Our mission at MRP is to identify investment themes that arise from disruption. The latter term seems to have become synonymous with technological innovation. But, disruptive change can be caused by more than just technological innovations. Indeed, disruptive change can be brought on by business-cycle turning points, government regulations, elections, new business models, and natural events. The changes can arise gradually as tipping points or suddenly when gales of Schumpeterian creative destruction rip through economies. There are several such changes on the horizon that have bearish implications for the fixed-income markets. Looking ahead, bond returns are likely to be, at best, very disappointing.
First, a look at where interest rates are now relative to past norms. There can be little doubt that interest rates are extremely low by historical standards. In absolute terms, today’s rates of 2.42% on the 10-year treasury are very low compared to their average level over the past half century: since 1967, the average yield on the 10-year was 6.45% and the median was 6.28%.
But, interest rates are influenced, of course, by the macroeconomic environment. Indeed, over the years, rates have tended to track quite well against the trend of nominal GDP growth. It makes sense theoretically and it is well documented empirically. There have been, however, numerous episodes in which rates diverged from the GDP growth rate for a sustained period. Back in the 1970s, for example, investors were not pricing in an acceleration of inflation even though it was in fact showing up in much of the data. For several years, interest rates tracked below the trend of GDP growth, which itself was rising strongly above the earlier trend due primarily to rising inflation.
The opposite happened in the 1980s and 90s. After the inflation rate peaked in March,1980, nominal growth rates fell more rapidly than bond yields; as a result, investors enjoyed higher than average “real yields” for 14 out of 16 quarters between 1982 and 1985.
Today, a confluence of disruptions are converging that could push rates back towards the trend rate of nominal GDP growth.
1. Balance Sheet Shrinkage
Currently, bond yields, even after rising over 100 basis points from their July, 2016 trough, are still more than one standard deviation lower than their past relationship with the nominal GDP growth trend would suggest. Most observers would attribute that fact to the unprecedented impact of quantitative easing distorting pricing in the fixed income markets, although there have been other factors at work. The four episodes of QE in which the Federal Reserve bought various government and other bonds, paying for them by printing new currency and expanding bank reserves, resulted in a more than four-fold rise in the Fed’s balance sheet.In other words, new high-powered money created out of thin air appears to have been the primary force holding down yields from their natural level. Thus, the current plans by the Fed to begin shrinking its balance sheet, albeit gradually, could mark a major turning point.
Although it has been widely telegraphed, the balance sheet unwinding is still a major experiment. The Fed will not proceed aggressively, choosing to allow assets to mature instead of selling them outright. Nonetheless, the impact will be enormous: $1.4 trillion of the $2.5 trillion in treasuries have maturities of less than 5 years. This path should reduce total assets to less than $3 trillion by 2020 from $4.5 trillion today. Meanwhile, the yield on the US 10-year Treasury recently touched its highest level since March. Around the world, such as in China where 10-year yields came close to 4% for the first time since 2014, bond yields still seem to be building momentum on the back of signs of a sustained surge in growth and inflation.
2. Rising Short Term Rates
Another Fed-related factor that has kept long-term rates down has been the near-zero Fed Funds rate maintained for so many years after 2008 and the very dovish path, so far, on the return to normal. Since 1971, once a tightening cycle commences, the Fed has raised rates 6 times on average during the first two years. The current cycle is below average, with only 4 hikes since it began in December 2015. Moreover, those four hikes have only brought FF back to 1.25%, compared with an average level of 5.4% over the past 50 years and a median of 5.3%!
The Fed is now widely expected to hike short-term interest rates for the fifth time in this cycle next month. In the futures market, the probability assigned to a 0.25% hike in December has now hit 90%. That boost, according to the Fed’s “dot plot”, is expected to be followed by 3 more hikes in 2018 and 2 more the following year. It remains to be seen, however, once this highly-anticipated December rate hike is done, where the Fed will be relative to its dual mandate. Unemployment is sliding towards 4%. Inflation, on the other hand, is just 2% YoY as measured by the CPI, while the Fed’s stated goal is also 2%. But, the Fed’s preferred measure of inflation – the Personal Consumption Expenditure deflator ex-food & energy – remains at 1.4%.
Nonetheless, some experts are concerned that the Fed will delay yet again, because of lingering trepidations about the fragility of the economy and ingrained fears of deflation. It is easy to have such qualms given the abundance of anecdotal reports and data cited day after day of downward pressure on prices. Indeed, the futures market still does NOT believe that the central bank will stick with its projections. While the Fed has projected 5 more hikes after December, which would bring the FF rate to 2.75% by 2019, futures traders are assuming only 1 additional hike to a target rate of just 1.75%.
