There has been a huge drain of liquidity from the U.S. Treasury market over the past few years, and may signal a structural change to how the United States finances budget deficits.
The government will always find a way to fund itself and will siphon and drain liquidity and buying power from other asset markets. During the past 20 years, the Treasury market has been dominated by foreign and official sector buyers That is changing and may explain why the stock market is trading so poorly even with, what appears, to be stellar earnings.
Read on.
Determination Of The 10-year Yield
There will be many posts to come on this topic as we believe it is the most critical issue investors need to grapple with and get right over the next year.
What is the right price for the U.S. 10-year Treasury yield?
Moreover, how is the yield determined, and how has it been distorted over the past 20 years by central banks, both foreign and the Federal Reserve?
What does the future hold?
Capital Flows
We agree that inflation, growth expectations, and other fundamental factors weigh heavily on determining bond yields but we alway maintain, first, and foremost,
“asset prices are always and everywhere determined by capital flows.”
New Issuance, Foreign, and Fed Flows Into The Treasury Market
The following table illustrates the new issuance of marketable Treasury securities held by the public and net purchases by foreign investors, including central banks, and the Federal Reserve over various periods.
The data show since the beginning of the century, foreign investors, mainly central banks, and the Federal Reserve net purchase of Treasury securities, those which trade in the secondary market, is equivalent to 60 percent of all new marketable debt issued by the Treasury since 2000.
We do not suggest all these purchases were made directly in Treasury auctions, though many of the foreign buys certainly were.
From 2000-2010, foreign central banks were recycling their massive build of foreign exchange reserves back into the Treasury market. During this period, the foreign central banks bought the equivalent of 50 percent of the new issuance. Add foreign private investors and the Fed’s primary open market operations, and the total equated to 70 percent of the debt increase over the period.
Alan Greenspan blames the foreign inflows into the Treasury market during this period for Fed losing control of the yield curve, a major factor and cause of the housing bubble, and not excessively loose monetary policy.
Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have “prevented” the housing bubble. – Alan Greenspan, March 2009
Greenspan raised the Fed Funds rate 425 bps from June 2004 to June 2006 and the 10-year barely budged, rising only 52 bps. More on this later.
Fed Plus Total Foreign Purchases
Fed Plus Foreign Central Banks
During the Fed’s QE period, 2010-2015, foreign investors and the Fed took down the equivalent of 80 percent of the new debt issuance.
The charts also illustrate that for several of the 3-month rolling periods, net purchases were significantly higher than 100 percent of new supply, distorting not only the 10-year yield, but the valuation of all other asset prices.
Interest rate repression also cause economic distortions, which have political consequences. Most notably, wealth and income disparities.
Rapid Technical Deterioration
Since 2015, flows into the Treasury market have deteriorated markedly, and the timing could not be worse as new Treasury issuance is ballooning with skyrocketing budget deficits.
During the past twelve months, for example, net foreign and Fed flows collapsed to just 17.6 percent of new borrowings. Even worse, the net flows were negative (we estimated March international flows) during the first quarter during a record new issuance of Treasury securities of almost $500 billion.
Can we say, “Gulp”?
Stock Of Outstanding Treasury Securities
Given the rapidly deteriorating technicals and fundamentals — rising inflation –, we believe the 10-year yield should be and will be much higher sometime soon.
That is we are looking for a “super spike” in bond yields, and expect the 10-year to finish the year between 4-5 percent. The term premium, which has been repressed due to all of the above, should begin to normalize.
Why is it taking so long?
Aside from the record shorts and natural inertia of markets, the stock of Treasury securities remains favorable, as the bulk is still held by the Fed and foreign central banks, who are not price sensitive.
Debt Stock Shortage, Debt Flow Surplus
Ironically, there remains an artificial shortage of the stock of Treasuries but now a huge glut in the flow. See here for a must read.
The Bund And JGB Anchor?
Treasuries are at almost record spreads on some maturities vis-à-vis the German bund, and foreigners are on a buying strike as the above data show.
How can an anchor be an anchor if there are no buyers? One asset arbitrage?
It is also not normal for the 10-year to be trading in such a tight range with a record short position in the futures market. The average daily move in the VIX has increased from 0.20 percent in 2016, to 1.37 percent in 2017, and shorts are now hardly spooked by a 500 point flop in the Dow.
Something must be going on beneath the earth’s crust. We have our ideas.
Dollar Strength
The recent dollar strength may be a signal foreigners are getting yield-hungry again, however. We are not so sure the rally has legs.
