The U.S. 10-Year Treasury Yield has dropped back below the line containing the past decade’s “extraordinarily low-rate” regime.
Among the many significant moves in financial markets last fall in the aftermath of the U.S. presidential election was a spike higher in U.S. bond yields. This spike included a jump in the 10-Year Treasury Yield (TNX) above its post-2007 Down trendline. Now, this was not your ordinary trendline break. Here is the background, as we noted in a post in January when the TNX subsequently tested the breakout point:
“As many observers may know, bond yields topped in 1981 and have been in a secular decline since. And, in fact, they had been in a very well-defined falling channel for 26 years (in blue on the chart below). In 2007, at the onset of the financial crisis, yields entered a new regime.
Spawned by the Fed’s “extraordinarily low-rate” campaign, the secular decline in yields began a steeper descent. This new channel (shown in red) would lead the TNX to its all-time lows in the 1.30%’s in 2012 and 2016.
The top of this new channel is that post-2007 Down trendline. Thus, recent price action has 10-Year Yields threatening to break out of this post-2007 technical regime. That’s why we consider the level to be so important.”
We bring up this topic again today because, unlike January’s successful hold of the post-2007 “low-rate regime” line, the TNX has dropped back below it in recent days. Here is the long-term chart alluded to above.
And here is a close-up version.
As can be seen on the 2nd chart, the TNX has just broken below several key Fibonacci Retracement levels near the 2.30% level – not to mention the post-2007 Down trendline which currently lies in the same vicinity. Does this meant the extraordinarily low-rate environment is back?
Well, first of all, the Federal Reserve only sets the overnight “Fed Funds” rate – not longer-term bond yields (at least not directly). So this is not the Fed’s direct doing (and besides, they’re in the middle of a rate hiking cycle). Therefore, the official “extraordinarily low-rate” environment that the Fed maintained for the better part of a decade is not coming back – at least not imminently. But how about these longer rates?
Outside of some unmistakable influence resulting from Fed policy, longer-term Treasury Yields are decided by free market forces. Thus, this return to the realm of the TNX’s ultra low-rate regime is market-driven, whatever the reason. Is there a softer underlying economic current than what is generally accepted at the present time? Is the Trump administration pivoting to a more dovish posture than seen in campaign rhetoric? Are the geopolitical risks playing a part in suppressing yields back below the ultra low-rate “line of demarcation”?
Some or all of those explanations may be contributing to the return of the TNX to its ultra low-rate regime. We don’t know and, frankly, we don’t really care. All we care about, as it pertains to bond yields, is being on the right side of their path. And currently, the easier path for yields is to the downside as a result of the break of major support near 2.30%.
Federal Reserve Shocker! What It Means For Housing
The Federal Reserve has announced it will be shrinking its balance sheet. During the last housing meltdown in 2008, it bought the underwater assets of big banks. It has more than two trillion dollars in mortgage-backed securities that are now worth something because of the latest housing boom. Gregory Mannarino of TradersChoice.net says the Fed is signaling a market top in housing. It pumped up the mortgage-backed securities it bought by inflating another housing bubble. Now, the Fed is going to dump the securities on the market. Mannarino predicts housing prices will fall and interest rates will rise.
It appears, the worse the economy was doing, the higher the odds of a rate hike.
Putting the Federal Reserve’s third rate hike in 11 years into context, if the Atlanta Fed’s forecast is accurate, 0.9% GDP would mark the weakest quarter since 1980 in which rates were raised (according to Bloomberg data).
We look forward to Ms. Yellen explaining her reasoning – Inflation no longer “transitory”? Asset prices in a bubble? Because we want to crush Trump’s economic policies? Because the banks told us to?
For now it appears what matters to The Fed is not ‘hard’ real economic data but ‘soft’ survey and confidence data…
It started with a whimper a couple of years ago and has turned into a roar: foreign governments are dumping US Treasuries. The signs are coming from all sides. The data from the US Treasury Department points at it. The People’s Bank of China points at it in its data releases on its foreign exchange reserves. Japan too has started selling Treasuries, as have other governments and central banks.
Some, like China and Saudi Arabia, are unloading their foreign exchange reserves to counteract capital flight, prop up their own currencies, or defend a currency peg.
