“Americans will always do the right thing — after exhausting all the alternatives.” Winston Churchill? Abba Eban? An Irishman? Apocryphal? For a history of the quote, see: https://quoteinvestigator.com/2012/11/11/exhaust-alternatives/ .
When it comes to interest rates, inflation, and financial markets, that hopeful outcome is being sorely tested. We’ll look at some current evidence of US economic trouble signs. But first, a few notes on the situation in Europe:
1. Some $17 trillion in debt (partly Japanese but mostly European) is now trading at negative interest rates.
2. In Europe, most sovereign debt of major countries is trading today at a negative interest rate. Some rates are approaching minus 1%.
3. In Europe, in addition to sovereign debt, about $1 trillion in corporate debt is trading at negative interest rates.
4. In some places, such as Denmark, a home mortgage is obtainable at a negative interest rate.
5. Meanwhile, the inflation rate in the European Union was recorded at 1.40% in July 2019 (https://tradingeconomics.com/european-union/inflation-rate). Thus the gap between inflation and interest rates is about 2% with the inflation adjusted rate about a minus 2%.
When it comes to the United States, we have a strange and mixed picture.
1. The Federal Reserve’s policy interest rate is about 2% for riskless overnight dollars.
2. The 10-year US Treasury note is about 1.5%, and the 30-year US Treasury bond is about 2%.
3. So, depending on which maturities you use, you can call the US Treasury yield curve flat (from one day to 30 years) or inverted.
4. Almost all of the world’s major countries’ sovereign debt now trades with a yield below the overnight risk-free rate of the United States. I cannot find an historical precedent for such a global financial construction.
5. Foreign usage of the Fed-controlled and “uncapped” US reverse repo program (RRP) is at a record high – about $300 billion. Who can blame a foreigner for seeking US yield in the world described above.
6. Meanwhile, the most recent auction (August) of the 30-year inflation-indexed bond issued by the United States (TIPS) had a real yield of about 0.5%. Compare August to February, when the auction yield was about 1.1%. (Action Economics)
7. The abruptness of the August 2019 decline in US Treasury bond rates has been matched only six other times in more than three decades – in October 1987, June 1989, February 2000, November 2001, December 2008, and August 2011. These dates were all during or close to recessions. (Bianco Research)
8. Meanwhile, the tax free municipal sector is telling a different story. Texas recently sold a natural AAA tax-free bond due in 2040 at a yield above 2%. That’s right Texas tax free higher yield than US taxable. Minnesota Housing 2044-maturity tax-free (secured by a basket of GNMA mortgages) recently sold at 2.75%. Note that the tax-free Minnesota Housing bond is yielding 140% of the taxable 30-year Treasury bond, and the security on both is ultimately the United States. Also note: Per Moody’s, there were no rated muni defaults in 2018. Remember that Puerto Rico was not rated by Moody’s. In corporate bond land, S&P Global notes that there were 47 defaults among rated US companies in 2018, totaling $101 billion. The US “speculative” (junk) bond default rate was about 2.5% in 2018.
9. Meanwhile, the US annual inflation rate rose to 1.8% in July 2019 from a four-month low of 1.6% the previous month and above the market consensus expectation of 1.7% (https://tradingeconomics.com/united-states/inflation-cpi). Also note that some measures of inflation are now above 2% and trending higher when recent time periods (rather than year-over-year comparisons) are examined. Essentially the gap between inflation and interest rates is near zero which means the use of money (by a borrower) is essentially free.
10. While US Treasury note rates have declined, junk bond rates have not; thus the spread has widened. Compare yield on HYG to GT10 (Bloomberg) to obtain a market-based spread. It is now about 350 basis points. On January 1 it was 314 bps. Before the tariffs and trade war it was about 250 bps. Conclusion: Trump tariffs are raising credit risk premia, and the higher risk premia explain weaker sectors of financial markets, slowing economic growth, and rising volatility.