Market concerns over the political stability in the U.S may trump yield-seeking for the rest of the year.
How Foreign Flows Contributed To The Housing Bubble
We are not going to spend much time here but we are starting coming around to Mr. Greenspan’s reasoning. The lack of response of long-term yields to a 425 bps increase in the Fed Funds rate from 2004-2006 greatly contributed to the housing bubble. The 10-year yield only moved up 52 bps from when the Fed started their tightening to when they paused.
Take a look at the chart.
The Fed’s interest rate hikes didn’t even put a dent in the momentum of the housing bubble. Household mortgage debt continued to rise from 60 to 72 percent of GDP from the first interest rate hike before the market collapsed on itself.
Bubbles are hard to pop.
Why Long-Term Yields Didn’t Respond
Simple.
As, always and everywhere, capital flows or the recycling thereof.
The biggest economic event in the past 25 years, in our opinion, is the exchange rate regime shift that took place in the emerging markets in the late 1990’s. These countries now refuse to allow their currencies to appreciate in any significant magnitude as the result of capital inflows.
They learned some hard lessons in the mid-1990’s with Mexican Peso and Asian Financial Crisis, and the Russian Debt Default.
Balance of payments surpluses are now reconciled with dirty float currency regimes, where central banks intermittently intervene if their currency becomes too strong.
The result was a massive build of global currency reserves, much of which were recycled back into the U.S. Treasury market in the mid-2000’s.
The chart illustrates that foreign central bank net purchases of Treasury securities, alone, were equivalent to the over 66 percent of net Treasury issuance during the Fed 2004-2006 tightening cycle.
International Reserves Drive Gold
The gold price also ramped with international reserves during this period.
We believe the global monetary base, mainly international reserves, are the main driver of gold. See here.
Reserves have not been growing witness the punk trading range in gold. This may change as the U.S. current account blows out again.
Current Account And Trade Deficits
The Mnuchin crowd are wasting their time in China trying to negotiate lower trade deficits. Trade deficits are the result of macro internal imbalances where investment exceeds savings. See here for another must read.
Introducing trade distortions to artificially lower the external deficit will only accelerate stagflaton, which is already starting to take hold. Then we will all be worse off. See here.
Besides, where is Mr. Mnuchin going to obtain the financing for his proliferating budget deficits if his goal is to run trade surplus or balances with our trading partners?
We are all for better terms of trade and protecting are intellectual property rights, but know and understand thy national income accounting before starting trade wars.
Upshot
We have laid out why we believe, and we could be wrong, long-term yields are unlikely to behave as they did during the last monetary tightening. That is the a further collapse in Treasury term premia and a yield curve inversion until something breaks.
Unless the U.S. blows up its current account again, credit expansion accelerates significantly, creating another blast of capital flows into the emerging markets, to be recycled back to the U.S,, the foreign and Fed financing of the U.S. budget deficit is over. Punto!
We are preparing for a significant move higher in bond yields.
What Is The Right Real Yield?
Do you really think with the deteriorating flows in the bond market, coupled with rising inflation warrants a 0.5 percent real 10-year yield?
Au contraire! We believe a 2-3 percent real yield is closer to fair value.
Tack on another 2.5 percent for inflation, generous as shortages seem to be breaking out everywhere, and that gets the 10-year to at least 4 1/2 percent.
Timing
A little CYA. Yields could be move a little lower, maybe to 2.80 percent (a stretch), given the dollar strength as Europe slows, and shorts get spooked.
Our suspicions, however, it is going to be a hot summer. Higher interest rates and lower stock prices.
If stocks really crack hard, there will be a flight to quality keeping a lid on interest rates, however.
Disclaimer
Now let us add our disclaimer.
Even if all our facts are correct, our conclusions may be completely wrong.
If you have been reading the Global Macro Monitor over the years, you have probably seen it several times.
To illustrate our point, we like to tell the story Abraham Lincoln used to persuade juries when he was an Illinois circuit court lawyer.
The story goes that Lawyer Lincoln was worried he had not convinced the jury during the closing argument of a civil case against a railroad. The jurors had gone to lunch to deliberate. Lincoln followed them and interrupted their dessert with a story about a farmer’s son gripped by panic,
“Pa, Pa, the hired man and sis are in the hay mow and she’s lifting up her skirt and he’s letting down his pants and they’re afixin’ to pee on the hay.” “Son, you got your facts absolutely right, but you’re drawing the wrong conclusion.”
The jury ruled in Lincoln’s favor.
