Is there a fundamental reason for long dated US yields to spike ?
(this is an excerpt from our flagship report from last week, Friday April 27)
We are once again at a tipping point regarding the technical outlook for US fixed income. An old friend (thanks David!) dug out a classic, which is the US 10-year bond chart since 1990 that shows the steady decline in yields. We yet again are testing this down trend. As you know, I am not much of a technician, but I would ask the following question:
Is there a fundamental reason for long dated US yields to spike significantly higher breaking a multi-decade disinflationary period?
The following was a brain storming session I recently had with a client, looking at the reasons for and against a rise in long term interest rates. I haven’t tried to handicap them in any way. It is simply a list.
Reasons for higher long dated yields
- Rising US deficits.
- A reckless US tax cut when the economy was at or close to full employment.
- A decade of global excess liquidity and pent up inflation pressures.
- Rising tariffs / protectionism stoking cost inflation.
- Oil prices will rise due to a lack of long term investment, despite the rise of renewables. The price in oil will rise due to supply constraints despite long term declining demand.
- The absence of productivity growth.
- A more aggressive Federal Reserve recalibrating an artificially flat yield curve.
- Rising structural growth rates in the emerging world as demographic dividend is rewarded in the Middle East, India, and Africa.
- Chinese consumption booms as incomes rise.
Reasons for long dated yields to be stable or go down
- Global inflation pressure will never re-emerge due to poor western demographics and technology deflation. Investors have consistently underestimated these themes. Remember, older people buy safe yielding assets and are less likely to own stocks.
- A chronic shortage of global yield. According to the IMF, there are currently less than $1.8tn of investment grade securities yielding more than 4% down from $15.8tn in 2007.
- We are on the verge of a productivity miracle that will keep inflation in check. Electric vehicles are deflationary, the cloud is deflationary, big data is deflationary. The list goes on and on and on.
- Overcapacity remains a concern across a variety of segments from banking to autos to data storage. Prices will continue to adjust, especially when emerging market governments continue to prop up unprofitable “State Champions”.
While I haven’t tried to weight these reasons in terms of importance, any investor has to do so. More importantly, when deciding whether or not to buy fixed income, you will also need to determine which factors are relevant now and which will be drivers of yields at some stage in the future. This sums up the thinking between tactical traders and investors who have a multi-quarter or multi-year time horizon. A tactical investor who believes that yields will rise is probably not going to perform an in-depth analysis into the long-term trends in global productivity. While tactical elements like market positioning may influence the timing of the entry into a long developed market bond exposure, an endowment or family office investor looking for future income is probably not going to concern itself with short term gyrations. The level of assets is more important than finetuning the timing.
My structural disinflationary biases are well documented, and it will surprise no one that I will weigh the long term deflationary influences on the economy much more heavily than issues such as larger deficits or fears of protectionism. That said, when I look at both the tactical framework and the long-term drivers of pricing pressures, I am rapidly coming to the following conclusion:
Developed market interest rates are currently jumping at precisely the time when the global economy is coming off the boil. Despite a very robust US earnings season, guidance implies that we may have seen the peak in corporate profitability for the next several quarters. Throw in some legitimate geopolitical concerns and I can paint a scenario that both the tactical and structural outlook for both yields and inflation is capped.
I wrote last Sunday that US 10-year yields could easily spike through 3% for a brief period before retreating. While trying to pick tops and bottoms in markets is a thankless task, I have one very simple reason to believe that we may have, in the short term, seen the high print for US bond yields for 2018.
This is very anecdotal, but the speculative community is so aggressively short US interest rates that market constructs make a further jump in yields, in the near term, very unlikely.
This is important because the market is very short interest rates at precisely a time when the fundamental outlook for inflation and growth are weakening at the margin. This makes short positions vulnerable if the economic data continues to come in sluggish.
Founder, View from the Peak
IND-X Advisors Limited