U.S. Treasury yields are supposed to be rising, instead they are falling.
The next recession will leave the Fed with little room to lower rates which may mean using negative interest rate policy.
The bull market in U.S. Treasuries will continue for some time, as the economic fundamentals for future increases in rates are not there.
Contemplating Negative Rates, and the Design of Monetary Policy, in a Low Yield World: A Bullish Backdrop for the Zero Coupon U.S. Treasury Market
Many contend that interest rates are on a slow and steady path higher. Many banks on Wall Street are forecasting a continued rise in rates, with several increases slated for 2018, but what if these prognosticators were in fact incorrect, and not only is the Fed not going to raise rates any further, but could actually take rates lower, much lower, even negative at some point in the near future? Many would contend that this would drive a market, which is already supported by abnormally low interest rates, even higher, but I believe it is an indication that there are very serious challenges in the economy and talk of negative rates should not be ignored.
Many will tout the recent low employment figures as proof of progress in the employment market, even as proof of the success of quantitative easing. However, they ignore the severely low participation rate that accompanies those figures. Even worse, the U.S. has a very serious shortage of workers to fill a host of different trades' positions from welder, to electrician, to plumbers and so much more. The structural challenges we face must be addressed if we are going to provide the prospect of financial stability to a large cross-section of the population who are seeking employment and opportunity to realize the American dream.
A recent article from Barron's discussed the notion of slow growth and the challenges of producing inflation in such an environment that meets the Feds target of 2%:
Everyone who is anyone among market players says that U.S. Treasury 10-year yields have to go up. Don’t they? After all, the Federal Reserve, which hiked interest rates by 0.25 of a percentage point again on Wednesday to a range of 1% to 1.25%, is working diligently toward that goal. It has even begun talking about slowly selling some of the trillions of dollars in fixed-income assets it bought during the quantitative-easing period. That would normally pressure bond prices. (Bond prices move inversely to yields.) Central banks around the world, including the European Central Bank, are also expected to ease off the stimulus accelerator in the next 12 months, in response to a strengthening global economic expansion. And the banks want rates and Treasury yields to go up, oh so badly, to help net-interest margins and profits. And many of the most important fixed-income institutional investors have publicly said it will be so. Repeatedly. And yet. Treasury yields are stubbornly resisting all of this wishing and hoping. Last week, as if to mock the Fed, 10-year yields actually fell after the rate hike. Indeed, the yield curve—the spread between yields on the three-month bill and the 10-year bond—has begun to flatten, a sign that economic expansion might be slowing. If it inverts, that’s a classic indicator of a recession."
In addition, there is a host of economists who are calling for the Fed to end its 2% targeting of inflation and seek a higher target, enabling the Fed to run negative real rates, as a policy tool. While I am not going to engage in an extensive discussion about the concept of inflation targeting and the 2% figure specifically, I do believe it is important to evaluate the effectiveness of monetary policy, as other countries in the developed world do.
A recent Brookings Paper entitled "Monetary Policy in a Low Interest Rate World" by Michael T. Kiley and John M. Roberts, both of the Federal Reserve, sought to explore the topic of inflation targeting, and more generally how the Fed should design monetary policy in a world that will likely see a protracted period of low interest rates. They state:
"A number of conclusions emerge. First, monetary policy strategies based on traditional simple policy rules lead to poor economic performance when the equilibrium real interest rate is low, with economic activity and inflation more volatile and systematically falling short of desirable levels. Moreover, the frequency and length of (Effective Lower Bound) ELB episodes under such policy approaches is estimated to be significantly higher than in previous studies. Second, a risk adjustment to a simple rule in which monetary policymakers are more accommodative, on average, than prescribed by the rule ensures that inflation averages its 2 percent objective – and requires that policymakers systematically seek inflation near 3 percent when the ELB is not binding. Third, commitment strategies in which monetary accommodation is not removed until either inflation or economic activity overshoot their long-run objectives are very effective in both the (dynamic-stochastic-general-equilibrium)DSGE and FRB/US model. Finally, raising the inflation target above 2 percent can mitigate the deterioration in economic performance; the desirability of such an approach ultimately hinges on the economic costs of inflation averaging more than 2 percent and assessments of the feasibility of commitment strategies."
For those interested in market history, low rates can persist for some time. After the Great Depression we saw interest rates stay low from the 1930s well into the 1960s. During this period, dividend yields were meaningfully above the risk-free rate of a U.S. Treasury security much like they are today.
However, there is a great deal that is different in this period, from the risks we face to the structural challenges in the design of our economy, labor force and trade agreements, and most notably the vast levels of indebtedness that plague both governments and households around the world. This creates significant concern that in the next crisis the Fed will be forced into using negative interest rates as a policy tool.
A recent Bloomberg article entitled "With Next Recession Looming, Central Banks Better Make Peace With Negative Rates" discusses the need for central bankers to prepare themselves for the use of negative rates in the next crisis. This is largely due to the fact that economic fundamentals have not allowed central bankers to meaningfully raise rates.
