Last week the bond market suffered large price declines and I expect that interest rates will continue to move higher. Since my article from September 15, 2016 when I strongly recommended selling bonds based on an expectation of a Trump victory, the price of the 30-year 2.25%'46 has plunged from 95.8087 to 79.2815 and the 10-year from 98.1953 to 88.2188. With a very robust economy for the remainder of this year and in 2019, the price declines will continue and I am, therefore, still recommending selling bonds.
Yield Curves (Oct 5 2018 Vs. Sept 14, 2016) U.S. Treasuries
Source: U.S. Treasury
Over the last two years, interest rates on the shorter end of the yield curve have risen more than the longer-dated debt as seen by the graph below. The spread has narrowed between 10-year and 2-year yields.
10-Year U.S. Treasury Yields Minus 2-Year
While the yield curve has become flatter, I expect the spread to remain fairly constant going forward as both short and long-term rates rise. I do not, however, expect sharp increases in the spread to levels seen a few years ago.
10-Year U.S. Treasury Yields Minus 2-Year
Some investors and SA readers disagreed with my recommendation of selling bonds because they asserted that lower quality bonds would increase in price during a period of stronger economic growth, which would have more of a positive impact on the price than the negative impact from higher interest rates. Interest rates on BBB-rated bonds have moved sharply higher over the last two years with a few ups and downs in between. Even the lower quality BB-rated bonds have somewhat higher yields than two years ago. Of course, there are some individual debt issues that have moved much higher in price during that time period.
BBB Interest Rates
BB Interest Rates
Why Interest Rates Will Keep Rising
While my recommendation of selling bonds in September 2016 was in most cases correct, I think that rates will continue to rise for multiple reasons:
*Federal government is running a large deficit that will increase next year
*Federal Reserve is rolling-off $50 billion a month from their holdings
*Higher interest rates on savings accounts is increasing spending by consumers, especially seniors
*Rates are still at a historically low level
*Baby Boomer seniors could start drawing down their retirement savings accounts
*There still could be some major infrastructure spending program passed by Congress
Future Federal Deficits
Not only does the federal government need to keep rolling over existing debt, but as they spend more than they take in, they need to borrow more and more. This federal borrowing either crowds out other potential borrowers and/or raises the rates for all borrowers.
|Deficit $ Billions||890||1085||1076||1011||952||875|
Federal Reserve Decreasing Their Holdings
Last year, the Federal Reserve announced their plan to reduce their portfolio holdings of U.S. treasuries and mortgages. The plan was to start off rolling off small amounts each month and increasing the monthly amount until it levels off at $50 billion per month. This could mean $600 billion being rolled off next year. Not repurchasing maturing debt with new debt, in my opinion, has almost the same negative impact on the credit markets as selling that same debt. Some other investors need to buy the new debt and may require a higher interest rate to encourage them to purchase it.
Source New York Federal Reserve
The holdings by the Fed have declined at a modest rate so far, but that $600 billion a year could have a dramatic impact on interest rates that could cause the Fed to reconsider the $50 billion monthly level. There is also the issue of having $50 billion in maturing debt in a given month. Without knowing their exact holdings, some months may have less than $50 billion maturing. I am not sure what the Fed plans to do in that case.
Treasuries Held By The Federal Reserve
Higher Rates On Savings Accounts
After years of tiny returns on bank savings accounts, rates have increased to over 2.75% and moving higher. Higher rates on savings accounts (including passbook, CDs, money market) increases consumer income, especially seniors, and spending. Often the marginal propensity to consume on this increased savings income approaches 100% for some seniors. As more very low rate CDs mature in the near future and are rolled over into higher CDs, the impact on senior's spending could be dramatic.
In prior articles, I have asserted that the artificially low rates caused by QE1 and QE2 had the same impact as a very high tax on income from savings. Effectively, these quantitative easing schemes were a redistribution of wealth from savers to borrowers.
Higher interest income I feel is one reason why economic growth is over 4% and I agree with the current Federal Reserve Bank of Atlanta's GDP forecast for the 3rd quarter of 4.1%. There are other reasons as well, but this factor seems to be being ignored in the media.
Rates Are Still Historically Low
(Note: No FRED chart prior to 1976 for 2-year)
Baby Boomers Are Retiring
Already many of the 75 million baby boomers have retired and more will in the near future. It is almost impossible to estimate with any accuracy how much they will drawdown on their savings and spend versus keeping the savings to leave to their heirs. Various tax rules require withdrawals from certain type of accounts, but that does not mean that they are required to spend that money.
There are various estimates of how many of the 75 million boomers have no or little savings. Some with little savings, but own their home, could monetize their home asset and spend part/all of the sale proceeds. In addition, some of those with little savings could be relying on receiving a comfortable pension from their former employer and don't feel the need to have a significant amount saved for their retirement.
This increased spending by seniors could be huge and have a major impact on economic growth/interest rates. (From my own contacts with fellow seniors, I just don't see them being thrifty and just expecting to transfer all their wealth to another generation.)
Senior spending, including increased income from higher interest rates, could be the major driver for a booming economy for years to come. The problem is that this potentially critical issue is difficult to estimate. Future actions taken by seniors are often impacted by unexpected changes in their health - a variable almost impossible to predict in an econometric model forecasting consumer spending.
New Infrastructure Spending
I expected that there would have been a massive infrastructure program passed by Congress already since many from both parties support it. I was wrong. They would rather fight each other. While so far there has not been an Aaron Burr versus Alexander Hamilton duel (yet), Congress seems unwilling to pass an infrastructure program. This could change. It could be used as a unifier. This is the reason why I listed it last - because it is so uncertain. If it does happen, it could have a dramatic impact on interest rates.
First, there are many other factors that impact interest rates that I have not covered: Changes in inflation expectations, holdings by China and other countries, weather, geopolitical events, midterm elections, tariffs, changes in governmental officials, money supply, velocity, and changes in tax laws.
September 2018 Forecast - Federal Reserve
Since I am expecting real GDP growth to be higher than the Fed's projections (I will be writing another article covering my GDP projections based on my econometric model), I would also expect the Fed to raise their Fed funds rate target higher than in the above table. Factoring in the issues discussed in this article, I am expecting the entire yield curve to be over 4% by the middle of 2020.
Interest rates have risen sharply since September 2016 and because of a number of factors, I am expecting rates to continue to rise. Therefore, I continue to recommend selling bonds. There are, of course, a few bonds that could have increasing quality that impacts their price more than the general increase in interest rates.
I would also be careful when selecting stocks that trade mostly on their dividend yield. Those companies that will benefit from a stronger economy and are able to increase their dividends are still worth consideration. Companies with business models that are not as sensitive to a stronger economic growth (such as healthcare) and trade on yield should be avoided.
Disclosure: I am/we are short UST FUTURES.
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: I also own UST future puts