Unlocking the Mystery; Why US 10 Year Treasury Yields are Down at 2.4%, Ten Things You Need to Know

Date: Monday, August 18, 2014
Author: Larry McDonald

Special thanks to Robbert Van Batenburg of Newedge who Co-Authored this report.

How could Wall Street economists have been so wrong?  On January 1st the consensus forecast of the 66 most senior economists for the year end 10-year US Treasury yield was 3.44%. At the time, 10 year Treasury yields were hovering around 3%, their highest level in almost three years. Since then the benchmark interest rate has declined as low at 2.34% last week,  Treasury bonds have outperformed practically all major asset classes in 2014.

The US 30 year Treasury is up nearly 17% in 2014, triple the return on the S&P 500 SPY EFT.  The iShares 20+ Year Treasury Bond ETF TLT is up 15.4%.  The Pimco 25+ Year Zero Coupon US Treasury Index ETF ZROZ is up 27% year-to-date.  If it was a fight they’d stop it, long term bonds are crushing US stocks this year.

Late last year we made a very public, bullish call to buy US Treasuries.  It was really hard to do in the face of the explosion of conventional wisdom calling for higher yields.

The lesson?  An investing virtue we live by; whenever you see the crowd bunched together on one side of the boat, run, don’t walk the other way.

Many Wall St. analysts feel safety in numbers, they often gather together in large groups.  This presents an opportunity for investors; if you’re on the other side of the trade, just a slight shift in sentiment can create substantial profits.

Dangerous Crowded Wall St. Themes

“Buying right, never feels good.”

Hedge Fund Legend Seth Klarman

Whenever you see popular Wall St. theme centered investment ideas, beware.  In your mind, try and measure just how many people are invested the same thing?   The more popular, the more analysts trying to sell the idea, the more dangerous the investing outcome will likely be.

In December of 2000, analysts loved Merck as she approached $90 a share.  We were told the US’s aging population would fill Merck’s pockets with profits for decades to come.  The stock lost 70% of its value over the next 5 years.

In April 2011, we were confidently told to buy companies like iron ore miner BHP Billiton .   They screamed at us, “FIFTY Chicago’s are being built in China!”   The historic, relentless growth would propel shares to $150 they said, nearly every analyst on the Street had a “buy” on the stock.  The shares lost 42% over the next 12 months.

In January 2014, we were told an improving US economy and the Fed’s tapering plans for their quantitative easing bond purchase program would lead to a spike in long term interest rates.  Incredulously, Wall Street economists still believe 10 year rates will be at 3% by year-end.  What are they missing?

10 Reasons Why US 10 Year Yields are 2.40%, and Why They’re Heading Lower

1.    Geopolitical risk: While US government bonds have rallied all year, the turmoil in the Ukraine, Iraq and other hot spots around the world (Azerbaijan,  Syria, Israel) have accelerated the flight into US Treasuries. The alternative flight to safety assets, such as gold, oil or the dollar, have lost their reputation in recent years, due to their diminished resilience in times of turmoil. After peaking in September of 2011 at $1900 per troy oz. gold has declined by 31% and no crisis (Libya, Cyprus, Syria, government shut-down) was able to reverse the slide. Many investors have been burned by these historic, flight to safety heavens, pushing US Treasury demand higher in times of stress.

2. Foreign Demand: The Chinese, Japanese and OPEC countries continue to hold and buy US Treasuries as they sterilize the flows of dollars into their countries. Combined, the three hold $2.7 trillion of US Treasuries. The US is still the deepest and most liquid place to park cash on earth.  If you need a safe place to park $20B, it’s a lot easier to use liquid US markets than others such as those in Canadian or Australian.  In some respects it’s the only game in town.

According to U.S. Treasury data, the percentage of U.S. debt held by foreign investors was close to 34% of the United States’ total debt load as of April, 2014 vs 31% at the end of 2011.  Despite all the drama from US bond market doomsayers, China’s purchases of US treasuries notes and bonds hit a record in the first 5 months of 2014.  All in all, the Chinese government has increased its purchases of U.S. Treasuries this year at the fastest pace since records began more than 30 years ago.

3.    U.S. Mid-Term Elections:   The mid-term elections in November of this year look to deliver the Republicans their long awaited victory in the Senate. According to the reliable Iowa Electronic Markets from the University of Iowa, the odds that the Republicans re-take the Senate are now at 70%. Last week, pollster Nate Silver placed the odds at 60% up from 45% last fall.  If the Republicans control both chambers in the next Congress, their first order of business is to rein in government spending. Paul Ryan’s latest budget proposal calls for $5 trillion of extra budget cuts over the next ten years and will likely become the blueprint for the Republicans in the budget negotiations.

In March of next year, the Federal $17.4 trillion debt will once again be in focus.    Keep in mind, the debt ceiling will be expiring and the GOP is likely to use this tool to coerce Obama into a fiscal straight jacket.  The Republican imposed fiscal restraint will lead to even lower budget deficits, which in turn requires less net debt issuance by the Treasury department. With all the demand for Treasuries still in place, less supply leads to higher prices and lower yields.

