by Ivan Martchev
While the 10-year Treasury note yield closed Friday at a multi-year high of 3.22%, launching talk of a bear market in bonds, I have to remind readers of this column that we have been there before. The latest decisive move above 3% may seem dramatic, but it is no more dramatic than the move above 5% in the summer of 2007 that caused many market participants to say that the bull run in the U.S. Treasury market that began in 1981 was over. As Yogi Berra liked to say in such situations, “It ain’t over till it’s over.”
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
It is true that if one were looking at a long-term chart, the 10-year Treasury yield has “broken out” from the long-term downtrend that started in 1981, just like it did in 2007. It is also true that if one were to put the 10-year Treasury yield on a logarithmic scale, no long-term downtrend has been broken (see below).
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
This causes a bit of a problem for bond bears, as the economic cycle in the U.S. is very mature and we are probably not at the right time for a big bear market in bonds. The present economic expansion is nine years and four months old, while the all-time record is exactly 10 years (March 1991-March 2001). While I am confident we will beat the all-time record come next June 2019, I am not sure by how much.
The question then becomes, how much of the Federal Reserve balance sheet can be unwound? The rate of unwinding may be $600 billion per year in 2019, based on the runoff rate from October 2018, which was just upped to let $30 billion in Treasuries run off and $20 billion in mortgage-backed securities, for a total of $50 billion per month. Could this runoff rate go even higher? It sure could, but when combined with higher deficits due to the tax cut, this may create a problem in the Treasury market.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
All these monetary machinations raise interesting questions as to the slope of the U.S. Treasury yield curve and how predictive it will be this time, given that in all prior cases of inversion, long-term U.S. interest rates were market-driven. This time around, the Fed is meddling so much in the U.S. Treasury market that it can affect where the Treasury market goes. If the Fed wants higher long-term interest rates, it just makes sure that the balance sheet run off rate is higher, so the yield curve does not invert.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Also, because of the high amount of leverage in the financial system, materially higher U.S. interest rates may create a problem. Rising interest rates do not matter (until they do). No one is really sure how high those levels are on the 10-year Treasury or the fed funds rate. I guess we’ll find out soon enough.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
U.S. Dollar Rally to Accelerate Soon
Along with the big move in bonds last week came a renewed upward pressure on the U.S. Dollar Index, which closed the week at 95.62, even though we were above 96 at one point on Friday. The high for 2018 so far has been a hair shy of 97 and I think we have plenty of time to take out 100 before the end of 2018.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Keep in mind that the old U.S. Dollar Index includes no emerging markets currencies, which have become much more important in this Fed tightening cycle, given how much emerging economies have grown in the 21st century. The JP Morgan Emerging Markets Currency Index hit an all-time low in September and, despite a marginal rebound, it is probably headed for another all-time low before the end of 2018, given how fast U.S. interest rates are rising.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
So far, this move in the dollar has not yet produced a genuine emerging markets crisis, but the potential is clearly here as there has been a massive increase in borrowing in U.S. dollars in the past 10 years and those debts will have a hard time being serviced with much weaker emerging markets currencies. There has been a rout in emerging markets currencies, bonds, and now stocks, which was started by the change in Federal Reserve policies. Since the Fed does not appear to be done, neither is said rout.
