Economy
10 Reasons Long-Term Treasury Yields Remain Stuck Under 3%
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Higher interest rates are coming. That’s the message that the investment community has heard for the better part of 18 months now. And interest rates have risen in the United States. Still, what has happened is that longer-term interest rates in the 10-year Treasury note, and even out 15 and 20 years, have remained stuck under 3%. Even the benchmark 30-year Treasury’s long bond has barely managed to get that much higher than 3%.
24/7 Wall St. was not alone in the call for higher interest rates after the Federal Reserve went to its policy of raising interest rates and removing the overly accommodative low-rate policy as it exited quantitative easing. Jamie Dimon of JPMorgan has even gone on the record of late calling for investors to prepare for higher long-term interest rates, perhaps to 4% or even 5%, in the United States. And the 3% hurdle still somehow seems to act as a wall.
There are many reasons that the bond market has not seen that 10-year note and 30-year bond get that much higher than 3%. The problem is that these issues may all get in the way of Federal Reserve Chair Powell’s ambitions to get interest rates higher and away from the accommodative policies in a post-quantitative easing stance.
Second-quarter GDP was indicated to finally be above 4%, and consumer prices are just starting to get in that 2.5% to 3.0% range. Despite the Fed presidents continuing to predict, or even warn, that they want to keep raising interest rates, this 3% yield level continues to act as a barrier.
At issue is whether 3% will act as a barrier or the Fed will dare to risk the policy of raising interest rates into what the markets fear in an inverted yield curve (where short-term or intermediate-term bond yields actually have higher yields than long-term yields). And this all points to the risks that the nine-year recovery from the Great Recession could suddenly find itself tipping back into a recession or a very slow growth environment all over again.
As of mid-August, short-term rates (under one-year) were just under 2.5%, the two-year note had a yield of 2.6%, and the five-year had a yield of about 2.75%. The yield on the 10-year Treasury was just 2.87%, and the 30-year yield was just 3.03%. Those short-term and intermediate-term yields are up a full point from the same time in 2017, but the last year’s gains in yield were only about 70 basis points higher on the 10-year Treasury and just 25 basis points higher on the 30-year Treasury.
The markets better pay attention to the major reasons that are keeping Treasury yields so much lower than many experts and forecasters have called for. These reasons also may keep the longer-dated Treasury yields lower for the rest of 2018 and even into 2019.
It’s important to keep in mind that nothing lasts forever. And there is also the theory that high prices cure high prices and low prices cure low prices. Is the same true of interest rates?
While we have identified 10 reasons keeping longer-term interest rates at or under the 3% mark, there are arguably many other reasons that could be represented, and the following are not ranked in any specific order. Markets are complicated instruments, and at the end of the day the bond, equity and commodities markets are still all intertwined and linked to each other. Again, any or all of these issues can change in very short order.
1. Global Yields Remain Handily Lower Than Expected
Whether you want to address Europe or Japan, it turns out that kicking quantitative easing and then tightening monetary policy can be much harder to effect than simply predicting it. European Central Bank President Mario Draghi has been rather late to raise rates, and the efforts to remove all the quantitative easing measures have been slower than the Europeans previously indicated.
Germany’s government bonds still come with negative yields in their short-term and intermediate-term notes (even its 30-year bund has less than a 1% yield). Japan also has been slow to remove its endless quantitative easing measure. Japan’s government bond yields have barely risen, and the rates out to five years still remain negative. Japan’s 10-year yield is just 0.09% and the 30-year government bond yields barely 0.8%.
Brexit may be another negative for Europe, but now there are risks for Italy and Turkey to consider that could throw a wrench in the European Central Bank’s ambitions to start exiting quantitative easing late in 2018 or in 2019.
2. U.S. Housing Woes
The housing market has proven to be elusive when it comes to endless growth. When housing prices rise year after year, new buyers have growing trouble affording the homes. Even if you consider that interest-only loans are returning, and even many lenders starting to accept less than 20% down, the median home price has run into some headwinds. Housing affordability in the second quarter of 2018 has shown that home price affordability is running quite poorly. That will not bode well for mortgage demand (see below), which all helps to participate in capping long-term interest rates.