Others might sell US Treasuries because QE is over and yields are rising as the Fed has embarked on ending its eight years of zero-interest-rate policy with what looks like years of wild flip-flopping, while some of the Fed heads are talking out loud about unwinding QE and shedding some of the Treasuries on its balance sheet.
Inflation has picked up too, and Treasury yields have begun to rise, and when yields rise, bond prices fall, and so unloading US Treasuries at what might be seen as the peak may just be an investment decision by some official institutions.
The chart below from Goldman Sachs, via Christine Hughes at Otterwood Capital, shows the net transactions of US Treasury bonds and notes in billions of dollars by foreign official institutions (central banks, government funds, and the like) on a 12-month moving average. Note how it started with a whimper, bounced back a little, before turning into wholesale dumping, hitting record after record (red marks added):
The People’s Bank of China reported two days ago that foreign exchange reserves fell by another $12.3 billion in January, to $2.998 trillion, the seventh month in a row of declines, and the lowest in six years. They’re down 25%, or almost exactly $1 trillion, from their peak in June 2014 of nearly $4 trillion (via Trading Economics, red line added):
China’s foreign exchange reserves are composed of assets that are denominated in different currencies, but China does not provide details. So of the $1 trillion in reserves that it shed since 2014, not all were denominated in dollars.
The US Treasury Department provides another partial view, based on data collected primarily from US-based custodians and broker-dealers that are holding these securities for China and other countries. But the US Treasury cannot determine which country owns the Treasuries held in custodial accounts overseas. Based on this limited data, China’s holdings of US Treasuries have plunged by $215.2 billion, or 17%, over the most recent 12 reporting months through November, to just above $1 trillion.
So who is buying all these Treasuries when the formerly largest buyers – the Fed, China, and Japan – have stepped away, and when in fact China, Japan, and other countries have become net sellers, and when the Fed is thinking out loud about shedding some of the Treasuries on its balance sheet, just as nearly $900 billion in net new supply (to fund the US government) flooded the market over the past 12 months?
Turns out, there are plenty of buyers among US investors who may be worried about what might happen to some of the other hyper-inflated asset classes.
And for long suffering NIRP refugees in Europe, there’s a special math behind buying Treasuries. They’re yielding substantially more than, for example, French government bonds, with the US Treasury 10-year yield at 2.4%, and the French 10-year yield at 1.0%, as the ECB under its QE program is currently the relentless bid, buying no matter what, especially if no one else wants this paper. So on the face of it, buying US Treasuries would be a no-brainer.
But the math got a lot more one-sided in recent days as French government bonds now face a new risk, even if faint, of being re-denominated from euros into new French francs, against the will of bondholders, an act of brazen default, and these francs would subsequently get watered down, as per the euro-exit election platform of Marine Le Pen. However distant that possibility, the mere prospect of it, or the prospect of what might happen in Italy, is sending plenty of investors to feed on the richer yields sprouting in less chaos, for the moment at least, across the Atlantic.
With the Dow Jones just a handful of gamma imbalance rips away from 20,000, the CIO of One River Asset Management, Eric Peters, shares some critical perspective on the market’s recent euphoric surge, going so far as to brand what is going on as America’s “Massive Policy Error”, the biggest in the past 50 years.
His thoughts are presented below, framed in his typical “anecdotal” way.
“America’s Massive Policy Error,” said the CIO. “That’s the title of the book someone will write in ten years about what’s happening today.” Never in economic history has a government implemented a fiscal stimulus of this size at full employment.
“The Trump team and economic elites believe that anemic corporate capital expenditure is the root cause of today’s lackluster growth.” It’s not that simple.
If credit to first-time homebuyers hadn’t been cut off post-2008, and state and local governments had spent as generously as they had after every other crisis, this recovery would have been like all others.
“People think that if only we cut taxes, kill Obamacare, and build some bridges, then American CEOs will start spending. That’s nonsense.” Ageing demographics, slowing population growth, and massive economy-wide debts have left CEOs unenthusiastic about expanding productive capacity.