In such an environment, evidence that inflation is about to erupt, leaving the Fed way behind the curve, is often given little media attention. Reporting on the Small Business Optimism index, to the extent that got attention at all, was mostly about the 1.3 point decline in the headline index. In reality, the index has surged in the past few months and is matching pre-crisis levels. Over the past decade, this index has shown a pretty consistent relationship with the Core CPI. If that relationship holds in the year ahead, as the CPI has already begun rebounding in September and October, the narrative about where the fed stands on its inflation mandate could change rapidly.
3. A Changing of the Guard
A third potentially disruptive change is the departure of dovish chair Janet Yellen. Much depends on how new leadership at the Fed will react to economic data. On November 2nd, President Trump chose Fed Governor Jerome Powell to succeed Janet Yellen in January. The conventional wisdom is that this appointment will be “more of the same”, judging by Powell’s voting record that closely resembles Yellen’s; but, that may not be the case. Powell took office as a Fed Governor in 2012. Since that time, the vast majority of Fed members agreed that interest rates should remain low given anemic economic growth and low inflation. However, that landscape is changing rapidly with accelerating economic growth in the midst of a rate hike cycle. If President Trump wanted more of the same, he could have just nominated Janet Yellen for another term. Trump has said he likes low interest rates and has bragged about the trillions in stock market gains since he took office.
Some had argued that it was likely Trump would pick a Chair who is more on the dovish side to keep these going, and Powell is similar to Yellen in that respect. But, when it comes to regulation, they diverge. Yellen stood by the reforms made since the 2008 financial crisis while Powell, the central bank’s only republican for years prior to Trump’s recent appointment of Randall Quarles, has said he favors reviewing regulatory changes. Not only will there be a new chair of the Fed, but now Janet Yellen has decided to leave the Fed Board entirely once Powell takes over; she could have stayed on as a governor until 2024. With her departure, Trump will have appointed 5 new Governors to the 7-member board when all is said and done.
There is another big unknown: it is unclear how Powell and the new appointees will react if the economy picks up and inflation begins to rise. Just over a year ago, in October 2016, the Chairwoman suggested that perhaps it would be beneficial to let the economy “run hot”. In other words, the Fed might remain dovish even if higher economic growth stimulated inflation above the fed’s target. But, would Powell stay dovish under those circumstances? Moreover, FOMC minutes from the September meeting revealed that many officials at the central bank believe the stock market is too expensive: “In light of elevated asset valuations and low financial market volatility, several participants expressed concerns about a potential buildup of financial imbalances,” the minutes said. “They worried that a sharp reversal in asset prices could have damaging effects on the economy.” If members continue to feel that stocks are running too hot, Powell’s Fed may adopt a more hawkish stance to stifle a growing equity bubble.
4. Global Growth Picks Up
Lastly, while the US is trying to stimulate its economy in the eighth year of an expansion, global growth has already been picking up, which usually means higher bond yields. The US’ 2017 growth projection was recently revised upward by 0.1% to 2.2% for the year, according to the IMF, up 36% from 2016’s 1.6%. They projected US growth in 2018 to increase to 2.3%. These projections may be relatively conservative, though, since the US has already seen surprise QoQ growth of more than 3% in two consecutive quarters.
Economies around the world have also been looking stronger than in recent years. The IMF has forecast global GDP growth to be 3.6% this year and 3.7% in 2018, the highest level since 2010. This year’s growth is largely being driven by emerging market economies that are projected to expand 4.6%. Many commodities are surging, oil prices are climbing as we head into the heaviest travel season of the year, and global capex is ticking up. Accelerating growth both at home and abroad will put further upward pressure on interest rates. Almost every major nation has seen their 10 year bond yields increase since July.
Each of these four large disruptions could push historically low bond yields upwards from their below-normal levels. The balance sheet shrinkage is unprecedented and clearly represents the removal of a powerful force that has helped to prop up bond prices. A rising interest rate cycle has not occurred in a very long time. The behavior of the Fed in a “heating up” economy could be very different from market expectations. And, global growth is already pushing up rates around the world. All things considered, we believe bond yields may soon start moving in the direction of the US’ nominal growth rate, which itself may be about to accelerate. If the administration hits its real GDP growth goals and the Fed were to hit its inflation target, nominal GDP growth of 5-7% would, in time, suggest a more than doubling in the level of the 10-year yield.
Longer-term bonds perform poorly in rising interest rate environments, which is why MRP is reiterating its recommendation to be short long-dated U.S. treasuries. The ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA: TBT) is one way investors can gain leveraged inverse exposure to U.S. treasuries with a remaining maturity of at least 20 years. I personally hold a position in the TBT.
As noted in previous reports, the markets and the Fed have been growing more and more disconnected. The disconnect could lead to a shock for traders who have grown used to the central bank continually capitulating and resetting its trajectory for interest rate normalization. But, as the economic data bounces back from the storm-depressed third quarter and inflation continues to move higher, the Fed is likely to reaffirm plans to continue raising rates, changing further the discount rate used in the present value equation. That could ultimately be the catalyst for the correction that triggers a mean reversion of P/Es and a stormy equity market environment in the year ahead.