Tag Archives: interest rates

The Lowest Common Denominator, by Michael Lebowitz

Probably because most people don’t like to think or write about it, debt is one of SLL’s favorite subjects. Michael Lebowitz analyzes bond math and what it means for the debt-saturated US and global economies. From Lebowitz at 720global.com:

At a recent investment conference, hedge fund billionaire Stanley Druckenmiller predicted that interest rates would continue rising. Specifically, he suggested that, consistent with the prospects for economic growth, the 10-year U.S. Treasury yield could reach 6.00% over the next couple of years. Druckenmiller’s track record lends credence to his economic perspectives. While we would very much like to share his optimism, we find it difficult given the record levels of public and private debt.

Druckenmiller’s comments appear to be based largely on enthusiasm for the new administration’s proposals for increased infrastructure and military spending along with tax cuts and deregulation. This is consistent with the outlook of most investors today. Although proposals of this nature have stimulated economic growth in the past, today’s economic environment is dramatically different from prior periods. Investors and the market as a whole are failing to consider the importance of the confluence of the highest debt levels (outright and as a % of GDP) and the lowest interest rates (real and nominal) in the nation’s history. Because of the magnitude and extreme nature of these two factors, the economic sensitivity to interest rates is greater and more asymmetric now than it has ever been. Additionally, due the manner in which debt and interest rates have evolved over time, the amount of interest rate risk held by fixed income and equity investors poses unparalleled risks and remains, for the moment, grossly under-appreciated.

Proper assessment of future investment and economic conditions must carefully consider changes in the debt load and the interest rates at which new and existing debt will be serviced.

To continue reading: The Lowest Common Denominator


The Secular Trend In Rates Remains Lower: The Yield Bottom Is Still Ahead Of Us, by the Kessler Companies

Here’s a contrary opinion on interest rates: the bottom is not in and they’re going lower. From the Kessler Companies at kesslercompanies.com:

Donald Trump’s victory sparked a tremendous sell-off in the Treasury market from an expectation of fiscal stimulus, but more broadly, from an expectation that a unified-party government can enact business-friendly policies (protectionism, deregulation, tax cuts) which will be inflationary and economically positive. It doesn’t take too much digging to show that the reality is different. The deluge of commentaries suggesting ‘big-reflation’ are short-sighted. Just as before last Tuesday we thought the 10yr UST yield would get below 1%, we still think this now.

Business Cycle

No matter the President, this economic expansion is seven and a half years old (since 6/2009), and is pushing against a difficult history. It is already the 4th longest expansion in the US back to the 1700’s (link is external). As Larry Summers has pointed out (link is external), after 5 years of recovery, you add roughly 20% of a recession’s probability each year thereafter. Using this, there is around a 60% chance of recession now.

History also doesn’t bode well for new Republican administrations. Certainly, the circumstances were varied, but of the five new Republican administrations replacing Democrats in the 19th and 20th centuries, four of them (Eisenhower, Nixon, Reagan, and George W. Bush) faced new recessions in their first year. The fifth, Warren Harding, started his administration within a recession.

Fiscal Stimulus

Fiscal stimulus through infrastructure projects and tax cuts is now expected, but the Federal Reserve has been begging for more fiscal help since the financial crisis and it has been politically infeasible. The desire has not created the act. A unified-party government doesn’t make it any easier when that unified party is Republican; the party of fiscal conservatism. Many newer House of Representatives members have been elected almost wholly on platforms to reduce the Federal debt. Congress has gone to the wire several times with resistance to new budgets and debt ceilings. After all, the United States still carries a AA debt rating from S&P as a memento from this. Getting a bill through congress with a direct intention to increase debt will not be easy. As we often say, the political will to do fiscal stimulus only comes about after a big enough decrease in the stock market to get policy makers scared.