The St. Louis Fed keeps track of historical economic reports, and the pre-recession peak for the median home price hit $257,400 in the first quarter of 2007. After the bottom dropped out of the economy, it was not until 2013 that the median price caught up to its prior peak, and the median home price reached $337,900 at the end of 2017 before ticking down to $328,000 in the first quarter of 2018. This may not be the only time that home prices had ticked down, but the prices at the end of 2017 were on average more than 60% higher than the recession low of $208,400.
3. Mortgage Demand Remains Sluggish
On top of home prices becoming less affordable, it is crucial to decouple home prices and look specifically at the market for mortgages. This is not just new mortgages for home purchases, because the mortgage refinance market can often be larger than the market for new mortgages tied to home buying. And refinance activity has become almost anemic, with early summer data signaling a drop in refinancing applications to almost 20-year lows. If you didn’t refinance for under 4% mortgages when you could, that is gone.
While 4.7% for a 30-year mortgage may seem low compared to decades past, 30-year and 15-year mortgage rates generally move up and down with long-term Treasury yields. Now consider that mortgage rates were under 4% from the end of 2011 through mid-2013 and were again under 4% for most of the time between mid-2015 and the end of 2016 before the Fed began gradually raising interest rates.
4. Inflation Remains Relatively Tame
Despite trade war fears and rising producer prices and rising consumer prices, the current verdict from the bond market seems to be that inflation could remain elevated but not get out of control. One issue is that theory noted before that high prices ultimately cure high prices. That said, many metals and commodities have seen prices come way down from pre-trade-war fears. Copper was challenging $3.30 per pound in the first half of June, and it was more recently trading under $3.00. Gold and silver prices have backed way down from their 2018 highs as well.
Oil and gasoline prices at the pump have not continued to reach prior burdensome levels. Crude oil recently hit $70 per barrel. That price is of course higher than the $50 level a year ago, but for oil and gas to remain inflationary ahead the price would have to continue rising and rising. Can it? Sure. The problem is that $70 seems to currently be a level where the market finds more sellers of oil than buyers.
Even wage inflation (see below), despite a very tight labor market, has not gone out of control for businesses. And in business pricing power, it remains to be seen whether service-sector businesses can ramp up their prices endlessly for business orders and consumers alike.
5. Full Employment and Wages in the United States
When the U.S. unemployment rate reached 4%, as was seen recently, it is more or less considered to be a state of full employment. There also are currently more job openings than officially unemployed people who could fill those jobs. Many jobs simply cannot be filled due to geographic and skill-gap issues. This could pressure companies to steal away each other’s workers with higher wage offers, as has been seen in recent months with workers quitting their job for other opportunities.
Still, employers selling physical goods and services alike know they cannot hire endlessly, and they know that they cannot keep grossly overpaying for workers without wrecking their margins. Hourly earnings have risen close to 3% from this time in 2017, and that’s up over 12% from five years ago, when there was very low wage pressure. Will increasingly higher wages finally cure higher wages? Some companies may just decide to not hire rather than pursue what they worry about is an overpayment that can spill over into their entire monthly payroll obligations.
6. That Major Stock Market Correction (That Never Seems to Arrive)
Perhaps the best way to create a stock market corrrection, or even a bear market, is to predict that a major correction just isn’t possible. That said, the selling pressure in equities around tariffs, trade war concerns, geopolitical risks and so on simply has not come around. The stock market selling in early 2018 has been much worse in Chinese stock exchange traded funds (ETFs) and many emerging market stock index ETFs than it has been in major U.S. index ETFs. That may be a very simplistic view for a comparison, but the stock market is supposed to “sell” itself as a price discovery mechanism that discounts the good news and bad news for six months (or longer) into the future.
