Assessing The Impact Of Safe-Haven Treasury Flows

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by: Michael Roat

Summary

Federal debt to GDP and deficit/GDP measures are high by historical standards.

The path of monetary policy and short-end rates has been primary to the treasury market and contributed to the rise in yields more than inflationary expectations.

Higher U.S. government debt and deficit ratios, tighter Federal Reserve policy, a strong underlying U.S. economy and potential increased U.S. political risk should support treasury yields.

Risk-on versus risk-off has been a factor in the treasuries market recently - the question is how important is it to treasury prices? I will breakdown nominal ten-year yields into two components to find out. Bond prices have short-term rallied (10Y yields fell from 3.11% down to 2.86%) on global risk concerns and the questionable sustainability of the global reflation and synchronized global growth themes. There are a variety of factors at play in determining treasury prices and one shouldn't overestimate the idea of a safe-haven demand necessarily leading to higher treasury prices. I will also add - nor does declining inflation expectations lead necessarily to lower yields. Monetary policy, short end rates, economic growth and fiscal credibility also contribute. Investors can look back to 2013, where inflation expectations fell, but yields still rose.

The Federal Reserve is tightening policy and the nominal 10Y yield has risen from a local minimum of 1.36% in July 2016 to 2.86% currently or 150 basis points. Breakeven inflation expectation rates have risen from 1.41% to 2.11% currently or 70 basis points over the same time period. This means the other 80 basis points in the total 150 basis point rise in nominal ten-year yields were attributable to other factors such as monetary policy, economic data and short-end rates. That is a majority meaning treasury yields will likely not automatically follow inflation expectations. The outlook for 10Y treasury prices is neutral to bearish in my view even in a scenario of declining inflation expectations as long as monetary policy stays on a tightening trajectory and the U.S. economy performs. The Federal Reserve balance sheet reduction strategy also known as quantitative tightening is gaining momentum as the wind-down in MBS and treasury securities is increasing each quarter. The median Federal Reserve dot-plot interest rate projection shows an expected two more increases this year.

As for politics, I believe U.S. political risk is fairly elevated right now. The U.S. president is claiming the FBI interfered with and infiltrated his campaign. House republicans are threatening to hold Rod Rosenstein of the Department of Justice in contempt of congress. Without going too far into the Trump/Russia investigation, the republican controlled house of representatives has asked, the FBI and Department of Justice to hand over information proving there wasn't a politically biased campaign within the FBI to stop Trump.

To the unbiased observer it may seem there was. For example, the lead agent on the Trump-Russia and Clinton e-mail investigation, Peter Strozk, had exchanged texts with another FBI agent saying they would "stop" Trump and that there needed to be an "insurance policy" against a Trump presidency. Also according to James Comey the Trump-Russia investigation began in July 2016. Michael Caputo and Roger Stone (Trump campaign associates) testified they met a Russian man named Henry Greenberg who offered dirt on Hilary Clinton. This was in May 2016. Only recently has it been discovered that so called Henry Greenberg actually has a 17-year career as an FBI informant.

If Caputo and Stone are right in the sense they encountered a sting operation and FBI informant, the next question could be why was the FBI using informants before the investigation actually began? Some believe there was a high-level movement to prevent a Trump victory or have an impeachment "insurance policy" through creating a Trump/Russia collusion narrative. It is fact, that Russia tried to influence the election and this has been proven by Robert Mueller. The Trump campaign's knowingness and participation are the subject of the ongoing investigation in my view. When you have though, Peter Strozk, a clearly politically biased person opening and running the initial investigation prior to the special counsel, it is a little suspicious, in my opinion.

To get a sense of the significance of the political strife between the U.S. congress and the Department of Justice I would recommend watching the latest House Judiciary Committee meeting with Rod Rosenstein. House republican, Jim Jordan, directly asks the Deputy Attorney General of The United States, "Why he's hiding information from congress?" and says he has "seven days to get his act together". The House recently passed a resolution demanding more documents from the Department of Justice. If the DoJ doesn't comply, increased political uncertainty is on the table for the United States. I'm of the opinion, the Trump/Russia investigation and the House Intelligence Committee's investigation led by Devin Nunes into the Department of Justice will not simply blow over smoothly. I believe it is actually reaching a boiling point.

Leaving politics aside, the fiscal situation of the United States bears close watching. According to the Congressional Budget Office:

As a result, federal debt is projected to be on a steadily rising trajectory throughout the coming decade. Debt held by the public, which has doubled in the past 10 years as a percentage of gross domestic product (NYSEMKT:GDP), approaches 100 percent of GDP by 2028 in CBO’s projections. That amount is far greater than the debt in any year since just after World War II.

Also according to the CBO:

In CBO’s projections, budget deficits continue increasing after 2018, rising from 4.2 percent of GDP this year to 5.1 percent in 2022 (adjusted to exclude the shifts in timing). That percentage has been exceeded in only five years since 1946; four of those years followed the deep 2007–2009 recession.

Next I'd like to say, I am not one to advocate the United State's government is going to go bankrupt and actually I firmly disagree with that viewpoint. In my model, I view the government as distinctly different than a business or a household. The main reason is, the economic goal of a government is not to profit maximize, but rather to adjust to different turns in the business cycle by providing or withdrawing stimulus through increased or decreased deficit spending. The Federal budget is much more pliable than a business or household. Government spending is not revenue constrained like a household because governments in the modern monetary system function more like banks as they are currency issuers. Deficits create monetary inflows and spending in an economy- thus are simulative. Federal budget surpluses drain the money supply and overall spending in an economy. A government surplus can be thought as disinflationary or a technique to cool down an economy experiencing high inflation.

Inflation is the ultimate check on government spending. When a government taxes, the reduction in your dollars and spending power creates room for a government to spend without causing higher inflation. Inflation is the result of spending rising above capacity in the economy also known as overheating. The check on government spending is therefore inflation, not revenue as the government can at any point increase issuance and run a larger deficit. That's not to say government should spend recklessly as the result of such policies would be high inflation.

With that being said, one could also reasonably argue, if this is the case, then Trump's tax cuts and deficit spending is leading to a pro-growth/inflation scenario that is encouraging the Federal Reserve to tighten monetary policy quicker and this could drive yields higher. I would estimate the U.S. economy at later-mid cycle. Large fiscal stimulus may be better reserved for when the economy is performing worse than average or at the low in a cycle. Placing fiscal stimulus on top of an economy that is later-mid cycle, achieving target rate inflation and performing well will almost inevitably at a minimum keep treasury prices contained and a floor under yields. The chart below explains why the U.S. economy is still mid-cycle. The percent change in total private sector credit is running at around 4.3%. Every pre-recession peak in credit growth in the last 60 or so years occurred around 10% to 14%.

I concur with the idea that a global risk-off shift, largely stemming from trade tensions, slowing of global growth and a downturn in emerging market equities and currencies will contribute to muted inflationary expectations and a flight to treasuries in some manner. Will it be enough to offset the headwinds to bond prices such as a strong underlying U.S. economy, potential political uncertainty, a tightening Federal Reserve and a widening government deficit? I'm of the opinion U.S. yields will still continue to rise over the intermediate term despite a risk-off and disinflationary theme in the financial markets. Thus, safe-haven demand and global disinflationary demand for treasuries will likely prove insufficient for the U.S. bond bulls.

Disclosure: I am/we are short GG, FCX, ABX, RGLD, WPM.

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.