Also, fiscal stimulus doesn’t seem to generate inflation, probably because it is only used as a mitigation against recessions. After the U.S. 2009 Fiscal stimulus bill, the YoY CPI fell from 1.7% to 1% two years later. Japan has now injected 26 doses (link is external) of fiscal stimulus into its economy since 1990 and the country has a 0.0% YoY core CPI, and a 10yr Government bond at 0.0%.

Rate sensitive world economy

A hallmark of this economic recovery has been its reliance on debt to fuel it. The more debt outstanding, the more interest rates influence the economy’s performance. Not only does the Trump administration need low rates to try to sell fiscal stimulus to the nation, but the private sector needs it to survive. The household, business, and public sectors are all heavily reliant on the price of credit. So far, interest rates rising by 0.5% in the last two months is a drag on growth.

To continue reading: The Secular Trend In Rates Remains Lower: The Yield Bottom Is Still Ahead Of Us

Will the “Rout” in Government Bonds Turn into Carnage? by Wolf Richter

For all the conniptions in the stock market this week, the real story has been in the much bigger, much more important, and much less publicized, bond market. From Wolf Richter at wolfstreet.com:

“Inflation Trade” Heats Up, “Greater-Fool” Trade Falls Apart

The Government “bond rout” didn’t start with Trump’s election victory. It started in July. And it didn’t just hit US Treasuries. It hit government bonds around the world. It’s predicated on the idea that inflation was raising its ugly head again. That idea has now become further entrenched.

The threat of inflation puts holders of low-yielding or zero-yielding long-term bonds in a very foul mood because the purchasing power of their capital gets destroyed without compensation.

It hit US Treasuries particularly hard. Central banks can push down long-term rates by buying bonds. The ECB and the Bank of Japan are doing that. But the Fed has been flip-flopping about raising rates. There is a good chance it will raise them another notch in December, from nearly nothing, by almost nothing, to next to nothing. So it isn’t going to revolutionize short-term rates. But it does point out that long-term rates in the US are on their own.

Then Trump won. He’d campaigned on a big deficit-funded stimulus program that includes a military buildup and – by golly, much needed – infrastructure work, funded, so to speak, by corporate and individual tax cuts….

The US bond markets reacted with a vengeance. They figured that these plans, once they sail through the Republican Congress, would create much larger deficits which would have to be funded by an onslaught of new bonds that somebody would have to buy, and that somebody wouldn’t be the Fed.

Dreading this supply, bond traders went out and cut great-big holes into the most magnificent bond bubble in history, and what we’ve been hearing since this act of Fed-defying vandalism is the deafening sound of hot air hissing out of it.

Today, Veterans Day, the US bond markets are closed, which may be a good thing. It gives them an extra day to take a breath. Because over the last three trading days, the US 10-year yield has skyrocketed 35 basis points, from 1.8% to 2.15%. That’s a huge move (chart via StockCharts.com):

Since early July, the 10-year yield has jumped by 77 basis points. So what does this mean for bondholders, in dollars and cents? Bond prices fall when yields rise. This chart (via StockCharts.com) shows the CBOT Price Index for the 10-year note. It’s down 4.5% since July.

It gets outright ugly with 30-year Treasury bonds. Over the last three trading days, the 30-year yield has soared by 38 basis points and since early July by 83 basis points (via StockCharts.com):

To continue reading: Will the “Rout” in Government Bonds Turn into Carnage? 

Economic stress as world runs out of dollars, by Ambrose Evans-Pritchard

A number of market-based indicators are signaling  that dollar liquidity is tightening. Tread carefully. From Ambrose Evans-Pritchard at telegraph.co.uk:

Surging rates on dollar Libor contracts are rapidly tightening conditions across large parts of the global economy, incubating stress in the credit markets and ultimately threatening overvalued bourses.

Three-month Libor rates – the benchmark cost of short-term borrowing for the international system – have tripled this year to 0.88pc as inflation worries mount.

Fear that the US Federal Reserve may have to raise rates uncomfortably fast is leading to an acute dollar shortage, draining global liquidity.

