Why U.S. Treasury Yields Are At All-Time Lows

| About: The United (USO)

With the U.S. stock market at all-time highs, did anyone stop and ask why the 10-year Treasury note yield would make an all-time low on a day when the employment report surprised strongly to the upside? Typically, a strong jobs report has been taken as an excuse for the Federal Reserve to ratchet up rate hike talk; but by now most market participants have assumed, correctly, that no rate hikes are coming in 2016.

It is peculiar to note that the December 2016 fed fund futures (ZQZ16) traded to a fresh contract high on June 24th (the day after the Brexit vote) for a short time calling for a rate cut. Since that date, they have settled down but still indicate no probability of a fed funds rate hike by December 2016. As a reminder, fed fund futures predict the fed fund rate at the time of settlement of the contract, so a price of 99.59 as of Friday's close translates to a fed fund rate forecast of 0.41% (100 less 99.59). The present fed funds target is 0.5%.

Thirty Day Fed Funds - Daily OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Clearly, external factors are to blame for the dramatic decline in Treasury yields. Deflationary dynamics in Europe and Asia are causing high demand for Treasury notes at a time when nearly $12 trillion in government debt globally carries negative yields. Collapsing European interest rates are also causing quite a headache for European financials as their net interest margins are disappearing. This has caused an interesting dynamic where the falling U.S. 10-year Treasury yield now strongly correlates with the share price of a large European financial firm, Deutsche Bank (NYSE:DB) (see my June 24, 2016 Marketwatch article, "A look at the global economic malaise through Deutsche Bank"). (Please note: Ivan Martchev does not currently own a position in DB. Navellier & Associates, Inc. does not currently own a position in DB for any client portfolios.)

Deutsche Bank Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

With Brexit and its expected effects on European deflationary dynamics, Deutsche Bank shares trade for $0.23 per dollar of book value, a valuation below the 2008 Great Fiscal Crisis low and indicative of a serious problem not only with Deutsche Bank, but with the European financial system in general. Other large European financials are in the same dire situation, not to mention the Italian banking system, which is nearly insolvent.

We seem to be nearing some sort of European banking crisis, catalyzed by the now infamous Brexit vote. There are reports of multiple property funds in the UK halting redemptions and taking large NAV haircuts in order to discourage withdrawals. The logic of marking down net asset values by 15% to 20% as a tool to discourage investors from pulling out money is a bit difficult to understand, but it comes from investors fearing losses. Now that they have the NAV haircut imposed, this is somehow going to make them stay?

The U.S. banking system is in relatively good shape to weather any European financial storm. While large-cap banks have generally underperformed the S&P 500 and are performing as one would expect in a flattening yield curve environment, on a relative basis they are trading at lows last seen in the Eurozone crisis. That is evident in a chart comparing the large-cap KBW Bank Index (BKX) and the S&P 500 (SPX).

KBW Bank Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Omitting the banks' sharp decline in 2007-2008, what is happening at present is actually "normal" in an environment where the 2-year note yield has gone up while the 10-year note yield has fallen dramatically. This causes a popular measure of the U.S. yield curve - the 2/10 spread - to shrink notably (see below).

Ten Year Treasury Constant Maturity Minus Two Year Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I think that as long we have yield curve flattening in the U.S., the U.S. banking sector should continue to trade at a discount to the rest of the market and lag overall, simply because banking profitability in a flattening yield curve environment tends to be under pressure. If the 10-year Treasury note yield is indeed headed to 1% or lower, the 2/10 spread is only going to shrink from its present depressed levels.

Watch Out for Oil - and the Ruble

My suspicion that the seasonal high in the oil market may arrive earlier than usual, simply because the seasonal bottom in February was also rather early, seems to be playing out. (See June 21, 2016 Navellier Marketmail: "Was $52 the Seasonal Top in Oil?") In the three weeks since I wrote that column, there has been a rather peculiar selling into strength in the front-month August 2016 crude oil futures (CLQ16).

West Texas Intermediate Crude Oil - Daily OHLC Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This CLQ16 contract has only been as low as $32 in January of this year, but the front-month futures at the time made it as low as $26. I think come January or February of 2017, we may very well be below $26 on what would be the front-month futures then. U.S. oil production has not declined meaningfully and the rig count has begun to rise again to take advantage of the price rebound since February.

Last year, crude oil was flattish throughout May and June and began a rather steep sell-off in July. I don't want to go blindly just by dates, but there have been no fundamental improvements in the crude oil market to warrant a new bull market in crude oil. I have viewed this rebound off the February lows as a seasonal cycle all along and am watching with great interest how July trading in crude oil will unfold.

Russian Ruble Versus Brent Crude Oil Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The situation in the crude oil market raises an interesting question for the Russian ruble or "рубль" as the Russians call it. Crude oil has begun to weaken but the ruble has not. The correlation of weak oil and a weak ruble - the USDRUB rate is inverted so more rubles per USD mean weaker ruble - has to be one of the more reliable indicators in today's markets. I think that the ruble will begin to follow the crude oil price lower very shortly, if a July decline this year resembles what happened last year.

There is also a very strong correlation between oil prices and emerging market stock prices as represented by the MSCI Emerging Markets Index (dark line, below). The year-to-date returns on the MSCI Emerging Markets Index look rather good when viewed from a short-term perspective.

Light Crude Oil - Continuous Contract Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Buyers of crude oil and/or the MSCI Emerging Markets Index at these levels must believe that both the imbalance in the crude oil markets is fixed and/or that China will not have a hard landing.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

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