Since 2008, the Federal Reserve has kept short-term interest rates near zero and suppressed longer-term Treasury yields via its bond-buying QE programs. As most interest rates are benchmarked off of Treasury yields, these policies kept borrowing costs low for all. Over this period, corporate sector debt grew by 30%, and government debt ballooned 109%, such that total U.S. non-financial debt outstanding now amounts to $46.3 trillion, according to the Federal Reserve. This massive debt means that even a moderate increase in interest rates will increase borrowing costs substantially.
Bond prices began to fall after peaking in mid July. Yields, which are inverse to prices, have rebounded: for example, the 10-year Treasury yield rose from the bottom of 1.37% to 1.79% currently, a 19 basis-point rise so far in October - a substantial move in the current environment of ultra-low rates. While the iShares U.S. Aggregate Bond ETF (NYSEARCA:AGG), Vanguard Total bond Market ETF (NYSEARCA:BND), and iShares 7-10y Treasury ETF (NYSEARCA:IEF) are up by about 4.5% in the past 12 months (see chart), they are down between 0.3% and 1.7% since June 30th.
Bond Total Returns, 12 Months
Most observers attribute the rise in rates to the Fed's expected interest rate hike this year. This is only part of the reason, in my view - the Fed directly sets only the short-term rate (known as the fed funds target rate). Unlike the ECB and the BoJ, the Fed is no longer buying bonds (other than reinvesting interest), so longer-term Treasury yields are, to some extent, set by the market. I describe below two market forces that are contributing to this trend: inflation and currency market.
As I wrote previously here and here, inflation pressures are rising this year - in fact, core CPI inflation, excluding food and energy, currently stands at 2.3%. In contrast to earlier market consensus of continued deflation, an expectation of gradual rise in inflation is slowly becoming commonly accepted by investors. The rationale remains unchanged since my last post, with one important new development. Oil price jumped from mid $40s to above $50 per barrel (see chart) on the heels of the agreement by OPEC and Russia to cooperate in capping or lowering production. It's also important that year-ago prices were falling, so the "base effect" will strengthen in the coming months and will likely push total inflation (currently 1.06%) up toward core inflation (2.3%).
Inflation and Oil Price, 1 Year
How FX Affects Treasuries
Interest rates, in theory, drive capital to higher-yielding currencies. In turn, FX markets also affect bond markets in this interconnected world. This increasingly happened in 2016: large moves in the Chinese yuan, the Japanese yen, and the British pound after Brexit required central banks to intervene, which is beginning to have an effect on U.S. Treasury yields - here's how.
Japan and China are very large exporters, so their economies benefit tremendously from depreciating their currencies. Prime minister Shinzo Abe's bid to revive Japan's economy hinged primarily on depreciating the yen, as we now know: "Abenomics-1" in 2012 and "Abenomics-2" in 2014 can be clearly seen on the chart above (the yellow line rising means falling yen). However, it backfired in 2016: market forces sent the yen rallying to around 100 Y/$. The BoJ had to intervene to try to depreciate the yen by selling the yen against dollars. Note that when a central bank buys or sells "dollars" it typically buys or sells USD-denominated securities - mostly U.S. Treasuries. After the yen approached the 100 Y/$ level, the BoJ was able to push it beyond 103 most recently.
The situation is largely the opposite with the Chinese yuan: as much as the yen "naturally" (without central bank intervention) rose in 2016, the yuan has been naturally falling since 2014. If China let the yuan fall too quickly, it would risk to be labeled a currency manipulator (China is already on the Treasury's "unfair FX practices" list). The People's Bank of China, then, had to buy the yuan and sell dollars (i.e., Treasuries) in order to prevent the yuan from falling too quickly. In the past two years, the yuan has fallen just under 5% per annum - the PBoC probably figured that 5% is what it can get away with.
China and Japan are massive holders of Treasury securities, with about $1.2 trillion each in July 2016, according to the U.S. Treasury. The distant third is Ireland (likely custody for some foreign accounts) with $270 billion.
Source: U.S. Department of the Treasury
You can clearly see these trends of changing Treasury holdings on the above chart (data available only through July 2016). China's Treasury holdings have been gradually declining in the past three years and fell sharply in July 2016. This accelerated decline in July may have been due to another reason which I will only mention briefly today: China's long-coveted admission of the yuan to the IMF's list of reserve currencies which just came into effect on September 30th. The PBoC may have begun to diversify its currency holdings into the yuan from USD and other currencies in July in anticipation of this being finalized in September. Just as FX-based selling, this also puts downward pressure on Treasuries (upward pressure on yields) and may quicken the trend substantially - we have to see if the U.S. Treasury's data confirms this in the coming months - stay tuned.
After falling in 2014-15, Japan's Treasury holdings rose this year (the yellow line), which offset China's selling. But as the yen falls back from the 100 Y/$ level, the BoJ steps away from the FX market, and China's selling, as well as the UK's selling to defend the plunging sterling, go in the same direction: selling of U.S. Treasuries. This is what happened so far in October.
Rising inflation and FX market trends combined forces since July to drive longer-term U.S. bond prices down and yields up. These market forces added to the expectation of the Fed raising the funds rate this year will likely continue downward pressure on bond prices. In the short term, my sense is that 1.80% on the 10-year Treasury is critical level to watch - if it doesn't hold, then it may jump to 2% quickly (which is Goldman's prediction at year-end). This would mean an additional 1.5% to 2% loss for 10-year bonds. This is probably the baseline, most likely scenario.
In addition, if the PBoC diversifies its massive reserves from dollars to yuan as a result on its new reserve status, the selling may accelerate. It may also accelerate simply if some large investors want to get out, creating a self-reinforcing trend. This is the really bad scenario.
Some of our ETF-based suggestions to active (meaning not buy-and-hold) bond investors include:
- Avoid long-term (such as TLT), and 10-year Treasuries
- Minimize 10y corporates (NYSEARCA:LQD) and aggregate bonds (AGG, BND)
- Reduce mid-term bonds
Some bond market segments we like in this environment:
- We consider floating-rate notes (FLOT, FLRN) to be especially attractive due to recent rise in US Libor rate, and no exposure to rising rates - I may write on this in more detail, please stay tuned.
- Moderately-positive on short-term, 2-3 year corporate bonds (SCPB, VCSH) - due to their low (but still non-zero) exposure to rising rates.
Disclosure: I am/we are long FLOT, FLRN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Roman Chuyan is the president and general partner of Model Capital Management LLC, a Registered Investment Adviser. This article is for informational purposes only. There are risks involved in investing, including loss of principal. Roman Chuyan makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Model Capital Management LLC. There is no guarantee that the goals of the strategies discussed in this article will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any security.