“The Libor rate is one of few instruments left that still moves freely and is priced by market forces. It is effectively telling us that that the Fed is already two hikes behind the curve,” said Steen Jakobsen from Saxo Bank. “This is highly significant and is our number one concern. Our allocation model is now 100pc in cash. This is a warning signal for the market and it happens extremely rarely,” he said.

Goldman Sachs estimates that up to 30pc of all business loans in the US are priced off Libor contracts, as well as 20pc of mortgages and most student loans. It is the anchor for a host of exotic markets, used as a floor for 90pc of the $900bn pool of the leveraged loan market. It underpins the derivatives nexus. The chain reaction from the Libor spike is global. The Bank for International Settlements warns that the rising cost of borrowing in dollar markets is transmitted almost instantly through the global credit system.

“Changes in the short-term policy rate are promptly reflected in the cost of $5 trillion in US dollar bank loans,” it said. Roughly 60pc of the global economy is linked to the dollar through fixed currency pegs or “dirty floats”, but studies by the BIS suggest that borrowing costs in domestic currencies across Asia, Latin America, the Middle East, and Africa, move in sympathy with dollar costs, regardless of whether the exchange rate is fixed. Short-term “Shibor” rates in China have been ratcheting up.

The cost of one-year swaps jumped to 2.71pc last week, and the spread over one-year sovereign debt is back to levels seen during the Shanghai stock market crash last year. This is not a pure import from the US. The Chinese authorities themselves are taking action to rein in a credit bubble.

It is happening in parallel with Fed tightening, each reinforcing the other, and that makes it more potent. Three-month interbank rates in Saudi Arabia have soared to 2.4pc. This is the highest since the global financial crisis in early 2009 and implies a credit crunch in the Saudi banking system. The M1 money supply has fallen 9pc over the last year. The Bank of Japan has doubled its window of dollar credit for Japanese banks to head off an incipient dollar squeeze, drawing on the country’s ample foreign reserves.

It may not be so easy for others. Credit analysts are becoming nervous about the spread between Libor and the overnight index swap, the so-called Libor-OIS spread that is used to gauge problems in the plumbing of the credit system. It has widened to 38 basis points, near levels seen in the eurozone debt crisis and past bouts of stress.

The message from the “TED spread” is similar, if less severe. This measures the spread between eurodollar rates in Lon­don and three-month futures contracts for US treasuries. The picture is complex. These signals have been distorted by new rules for US prime money market funds, which have shrunk by $560bn and led to a contraction of commercial paper. The deadline for this reform has come and gone, yet the spreads have not settled.

To continue reading: Economic stress as world runs out of dollars

Ray Dalio Warns A 1% Rise In Yields Would Lead To Trillions In Losses, by Tyler Durden

When yields are very low or negative, relatively small increases in interest rates inflict huge losses. From Tyler Durden at zerohedge.com via theburningplatform.com:

Last week, we shared with readers a fascinating presentation that Bridgewater’s Ray Dalio made to NY Fed staffers at the 40th Annual Central Banking Seminar held on Wednesday, October 5, 2016. In it, Dalio pointed out that thoughts which dared to question the economic orthodoxy, and which were once relegated to the fringe blogs, have become the norm, pointing out that it is no longer controversial to say that:

• …this isn’t a normal business cycle and we are likely in an environment of abnormally slow growth
• …the current tools of monetary policy will be a lot less effective going forward
• …the risks are asymmetric to the downside
• …investment returns will be very low going forward, and
• …the impatience with economic stagnation, especially among middle and lower income earners, is leading to dangerous populism and nationalism.