"In a new paper published in the Journal of Economic Perspectives, Harvard professor Kenneth Rogoff makes a case for negative rates, exhorting policy makers to develop the market infrastructure now for their widespread adoption before the next downturn strikes.
It makes sense not to wait until the next financial crisis to develop plans and, in any event, it is time for economists to stop pretending that implementing effective negative rates is as difficult today as it seemed in Keynes’s time," he writes.
The low interest rates this late in an economic cycle is without precedent. Rogoff notes the Federal Reserve cut borrowing costs by an average of 5.5 percentage points in the nine recessions since the mid-1950s -- an impossibility today without negative rates."
The fact that we are even having this discussion about negative rates should be concerning to investors, most of whom, are largely overexposed to equities.
Could Negative Yields Lie Ahead?
Current Treasury yields indicate the real economy is undergoing structural difficulties. In the United States, we have the baby boomers entering a period of reduced spending in retirement. While this is great for the healthcare sector, which I continue to believe offers some of the best opportunities in equities, it is not great for earnings of corporate America, and thus the prices of stocks in the market as a whole.
When we look around the world, government bond yields are severely depressed, and in many cases negative. Switzerland is a very reputable country, and yet its 30-year bond yields just 0.33%, its 10-year bond -0.13%, and its 1-year Bond -0.76%.
This negative rate phenomenon is felt throughout the world where a host of countries are now issuing debt at a negative interest yield. While most investors would contend that this supports their overexposure to equity securities, I believe it demonstrates the immense opportunity offered to investors in long-term zero coupon U.S. Treasury securities, which still sit at relative high yields today. To couple the opportunity for capital appreciation with the security offered by the U.S. Treasury bond when held to maturity, is a combination not offered by equity securities. I believe it is only a matter of time that the Federal Reserve joins other central banks around the world in taking rates negative. While long-term rates generally respond to inflation, there is certainly room for the Fed to take short-term yields - which are controlled by central bankers - negative as a way of fighting deflationary forces, and the lack of demand that will likely be with us for some time.
Negative interest rates are a concept not often understood even by professional money managers. Negative interest rate policy is generally thought of as an extreme in unconventional monetary policy, generally employed during a period of deflation to stimulate aggregate demand. The U.S. has for some time been engaged in unconventional monetary policy to boost aggregate demand following the 2008 financial crisis, though not through negative rates, at least not yet.
The Fed thought that moving interest rates to the zero lower bound would stimulate activity, and get people spending again. While some would contend the policy worked, unemployment is at an all-time low, and the stock market has gone through the roof, reality dictates that all the Federal Reserve has done is paper over the issues at hand that caused the financial crisis in the first place.
Instead of having a period of deleveraging, we are more in debt now than we were during the financial crisis, both as a country and as households, around the world (see my last piece where I explore aggregate debt burdens globally and the negative effect of debt on GDP growth and consumption.)
Velocity on M2 reserves is a statistic I cite a great deal, and the reason I cite it is that it is the ultimate indicator of whether the economy is really back to "normal" or whether the economic activity we are seeing is just noise. I would contend a great deal of the activity we have been seeing over the past eight years is just noise. The country has very low productivity, and instead of taking advantage of ultra low interest rates to invest in the future, companies have misused credit to fund stock buyback and dividend programs.
There is very little investment in property, plant, and equipment. Companies are hoarding cash, and using ultra low interest rate debt to play a game of financial engineering to get their stock prices up. This indicates to me that they see a time in the future where their cash will be worth more, and this is deflationary.
Currently, velocity on M2 reserves are sitting at a low not seen since 1949, and even worse, it is continuing to fall. Even worse than that, this is not simply a U.S. phenomena, it is a problem on a global basis where there is very little velocity, even while we are swimming in a lake of liquidity brought upon us by central bankers who have incorrectly diagnosed the problem as supply of credit, rather than demand for credit.
Demand is the issue here, and the fundamental reality that central bankers need to understand is that everyone is trying to sell goods and services to people who really do not want to buy them, except for the use of the cheap money being offered by the banking system. We are seeing the same thing across the commodities complex and particularly in energy prices. There is an oversupply of oil which has brought the prices down substantially; I believe this is also deflationary and I laid out my case some time ago in my piece Don't Ignore the Weakness in Commodities.
A recent study by BlackRock found that insurers were taking more risk than they were in 2008 in order to make up for losses they incurred in 2008. Insurance company collateral is supposed to be there to pay claims and is generally invested in plain vanilla bonds. A recent Bloomberg article profiled this study. They found:
"The world’s largest money manager mined regulatory filings of more than 500 insurance companies and modeled their portfolios in a similar downturn. The stockpiles -- underpinning obligations to policyholders across the nation -- would drop by 11 percent on average across more than 260 property and casualty insurers in that group, according to its calculations. That’s significantly steeper, BlackRock estimates, than their “mark-to-market” losses during the depths of the crisis.