The fiscal drag from Washington coming at the US economy in recent years has been profound.  The debt ceiling debate and the US government shutdown late last year have let a lot of air out of the US Economy.  The Dallas Fed’s Richard Fisher has publicly observed that close to 1% of US GDP has been lost over the last 12 months due to fiscal drag, leading to lower bond yields.  In 2013, the federal government spent $986 billion on discretionary programs, all told. That’s scheduled to shrink to $967 billion in 2014 as a result of sequestration under current law.  US monetarists have had it with Washington’s inaction.
4.   Demographics:  The American population is aging rapidly. Each day 10,000 of the 75 million “baby boomers” are retiring and this rate will continue for the next 20 years. This number was near 3,000 in 15 years ago.   With age, this army of investors are becoming savers and are shifting an increasing portion of their investments from equities into Treasuries and corporate bonds. We estimate that US households have increased their holdings to Treasuries and equivalents (savings deposits, life insurance, pension entitlements) by $5T since 2008 and the retirement boom will continue to fuel demand for US Treasuries.

5.   Stalling Global Economy:  While the 4% Q2 US GDP growth appeared promising, the rate of growth was measured over the dismal Q1, in which the economy declined by over 2%. Measured over the same period in 2013, the US economy grew by a mild 2.4% and is expected to grow this year by 1.7%, which is the lowest GDP growth outside of a recessions year since measurements started in 1930.  It’s not just slow growth but how much expectations have come down.  Last month, the IMF cut their Global Growth forecast down to 3.4%, back in January they were calling for 3.7% growth, thanks China.

The underlying causes for the stalling US economy are the stagnating US labor force, which is structurally suppressing the potential growth rate of the US. In the financial markets, the sputtering US economy manifests itself through the oil price, which even fails to rally in the face of serious risks to about 15ml barrels of daily output (Russia, Iraq and Libya).  Equally important, the S&P Retail Index peaked in November of 2013 against the S&P and has underperformed the benchmark index by nearly 10% ever since. The last time this happened was in 2006, one year before the start of the great recession.

2014
Retail XRT -2.8%
Restaurants -2%
S&P 500 SPY + 5.6%

Again, oil should be rallying today, given the serious risk to the global oil infrastructure, but Brent crude, which should have been most sensitive to the geopolitical turmoil, is flat year to date.  Today, it’s the same price it was in March 2008. This speaks to a slowing global economy.

More compelling, is the relationship between the US 2 and 10 year Treasury.  This is an important economic indicator, many pro’s watch the yield difference between the two bonds for clues as to the health and sustainability of the recovery.  The curve steepened over 250bps coming out of the 1990-91 and 2000-2 recessions as long term interest rates rose along with economic activity.  If you have an improving economy, the curve should be steepening.  Russian sanctions, global economic weakness is having an impact as the curve has flattened by more than 65bps this year.
 

Us Treasury 2s – 10s Yield Spread, the Great Flattener

August: 197bps
January 265bps

6.    Regulation: Regulation is forcing the commercial banks in Europe and the US to bolster their holdings of Treasuries.   New rules under Dodd Frank and Basel III require banks to boost their holdings of risk free assets, and banks continue to buy Treasuries. In addition, new money market rules may create as much as $500bl of demand for short term Treasuries away from money market funds.  The Fed’s new reverse repo facility was set up in the wake of Lehman Brothers failure to allow the Fed to have greater oversight of money markets.  The side effect creates an environment where higher levels of quality collateral are now required as participants must use greater levels of US Treasuries in order to stay in the game.

7.  Fannie and Freddie:  As the US housing market has recovered, the Government Sponsored Entities GSEs have become cash cows in recent years, in the last 18 months delivering more than $75 billion to the US Treasury.  All in all, with its previous payments totaling $126.7 billion, Fannie alone has more than fully repaid the $116 billion it received from taxpayers.  During the crisis the GSEs were put into conservatorship.    In 2012, the US Treasury changed the deal terms forcing the bailed-out firms to send all of their profits to Uncle Sam as dividend payments.

One of the reasons the US deficit is plummeting to $460 billion in 2014 (deficits have been $1T+ in recent years) has been the delicious cash surprise from Fannie and Freddie.  It’s like a juicy slush fund the White House and Treasury now hold to either spend or save at their wish.  As the US Treasury takes in cash, this lowers the amount of Treasury bonds which need to be sold in the market.  Once again, a lower supply of new issue treasury securities relative to demand has contributed to lower Treasury yields.

8. Americans Leaving the Work Force: The monthly jobs numbers are distorting the economic reality.  In 2007, there were 79 million people NOT in the US labor force, today we’re approaching 93 million souls left out of the game.  Think of the impact this has on US consumption?  There is a price we pay for this historic, unprecedented drop in the labor force participation rate.  Historically, consumer spending is upwards of 60% of US total economic output or GDP.   The surge of people leaving the labor force has been one of the main drivers explaining why so many on Wall St. are missed GDP targets.    A July survey of over 40 economist now calls for 2014 US GDP growth of just 1.6% (looking at Q4 2014 year end vs. Q4 2013′s).  This represents a sharp drop from Wall St. estimates of 2.2% in June and 2.8% in January, according to the Wall St. Journal.

