Rational Thoughts On Rising Rates

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Some prominent fixed-income analysts have officially declared an end to the 30+ year bull market in bonds. The prices of bonds move inversely to the movement of interest rates, and it is obvious that yields on the 10-Year US Treasury Note have broken out of the long-term trend of lower highs with resistance now becoming support (blue line below). While we agree that there are powerful forces supporting higher rates, we wonder how much has already been priced into the 20% year-to-date increase in the 10-Year yield and expect that it will see significant resistance at 3% (red line) as investors are enticed by the higher relative return. A break above 3% would not be alarming, as we believe the trading range for the coming 12 months on US 10-yr Bonds will be 2.65% to 3.35%. Fed Funds probably end the year near 2.25%. Those interest rates would still equate to a positively sloped yield curve, which typically presents a bond market environment that does not expect a recession.

10 Yr US Treasury Yield

One reason for the jump in rates is the Tax Cuts and Jobs Act. It is hoped to boost future US GDP by reducing taxes to encourage spending and investment, but is also expected to immediately widen the US budget deficit in 2018. Additionally, politicians in Washington have also recently agreed to a budget deal that adds $300 billion to US deficit spending over the next two years. The US Treasury will be tasked with funding the extra spending by nearly doubling last year’s issuance to around $1 trillion in new debt securities in 2018. So far, heavily scrutinized auctions of new or “on-the-run” Treasuries have been met with solid coverage from primary dealers and non-dealers absorbing the increased supply without large spikes in rates.

The timing of this fiscal stimulus is precarious as the US labor market was essentially already running at full employment. The tax cuts that were initially praised by investors are now perceived as a threat to over-heat the economy, exhibited when a strong employment report showed a 2.9% increase in year-over-year average hourly earnings caused a feedback loop including a spike in inflation expectations, higher US Treasury yields, and an increased probability of a more hawkish US Federal Reserve (the “Fed”). Now that perceived deflationary risks are out the window, many market participants are starting to price in four Federal Funds rate hikes in 2018, when in December, there was skepticism that there would even be three. We do not foresee inflation rising to levels that would necessitate an extra rate hike this year.

Adding to the upward pressure on yields, the Fed is reducing the size of its balance sheet at an increasing quarterly rate. Newly sworn-in Fed Chair, Jerome Powell, has remained committed to the process of “normalizing” the Fed balance sheet by following the plan of his predecessor, Janet Yellen. The process outlined is estimated to continue into 2022-’23, barring an economic crisis, where the balance sheet will be around half of where it is today, yet much larger than the historical average.

Federal Reserve - Total Assets

Disclosure: Chart created by Hanlon using data from https://fred.stlouisfed.org/. Normalization estimate from www.federalreserve.gov.

With the rising supply, demand will need to rise to prevent rates from ramping even higher. Already large US debt holders, US households are among those required to pick up the slack which is difficult without an increase in the currently low US personal savings rate. The unfortunate trade-off for an increase in savings is a decreased growth rate in consumption, the largest contributor to GDP. Looking outside the US – China is currently the largest foreign holder of US Treasuries at ~$1.2 trillion, but is skeptical about buying in the future. Many forecasters predict stability for the Yuan in the coming years, hence less need to intervene by increasing foreign reserves.

The Fed, by being ahead of other central banks in terms of “normalizing” post crisis expansionary monetary policy, should lure foreign investors still awaiting the end of such policies in other developed markets. This has the potential to end the paradigm of US interest rates remaining higher and rising faster than other sovereign yields (chart below).

10 Yr US Treasury Yield

But first, investors in Europe or Japan will need to see stabilization in the US dollar prior to adding to their US Treasury positions. The costs of hedging US dollar currency risk currently negate the relative higher yield to these foreign investors, but the recent paradox of rising yields and falling dollar is unlikely to persist. The dollar is holding support, which should keep inflation expectations in check, and lessen hedging costs or reduce the perceived need to hedge at all.

US Dollar Index - Cash Settle (EOD)

Institutions and pension funds should help soak up liquidity as the bull market in equities has proportionately increased the need for “safe-haven” assets as part of portfolio allocation and risk management. For example, a 60/40 portfolio of stocks and bonds that has had a ~20% return on its stock holdings will need to buy bonds to maintain the target 60/40 allocation. So not only do investors flock to the safety of bonds when equity market goes down, but intuitively, risk-averse investors demand more bonds as equity markets rise to maintain desired risk levels.

In conclusion, and in terms of “safe haven” assets, there is only a limited supply for a world of investors seeking protection. With European political turmoil unlikely to be over, and Japanese debt and demographic issues, the US’s deep and liquid government debt market is still the “safest house on the block” despite the perception of US fiscal improprieties. Indeed, the new tax cuts have put the Fed in a sticky situation, but the board of Fed governors know that it is in everyone’s best interest to not disrupt markets by being transparent and methodical in their actions. Inflation fears have likely been over-blown, and as the dollar finds support a healthy equilibrium in Treasury yields should become apparent that will likely be below historical averages. Expect US Treasury interest rates to rise, but not precipitously, because it is a necessary occurrence with a strengthening economy.

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