He further notes that the debt bubble which was not eliminated during the financial crisis of 2008, has since grown to staggering proportions, and notes that “the biggest issue is that there is only so much one can squeeze out of a debt cycle and most countries are approaching those limits.”
Alas, while the underlying symptoms are clear, that does not make the solution of the problem any easier. Quite the contrary. As Dalio further adds, “when we do our projections we see an intensifying financing squeeze emerging from a combination of slow income growth, low investment returns and an acceleration in liabilities coming due both because of the relatively high levels of debt and because of large pension and health care liabilities. The pension and health care liabilities that are coming due are much larger than the debt liabilities in most countries because of demographics – i.e., due to the baby-boom generation moving from working and paying taxes to getting their retirement and health care benefits.”

Here the Bridgewater head provides a simple explanation for why the system is unsustainable: debt is fundamentally a liability even though it is treated as an asset by those who “own” it. As a result, “holders of debt believe that they are holding an asset that they can sell for money to use to buy things, so they believe that they will have that spending power without having to work. Similarly, retirees expect that they will get the retirement and health care benefits that they were promised without working. So, all of these people expect to get a huge amount of spending power without producing anything. At the same time, workers expect to get spending power that is equal in value to what they are giving. They all can’t be satisfied.”

How does the Fed react to this inconsistency? By a familiar tool: financial repression.

As a result of this confluence of conditions, we are now seeing most central bankers pushing interest rates down to make them extremely unattractive for savers and we are seeing them monetizing debt and buying riskier assets to make debt and other liabilities less burdensome and to stimulate their economies. Rarely do we investors get a market that we know is over-valued and that approaches such clearly defined limits as the bond market now. That is because there is a limit as to how negative bond yields can go. Their expected returns relative to their risks are especially bad.

To continue reading: Ray Dalio Warns A 1% Rise In Yields Would Lead To Trillions In Losses,http://www.theburningplatform.com/2016/10/09/ray-dalio-warns-a-1-rise-in-yields-would-lead-to-trillions-in-losses/

Rock-Bottom Yields Dig Hole for Pensions, by Lisa Abramowicz

As recently noted in “You Will Be Poor,” ZIRP and NIRP are killing, among others, pension funds. From Lisa Abramowicz at bloomberg.com:

It’s going to be hard to reverse the damaging effects of ultralow bond yields on the global economy.A glaring example of the longer-lasting ramifications can be found by looking at big American corporate pensions, which were formed to provide retirees with a reliable income. These plans are now facing their worst deficit in 15 years, with enough money to cover just 76 percent of their estimated $2.1 trillion of liabilities, Wells Fargo analyst Boris Rjavinski wrote in a Sept. 9 note.

“Corporate pensions overall appear to be in worse shape now than at the peak of the crisis,” he wrote. This is especially galling because companies have poured almost $500 billion into their pensions since 2009, which should have put these funds in a better spot right now.

Deeper Shade of Red

Pensions are facing swelling deficits as their investment income fails to keep up with their obligations

So why are they facing such a dire outlook? Because they’ve been piling into longer-term bonds to avoid the volatile swings of stocks. Their bond allocations climbed to about 42 percent of their holdings last year, compared with 29 percent eight years earlier, the Wells Fargo analysts wrote.

The problem is that longer-term bond yields have dropped to record lows. These pools of bonds are providing a diminishing amount of income at a time when many pensions still rely on 6.5 percent or higher annual returns. The average yield on U.S. 30-year bonds has fallen to 2.4 percent, about one-half the average over the past 15 years.

Rates on long-term European bonds have fallen to 1.2 percent, about one-fourth of the 15-year average.

In Japan, investors are now paying for the privilege of lending to the government for a decade. Not so long ago, they used to earn money on these bonds. These are meaningful declines, which translate to billions of dollars less for pension funds.

And the problem promises to be long term. Even if benchmark yields start to rise meaningfully, it’ll be challenging for these pensions to benefit because they already have such big pools of the lower-yielding notes. Do they sell their existing holdings and lock in losses? Do they liquidate other positions to buy new bonds? Do they plead for more contributions?