Dropouts: US Labor Force Participation Rate

2014: 62.8%
2013: 63%
2012: 63.6%
2011: 63.6%
2010: 64%
2009: 64.2%
2008: 65.2%
2007: 66%

Today, the US civilian labor force is 155 million vs 154 million in 2007, but the US population has grown from 301 million in 2007 to 318 million this year.  Net net, that’s 17 million more Americans with NO change in the size of the labor force.  When you swallow that reality, the unemployment rate is practically meaningless.  In developing their interest rate forecasts, it’s like Wall St. is focused on 20th century economic yardsticks in a drastically different post-Lehman world.
9.    Convexity Hedging: Large holders of mortgages and mortgage backed securities need to protect themselves against pre-payment risk.   As rates move lower, mortgage borrowers are inclined to refinance their mortgages and pay back their old loan. This is pre-payment risk and every time rates go down, giant mortgage holders buy substantial amounts of US Treasuries to hedge against borrowers pre-paying their mortgage before its due. Mortgage hedgers need to buy an estimated $40B of extra Treasuries every 25bp 10 year yields drop below 2.5%.
10.    Global Yield Arbitrage:  Talk about an eye opener.  Take a look at the yield spread between the 10 Year US Treasury and the German equivalent.   The Spread is down at a remarkable -130bps for Germany, the biggest such difference in more than 15 years.  In 2007, US Treasuries yielded 60bps less than their Germany equivalent, today they yield 1.3% more (see below).

Some Investors are Buying US Treasuries and Selling European Sovereign Bonds

10 Year Bonds

Italy 2.78%
Spain 2.54%
US 2.38%
German 1.08%
Japan 0.50%

 Japan-ification of Europe

Euro area inflation is falling at the same pace as Japan’s was in the early 1990.  The European Central Bank, led by Mario Draghi may be forced to do more, a lot more to help the Eurozone economy.  One of the reasons for the rising expectations of an ECB quantitative easing QE program is the plunge in Euro area inflation.  A recent Bank of America – Merrill Lynch fund manager poll on possible ECB use of QE is up 38% from less than 25% early last year, more investors think we’re going to see QE out of the ECB.  This has been putting substantial downward pressure on German, France, Spain and Italy bond yields as investors buy bonds, trying to get out in front of ECB bond buying.  This has led to an explosion of US Treasury demand from global investors as US yields look attractive in comparison.   Sure, the US Fed is tapering their bond purchases but the ECB may just be starting theirs, thus US yields are being dragged lower.

German 10 Year Note

2014: 1.08%
2010: 3%
2005: 3.6%
2000: 5.3%
1995: 7.6%
1990: 9.1%

The Fed

On January 1st, the entire street knew the Fed would taper down their monthly Treasury bond purchases in 2014.  This information was fully priced in and explains why the US 10 year yield spike from 1.62% in May, 2013 to 3.02% on January 1st 2014.  What wasn’t priced in was the market’s perception of what the true “terminal rate” would be when the Fed is done raising rates in this cycle.  The terminal rate is defined as the place where the Fed finally stops raising the Fed Funds rate.

In June 2003, the Fed Funds rate was 1% and stayed there until June of 2004.  Seventeen rate hikes later she stood at 5.25% in June 2006.  This was the terminal rate in that rate hike cycle, the Fed stopped there.

Fast forward to January of this year.  Many market participants believed the terminal rate in this hiking cycle would end up being 4%.  The market believed the Fed would start hiking rates in mid 2015 and hike them up to 4% in 2018 or beyond when they were finished.  This assumption was extremely short sighted.

Earlier this year I attended a dinner with former Fed Governor Jeremy Stein.  We spoke about my book and the current risks building up in the financial system.  As I was listening to him, there was one thing that struck me.  He seemed surprised that so many investors in the market believed the ultimate terminal rate in this cycle would end up being 4%.  He thought it would be closer to 3% or below.   There’s no question in my mind, over the last few months the market has started to embrace, price in this 3% terminal rate outlook.  If you run a $5 billion portfolio of US Treasury securities for a big insurance company and you know the terminal rate ends up being 3%, instead of the previously held 4% market view,  your intermediate term risk – reward of owning treasuries just dramatically reduced.  What’s your next move?  You buy more, a lot more US Treasuries.

Many economists on Wall St. look at interest rates and rate hikes with too much emphasis on historical data.  Comparing this rate hiking cycle after the Fed’s $4.3 trillion of bond purchases, to previous ones is a fools game.  For one, the Fed cannot afford to raise rates quickly, they own too many bonds.  If interest rates quickly rise, the value of its holdings may plunge, prompting losses that may jeopardize its annual remittance to the U.S. Treasury.   For example, the central bank turned over a profit of $88.4 billion in 2012.

Buyers of 10-year Treasuries today face a loss of about 2.5% if yields for the notes increase to just 2.8% by year-end.  If rates were to spike to 3.5%, losses greater than 6% would start to inflict pain.  The Fed is sitting at the poker table with most of the chips and a good look at everyone else’s cards.  They’re driving this bus to lower yield land for now.