11. Meanwhile, the Trump federal deficits are now set to cross $1 trillion annually. The US Treasury is examining issuing longer maturities. In my view, Trump should stop bashing Powell and start directing his administration to issue 100 year TIPS. The world would buy a lot of them and the United States could achieve remarkable low cost permanent financing for its many needs and wants.
Some vital questions remain open:
1. How and when will the Trump Tariff War stabilize? Will it? Are we headed for global fortress regions and will we permanently reverse the benefits of a half century of globalization and economic integration? Trump has just threatened a new tariff level of 30% for the first time. Tariffs Revenue to the US Treasury has doubled since this trade war started and is still rising and accelerating up. At 30% on all China sourced imports, the federal revenue would grow to about $200 billion annually. The tariffs amount to a sales tax imposed on American consumers and businesses. For a metaphor, This amount would be roughly equal to a national increase in the gasoline tax of about $2 per gallon. That is the trajectory of the present thresholds of Trump-Navarro trade war policy.
2. Will Trump use the Exchange Stabilization Fund (ESF) as a supplemental weapon in the trade war? In our opinion this move would significantly undermine the long-term stature of the US and of the US dollar as a world reserve currency. The mere fact that Trump has alluded to using the ESF (and to wanting a weaker dollar) makes it now an unpredictable issue and raises risk premia.
3. What will the Federal Reserve do, when will they do it, and how will they explain it? Trump’s bashing of the Fed is likely to continue and intensify. They make a convenient political target, even though the economic issues and financial stresses originate in Trump’s protectionist policy and not in Fed policy. Any creditworthy borrower can obtain financing easily, and any refinancing is happening or has happened. There is not a lot left to “milk” out of the system. The problem is not with low rates; the problem is in weakening economics and rising uncertainty premiums that are resulting from Trump’s inconsistent and ill-advised behavior.
4. Lastly, there is a developing body of research that estimates how much damage negative rates and even very low rates are doing. Torsten Slok has published a partial list of those papers. Essentially, negative-rate policies and very-low-rate policies eventually become counterproductive and act as contractionary forces. See Brunnermeier and Koby, “The reversal interest rate,” January 30, 2019 (https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=2ahUKEwiM5JCwjJzkAhUQVd8KHVFiDgsQFjABegQIABAC&url=https%3A%2F%2Fscholar.princeton.edu%2Fsites%2Fdefault%2Ffiles%2Fmarkus%2Ffiles%2F20p_reversalrate.pdf&usg=AOvVaw0F9ZkQPUlLbzTjXedY-YzE). Also see NBER working paper 26040 by Sims and Wu, July 2019, entitled “Evaluating Central Banks’ Tool Kit: Past, Present, and Future” (https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=2ahUKEwjz_emnjZzkAhVmZN8KHTZGCE0QFjAAegQIABAC&url=https%3A%2F%2Fwww3.nd.edu%2F~esims1%2FSW.pdf&usg=AOvVaw2dJTpeNxHCREsdw_ovQtwD).
We enter the post-Labor Day period with caution about the policy outlook in the US and elsewhere. Bonds are in a barbell and avoiding a ladder. Ladders now center duration in the highest risk and lowest yield portion of the yield curve. Stock accounts are rebalancing and deploying cash reserves. Market corrections have allowed for repricing and entry. Fear is providing those entry opportunities. Quantitative accounts have been defensive for months; they are now redeploying as indicators confirm opportunity and market based prices indicate entry. When the inflation adjusted interest rate is zero or lower, money’s usage is free. This is bullish for many asset prices. Our job is to manage the investment landscape and be agnostic to a policy with which we disagree. We don’t like the Trump policy. Dislike of, disgust with and disdain for Trump behaviors do not prevent us from seizing market opportunities.
Note: Economic Data sourced from Bloomberg if not otherwise cited.
David R. Kotok
Chairman of the Board & Chief Investment Officer
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