“You make the most money in macro investing when there are policy errors and this will be the biggest one in 50yrs. These guys are going to crash the economy.” But not yet. First the anticipation of higher borrowing and rising growth expectations will widen interest rate differentials. Which will lift the dollar. But unlike recent episodes of dollar strength, this one will be accompanied by higher equities as investors ignore tightening financial conditions because they expect offsetting tax cuts and infrastructure spending.
Emboldened by higher equity prices, bond bears will push yields higher, lifting the dollar further, validating people’s belief in a strong economy in the kind of reflexive loop that Soros described in The Alchemy of Finance – the kind that drives extreme macro trends.
“This will be like the 1985 dollar super-spike. And the Fed will eventually be forced to follow the steepening yield curve, hiking rates aggressively, tightening the debt noose, killing the economy. Then rates will collapse, crushing the dollar.”
To visualize the impact the recent spike in mortgage rates will have on the US housing market in general, and home refinancing activity in particular, look no further than this chart from the October Mortgage Monitor slidepack by Black Knight.
The chart profiles the sudden collapse of the refi market using October and November rates. As Black Knight writes, it looks at the – quite dramatic – effect the mortgage rate rise has had on the population of borrowers who could both likely qualify for and have interest rate incentive to refinance. It finds it was cut in half in just one month.
Some more details from the source:
The results of the U.S. presidential election triggered a treasury bond selloff, resulting in a corresponding rise in both 10-year treasury and 30-year mortgage interest rates
Mortgage rates have jumped 49 BPS in the 3 weeks following the election, cutting the population of refinanceable borrowers from 8.3 million immediately prior to the election to a total of just 4 million, matching a 24-month low set back in July 2015
Though there are still 2M borrowers who could save $200+/month by refinancing and a cumulative $1B/month in potential savings, this is less than half of the $2.1B/ month available just four weeks ago
The last time the refinanceable population was this small, refi volumes were 37 percent below Q3 2016 levels
Which is bad news not only for homeowners, but also for the banks, whose refi pipeline – a steady source of income and easy profit – is about to vaporize.
It’s not just refinancings, however, According to the report, as housing expert Mark Hanson notes, here is a summary of the adverse impact the spike in yields will also have on home purchases:
Overall purchase origination growth is slowing, from 23% in Q3’15 to 7% in Q3’16.
The highest degree of slowing – and currently the slowest growing segment of the market – is among high credit borrowers (740+ credit scores).
The 740+ segment has been mainly responsible for the overall recovery in purchase volumes and in fact, currently accounts for 2/3 of all purchase lending in the market today.
Since Q3’15 the growth rate in this segment has dropped from 27% annually to 5% in Q3’16. (NOTE, Q3/Q4’15 included TRID & interest rate volatility making it an easy comp).
This naturally raises the question of whether we are nearing full saturation of this market segment.
Low credit score growth is still relatively slow, and only accounts of 15% of all lending (as compared to 40% from 2000-2006), the lowest share of purchase originations for this group on record. ITEM 2) The “Refi Capital Conveyor Belt” has ground to a halt, which will be felt across consumer spend. AND Rates are much higher now than in October when this sampling was done.
Net issuance seen rising after steady declines since 2009
Fed seen adding to supply as Treasury ramps up debt sales
Negative yields. Political risk. The Fed. Now add the U.S. deficit to the list of worries to keep beleaguered bond investors up at night.
Since peaking at $1.4 trillion in 2009, the budget deficit has plunged amid government spending cuts and a rebound in tax receipts. But now, America’s borrowing needs are rising once again as a lackluster economy slows revenue growth to a six-year low, data compiled by FTN Financial show. That in turn will pressure the U.S. to sell more Treasuries to bridge the funding gap.
No one predicts an immediate jump in issuance, or a surge in bond yields. But just about everyone agrees that without drastic changes to America’s finances, the government will have to ramp up its borrowing in a big way in the years to come. After a $96 billion increase in the deficit this fiscal year, the U.S. will go deeper and deeper into the red to pay for Social Security and Medicare, projections from the Congressional Budget Office show. The public debt burden could swell by almost $10 trillion in the coming decade as a result.
All the extra supply may ultimately push up Treasury yields and expose holders to losses. And it may come when the Federal Reserve starts to unwind its own holdings — the biggest source of demand since the financial crisis.