The reason is pretty simple. Insurers needed to make up shortfalls after the crisis. But in a decade of low interest rates they had to venture beyond their traditional holdings of vanilla bonds. They now own vast amounts of stocks, high-yield debt and a variety of alternative assets -- a bucket that can include hard-to-sell stakes in private equity investments, hedge funds and real estate."
T.I.N.A., and the 20-year Failure of the Equity Risk Premium
Stocks have been flying through the roof as Wall Street preaches a mantra of there is no alternative (TINA) to stocks amidst ultra low yields from bonds. I believe we have entered a phase of euphoria, that is quite different than others in the past, in that it has been characterized by this shunning of bonds and embracing of equities, and specifically the fund flows have been into stock indexes. These passive investment vehicles are a self-fulfilling prophecy for higher and higher equity prices, particularly among high-flying technology issues, which trade at astronomical valuations.
This week's Barron's has a story entitled "How This Bull Market Will End." In it they describe the various changes in the market, from high frequency trading to the vast inflows into ETFs and passive indexes. They caution that a market decline may be more swift than in the past due to the fact that everyone is owning the same stocks as a result of the rise in passive indexing.
"The market works differently than it did even 10 years ago, with exchange-traded funds now playing a far more dominant role. Some $2.4 trillion sits in equity ETFs, up from $534 billion at the end of 2007. These funds now account for more than 20% of equity assets under management, according to Morningstar.
Why does this matter? Imagine that there’s a selloff, and investors move to lighten their stock positions. If they have different portfolios of individual stocks, they’ll pick and choose among them, spreading out the selling, says Michael Shaoul, CEO of Marketfield Asset Management. But if they all own the same ETFs, everyone selling will be dumping the same stocks at the same time, exerting enormous downward pressure on their prices. “A bear market dominated by passive investing will be more volatile,” Shaoul warns.
But that might be the least of our problems. Trading is now dominated by machines, as algorithms battle other algorithms for shares of stocks. And even stock-pickers are using quantitative tools to help boost performance, a fact driven home by BlackRock's decision in March to make some of its active funds more programmatic. But machines make mistakes, just as humans do. Remember, it was the rise of portfolio insurance—a fairly simple system designed to protect against losses that involved quickly selling into market downdrafts—that turned what could have been a run-of-the-mill selloff on Oct. 19, 1987 into Black Monday."
Investors have wrongly drawn the conclusion for some time that stocks are safer than bonds, given that we are entering a rising rate environment, and the Fed continues to backstop the equity market. This set of policies has driven volatility to extreme lows, as the market has moved up in a straight line. This is further evidence that the risks of the music stopping in this game of musical chairs is getting extreme, and investors are taking a greater and greater risk per unit of expected return at these lofty valuation levels.
The 20-Year Equity Risk Premium Is Negative
We have been told from academic research that owning equity indexes provides a higher return. But when we test the results in real portfolios, equities have been a poor asset class to dominate one's investment portfolio over the past 20 years. I am not in any way suggesting individuals should not own equities - global equities represent an important part of a portfolio - but let's look at the facts.
For the last twenty years, U.S. equity indexes have proven to be a poor investment compared to long-term zeroes, and yet money continues to flow into these passive vehicles at an unprecedented rate. When valuation does not matter and record inflows to passive products abound, risk assets have been pushed to levels unseen, yet the Long-Term Zero Coupon U.S. Treasury continues to provide meaningful outperformance over two decades.
|The Equity Risk Premium is Negative||08/31/1997-08/31/2017|
|S&P 500 Index||290%|
|Long Term Zero Coupon U.S. Treasury Securities||428%|
Current economic fundamentals coupled with growing equity valuations, are creating a subdued market environment for future return expectations, at least according to fundamentals. Markets are known to run far past where they "should" and I am not a market timer so there is nothing to say markets cannot continue running higher for an extended period; but the further they rise at this point, the more severe the eventual drop down to earth will be.
U.S. Treasury bonds and cash continue to dominate our portfolio, as most risk assets look too expensive at these levels to model any sort of reasonable risk and return scenario. The risk/return trade-off is simply too asymmetrical to the downside for the market as a whole. I do believe value continues to exist in the healthcare space, which I believe can continue to benefit from an aging baby boomer population for some time. In addition, there are other pockets of the market where I continue to see opportunity for long and short positioning.
Given the current economic environment, the lack of velocity and subsequent levels of inflation, I continue to believe that long-term zero coupon U.S. Treasury securities offer investors a very compelling asset in a world of overvaluation, that will also benefit if we do see a significant selloff in risk assets.
Currently, risk assets make up only 35% of our total holdings. As Warren Buffett says, you don't have to swing at every pitch, and for now, I prefer to wait for true value to present itself rather than swinging at pitches far outside the strike zone. In the meantime, I believe there is tremendous value in holding cash, as well as in the U.S. Treasury market, where I expect rates to collapse much further towards 1% or below on the 10-year Treasury, and 2% or lower on the 30-year Treasury.
Disclosure: I am/we are long ZERO COUPON U.S. TREASURY BONDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.