Many investors invest with the classical theme that if stocks rise, bond prices ultimately fall, driving yields higher due to the inverse price/yield nature. And the runaway U.S. stock market gains seen in 2017 have been far more tame in 2018, which may relieve at least some fears of a bear market or a stock market crash.
We also have seen many of the companies with international exposure (particularly exposure to China, Europe and other trade-targeted nations) experience a substantial drop in their share prices. Still, the market as a whole has managed to remain close to all-time highs.
7. Foreigners May Find It Harder to Sell U.S. Treasuries
If interest rates and yields rise as bond prices drop, a wave of foreign nations threatening to sell their vast U.S. Treasury bonds should help to drive up interest rates. Some nations may want to sell U.S. Treasuries as a protest against the president and his tariffs. There have even been reports and ongoing fears that Russia and China have been or would like to be sellers of their large holdings in U.S. Treasuries.
It turns out that, particularly as the U.S. dollar remains strong, it’s easier to threaten to be a seller of Treasuries than it is to actually sell them entirely. Central banks are required to hold reserves of foreign currencies, and the International Monetary Fund noted in prior months that the global reserves by other central banks included almost $6.5 trillion worth of U.S. dollars in the first quarter of 2018.
Again, it’s easier for foreign leaders to threaten to sell U.S. assets (dollars and Treasuries) than it is to actually do it. Another consideration is that the United States has the most attractive bond yields among the developed and most stable Western economies. Other nations might not like it, but central banks and foreign entities may have to keep buying U.S. Treasury debt out of preservation and seeking returns, even if they would ultimately prefer to be sellers.
8. What About NAFTA?
Whether there will be an all-out trade war for years into the future remains to be seen, but the president wasted little time in going after the North American Free Trade Agreement (NAFTA) after taking office. Many American businesses have moved operations to Mexico or Canada in the past 20 years or so since NAFTA has been in effect. So targeting Canada and Mexico hits a lot closer to home and can have a much more obvious or similar impact on many business operations than targeting trade with Europe or China.
This NAFTA implosion risk keeps that “economic uncertainty” and “geopolitical risk” argument front and center, and this generally will keep interest rates from flying too high as long as this risk remains.
9. The U.S. Federal Reserve Rate Hikes: Quest Versus Ambitions
It is no secret that the Fed would like to keep rasing short-term interest rates. With a target rate of 1.75% to 2.00%, and with long-term rates closer to 3%, will it dare risk tipping the economy back into recession? The market for federal fund futures is currently pricing in just one or two more 25 basis point interest rate hikes over the coming six months. And the CME FedWatch Tool only had a 36% chance for the target fed funds rate to move up to a range of 2.50% to 2.75% by the September 2019 Federal Open Market Committee (FOMC) meeting.
The president also recently said that he is less than a fan of the continued interest rate hikes from the Fed. Again, inverting the yield curve historically has come in times of recession or almost zero growth. Now consider what happens if rates on the entire yield curve rise just 1% more with over $20 trillion in debt. The TreasuryDirect site showed that the total marketable interest-bearing debt had an average yield of 2.31% at the end of July 2018 (up from 2.08% a year earlier). If that were to rise another 100% basis points, it drives up the government’s annual debt burden by another $200 billion that could be used to pay for education, health care, social security, defense and so on.
24/7 Wall St.10. The Elusive Trump-Induced Recession
Much of the media incorrectly predicted that a Trump victory in 2016 would create an immediate recession. It turned out that this was not the case, and even some of the more pragmatic investors and economists who do not support the president have admitted on CNBC and other media outlets that the climate of lower corporate and personal taxes, a very “pro-business” climate, and other measures brought in the past 18 months are good for the economy.
That said, there are still many investors, economists, business owners and half of the public that still expect the wheels to come off the Trump bus. Whether the Trump Bump turns into a Trump Dump due to the ongoing Russia probe, a major electoral change, scandals about affairs or other avenues, there are still millions of Americans who expect the good times to come to an end. Many international investors are also in that camp.
So far, longer-term Treasury yields have been stuck at 3% and the stock market remains very close to all-time highs.
Stay tuned.
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