While U.S. corporate pensions are just one slice of the $35.4 trillion global pension industry, they provide a window into challenges that are pervasive throughout the world. Managers of these plans have been choosing between making leveraged bets on companies, nations and properties or accepting a shrinking amount of yield for hanging onto safer debt.

This equation hasn’t been working out too well. The result is that companies and municipalities will ultimately have to contribute more toward these plans or negotiate with their pensioners to reduce their obligations. Both options ultimately lead to similar economic outcomes — they’ll slow the velocity of money and hamper growth.

Companies will be forced to divert money away from developing new products and expanding their businesses. Local governments will have less cash to build new roads, parks and bridges. And retirees will have less money available to spend.

Academics will spend years debating the pros and cons of unconventional monetary policies that led to such low long-term yields. It’s a complicated debate, with legitimate points on both sides. But in this one pocket of the world, there are some deleterious effects that will linger for a long time.


Gundlach’s Bond-Market Inflection Point, by Lisa Abramowicz

The long bull market in bonds (since 1982) may be over. From Lisa Abramowicz at blomberg.com:

DoubleLine’s Jeffrey Gundlach indicated in a webcast on Thursday that financial markets are on the brink of turmoil, saying “this is a big, big moment.” He’s right. It is.

The mood has shifted suddenly. Investors are losing faith in the efficacy of monetary stimulus, and it appears that perhaps central bankers may be, too. The Bank of Japan and European Central Bank have refrained from committing to additional rounds of stimulus and are quickly running out of bonds to buy under their existing programs. The BOJ may run out of bonds within the next 18 months, while the ECB may run into a wall sooner than that, according to analysts cited by the Wall Street Journal and the Financial Times.

The Federal Reserve, meanwhile, is still planning to raise benchmark interest rates despite underwhelming economic data. This is in large part because policy makers are increasingly concerned about the threats to longer-term financial stability by keeping rates so low. Meanwhile, inflation expectations are rising on bets that government officials will embark on spending plans to stimulate growth.

This multifaceted dynamic is a game changer, and markets have taken note. Traders have started dumping government bonds, leading to the biggest rout in Japanese debt in 13 years.

On the Rise

Japanese bond yields have risen in the past few months as the BOJ studied its stimulus effort.

[For interactive graph, see original story, link below.]

Yields on 10-year German bonds just turned positive for the first time since July.


German 10-year bond yields turned positive for the first time since July

[For interactive graph, see original story, link below]

U.S. government bonds are poised for a second consecutive month of losses for the first time this year.

Going Down

U.S. government bonds are set for their second consecutive month of losses for the first time this year

[For interactive graph, see original story, link below.]

Futures traders are predicting a greater chance of the Fed raising rates this month than they were just a day ago, with every new speech or piece of data moving the needle. It’s clear that many are struggling to understand what the Fed members’ main considerations will be when deciding whether to take action.“Interest rates have bottomed,” Gundlach said in the webcast. “They may not rise in the near term as I’ve talked about for years. But I think it’s the beginning of something, and you’re supposed to be defensive.”

The big question now is, how far will this selloff go? If it stops here, it will be another blip soon forgotten. So far, the moves have not been drastic. Japanese government debt, for example, has been losing value steadily, but the losses since June amount to 2.3 percent, which isn’t the end of the world.

But this does feel like part of a bigger trend. Jitters are spreading.

If European and Japanese central bankers are approaching the end of their bond-buying programs, then investors will have little reason to buy debt at a premium that pays no interest. Developed-market sovereign bonds would certainly suffer some significant losses, sending ripple effects through stocks, currencies and riskier bonds.

No one really knows how damaging a bond-market tantrum would be for the worldwide economy. Indeed, it seems as though it would be healthy for bond yields to rise and some equity valuations to fall a bit. But it’s worrisome that global markets are moving together as much as they have been, leaving investors with few hiding spots.

The next few months will most likely be more turbulent than what traders have become accustomed to. And it probably won’t be much fun for many bond investors.