“It’s looking like we are at the end of the line,” when it comes to declining issuance of debt that matures in more than a year, said Michael Cloherty, head of U.S. interest-rate strategy at RBC Capital Markets, one of 23 dealers that bid at Treasury debt auctions. “We have deficits that are going to run higher, and at some point, a Fed that will start allowing its Treasury securities to mature.”
After the U.S. borrowed heavily in the wake of the financial crisis to bail out the banks and revive the economy, net issuance of Treasuries has steadily declined as budget shortfalls narrowed. In the year that ended September, the government sold $560 billion of Treasuries on a net basis, the least since 2007, data compiled by Bloomberg show.
Coupled with increased buying from the Fed, foreign central banks and investors seeking low-risk assets, yields on Treasuries have tumbled even as the overall size of the market ballooned to $13.4 trillion. For the 10-year note, yields hit a record 1.318 percent this month. They were 1.57 percent today. Before the crisis erupted, investors demanded more than 4 percent.
One reason the U.S. may ultimately have to boost borrowing is paltry revenue growth, said Jim Vogel, FTN’s head of interest-rate strategy.
With the economy forecast to grow only about 2 percent a year for the foreseeable future as Americans save more and spend less, there just won’t enough tax revenue to cover the burgeoning costs of programs for the elderly and poor. Those funding issues will ultimately supersede worries about Fed policy, regardless of who ends up in the White House come January.
As a percentage of the gross domestic product, revenue will remain flat in the coming decade as spending rises, CBO forecasts show. That will increase the deficit from 2.9 percent this fiscal year to almost 5 percent by 2026.
“As the Fed recedes a little bit into the background, all of these other questions need to start coming back into the foreground,” Vogel said.
The potential for a glut in Treasuries is emerging as some measures show buyers aren’t giving themselves any margin of safety. A valuation tool called the term premium stands at minus 0.56 percentage point for 10-year notes. As the name implies, the term premium should normally be positive and has been for almost all of the past 50 years. But in 2016, it’s turned into a discount.
Some of the highest-profile players are already sounding the alarm. Jeffrey Gundlach, who oversees more than $100 billion at DoubleLine Capital, warned of a “mass psychosis” among investors piling into debt securities with ultra-low yields. Bill Gross of Janus Capital Group Inc. compared the sky-high prices in the global bond market to a “supernova that will explode one day.”
Despite the increase in supply, things like the gloomy outlook for global growth, an aging U.S. society and more than $9 trillion of negative-yielding bonds will conspire to keep Treasuries in demand, says Jeffrey Rosenberg, BlackRock Inc.’s chief investment strategist for fixed income.
What’s more, the Treasury is likely to fund much of the deficit in the immediate future by boosting sales of T-bills, which mature in a year or less, rather than longer-term debt like notes or bonds.
“We don’t have any other choice — if we’re going to increase the budget deficits, they have to be funded” with more debt, Rosenberg said. But, “in today’s environment, you’re seeing the potential for higher supply in an environment that is profoundly lacking supply of risk-free assets.”
Deutsche Bank AG also says the long-term fiscal outlook hinges more on who controls Congress. And if the Republicans, who hold both the House and Senate, retain control in November, it’s more likely future deficits will come in lower than forecast, based on the firm’s historical analysis.
FED HOLDINGS OF TREASURIES COMING DUE
2016 ────────────── $216 BILLION
2017 ────────────── $197 BILLION
2018 ────────────── $410 BILLION
2019 ────────────── $338 BILLION
However things turn out this election year, what the Fed does with its $2.46 trillion of Treasuries may ultimately prove to be most important of all for investors. Since the Fed ended quantitative easing in 2014, the central bank has maintained its holdings by reinvesting the money from maturing debt into Treasuries. The Fed will plow back about $216 billion this year and reinvest $197 billion in the next, based on current policy.
While the Fed has said it will look to reduce its holdings eventually by scaling back re-investments when bonds come due, it hasn’t announced any timetable for doing so.
“It’s the elephant in the room,” said Dov Zigler, a financial markets economist at Bank of Nova Scotia. “What will the Fed’s role be and how large will its participation be in the Treasury market next year and the year after?”