust
Sat Jun 13th, 2009 07:40 PM
Here's something interesting. Mark Denniger commenting on Thurs. bond auction results. (Please keep in mind Mark Denniger is a super conspiracy theorist).
http://tickerforum.org/cgi-ticker/akcs-www?post=98458
"Its not dumb money in the bond market.
If you believe there will be massive deflation you buy the **** out of the long end of the curve.
Something CHANGED this morning Asi. You don't buy long bonds if you think printing is going to take place (or continue to take place); that's suicidal as the value change is "coupon change x duration" - you can literally lose half in a few months. Levered, you're dead in a day.
The PDs are long Ts up to their necks. If the selloff continues they will ALL blow up. Every one of them. It ain't gonna happen.
The only thesis that makes the buying logical is the belief that the values will INCREASE. That means the DX must rise and/or coupon must come down, and both require that the hyperinflationary thesis be WRONG."
Posted by MeekSheep
Sun Jun 14th, 2009 01:57 PM
How much volatility can you stomach then? I continually am looking at zero coupons that expire near 2050 but have recently been issued, short term corp. debt, and convertibles as market indicators. The real question isn't which way will it go, it's more of a who is leveraged into what and which bond class will "hurt" the most in the next few years (excluding CMBS.) There is so much fear and uncertainty you have to wonder what is the next lurking danger.
Posted by jeff
Sun Jun 14th, 2009 09:50 PM
Thisson,
I didn't mean to imply the situation was simple, far from it. I also don't think I said anywhere that savings was bad. it can be bad for an economy that has no population growth, relatively high wages and is not inventing much that creates efficiency....ala Japan...which is stagnating. In the U.S. a higher savings rate rather than mal-investment in real estate would have obviously been a good thing....you can add sock puppet company shares to that list as well. But hey at least in the U.S. we throw a bunch of things at the wall and some stick. My point is that while I think China is mal-investing in a big way, structurally they can get away with it for a long time. China like Japan and the Asian Tigers initially competed on low cost labor. They continue to to some degree, but they have used currency manipulation to keep Vietnam and other lower cost labor countries from taking too much share, while they try to move up the value chain. Like Korea and Japan, though, much of the move up the value chain has come through capital equipment investment rather than innovation...although all have been successful to some degree. But after the Asia crisis China learned to be a bit careful with how crazy it let it's capital investment get and has been somewhat careful with it's government owned companies, bank balance sheets, etc. So they have been able to maintain their unbalanced export dependent ways so far. Now they are shifting their model to more domestic demand driven and they have both the government and corporate balance sheet to do it. So for now I see China as a closed system that, can continue to "do it's thing". Part of which is consuming lots of commodities, which will put pressure on supplies here. The dollar has already weakened and every weak another avenue for trying to diversify away from our bonds (implicitly including a sale of dollars) is announced by one of our trading partners. There is no way this is good for either the dollar or bond yields. But as you point out, as the economy slows and these commodity levered economies feel the pain, the dollar and US bonds will be better bid, this is the likely counter-trend to the overall trend of higher rates and higher inflation. Could we have a worldwide deflationary implosion, sure we could, but we just stared one down and my guess is the liquidity unleashed to fight it will be bubbling through the system for at least a year....any further out and my radar goes blank.