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K E S S L E R K E S S L E R I N V E S T M E N T A D V I S O R S , I N C . & C O M P A N Y I N V E S T M E N T S , I N C .
What has happened to long-term U.S. Treasury yields and why they wont stay up here for long
What happened
US Treasury yields have risen sharply in the last four weeks with 10yr yields higher by about 50 basis points (fig.1). We are the first to admit that we didnt see this coming, but other than the secular and political interest rate bears, no one else did either. more than expected yet Building permits were less than expected. For the whole picture, it helps to consider indicators that combine individual data for the month into a single number. All of these show a slowing, not improving economy. The Chicago Fed National Activity Index showed a decrease in aggregate activity, the coincident indicators index (correlates well with real GDP growth) grew at just an annualized rate of 1.2%, and our Kessler Interest Rate Economic Indicator modeled after the Chicago Fed National Activity index is showing a decrease as well. Then of course, there is Ben Bernanke who made the slightest hint to the possibility that a tapering of purchases could begin in the next few meetings if the economics warranted. It wasnt so much what he said on its face, but just that the markets hadnt imagined this possibility was even entertained by him until that moment. But trying to position a trade based on the impact of the Fed quickly becomes a reflexive exercise going no place because the Treasury market finds a way to reflect macroeconomics despite them. The history of the Fed shows that economics always trumps their effects. This isnt to say that at any given moment, the Fed may have interest rates at a different level than they otherwise would be, but it isnt useful to use this as a reason to buy or sell because a change in their buying could just as easily mean that the economy will be weaker and thus rates would fall as that they would cause rates to rise. Regardless, yields have risen dramatically and we are not trying to dismiss it. The price is the price, however; it is important for us to express our thoughts for where we think yields are
01/01/2013 05/29/2013
+0.54%
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Direct causation is hard to find. While the economic data has improved in places, the prices have moved much more than the facts1! For just about every good piece of data, there was an equal piece of bad news. For instance, where the jobs report showed an unemployment rate improving to 7.5% from 7.6%, the broader underemployment rate (U6) that includes those that would like to work but havent looked for a job in the last 4 weeks, worsened to 13.9% from 13.8%. Durable goods orders came in better than expected, yet Industrial production came in worse than expected. New home sales were
1 This
phrase is borrowed from David Ader and Ian Lyngen at CRT Capital
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013
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ultimately going, especially when there is virtually no one out there to make this case. We also realize that the market never trades based on what the economy looks like now, but rather where it thinks it will be. And so, what this recent yield back-up boils down to is that the market is expecting that there is self-sustaining, above trend, GDP growth coming. It isnt often that prices become this divorced from fundamentals. Expecting selfsustaining above trend growth is hoping, not the result of a careful analysis. We continue to think that no matter how forceful this back-up has been, or where it ultimately peaks, we will see new low yields in the Treasury market before this cycle is over. Here is why.
leading indicator. The market hopes that higher consumer confidence will translate into higher consumer spending but that is far from guaranteed (fig.3).
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In the short-run: 1. The macro ingredients arent nearly there for the Fed to tighten policy and create a major sell-off in bonds like 1994 or 1999. It is useful to look at the state of the economy before major previous Fed tightening episodes (fig.2).
3. Inflation continues to fall. The core PCE deflator is running at 1.1% (yoy%) and is expected to drop to 1.0% this Friday, 05/31/2013 (fig.4).
Now
4/30/2013
Output Gap/Surplus Non-farm payrolls (prior 12 month avg) Unemployment Rate Real Retail Sales YoY Core Inflation (PCE)
*note: population has grown by 20% since 1994, and 14% since 1999
2. Higher consumer confidence was cited as a major reason for the large bond sell-off this Tuesday (05/28/2013). This indicator is not a
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013
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2014
4. Commodities are not confirming the risk-on sentiment, and for one important case, is suggesting the opposite (fig.5).
5. Positive sentiment exploded with the housing news released in May, but it is important to look at these charts nominally. Because they have fallen so much, high growth rates represent small nominal gains (fig.6).
fig.5 Commodities have been decreasing which is not consistent with a risk-on bull market
CRB commodity index
500 450 400
01/2005 05/29/2013
1,200k
350 300 250 200 150 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Data Sources: Thompson/Reuters, Jefferies
This indicator has improved by 68.2%! from the trough, but the percentage is nearly meaningless when the value has fallen so much.
-11.4%
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0k 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Data Source: U.S. Census Bureau
$380
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6. Europe is in recession. So far, the U.S. has been able to ignore it because it hasnt shown up in a measurable way. But, it would be a stretch to expect that this won't have some drag on U.S. growth when Europe represents nearly a quarter of global GDP (23%). The new Treasury Secretary, Jacob Lew, has been harping on this and just yesterday, the OECD cut their 2013 global growth forecast (fig.7).
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Note: Lumber futures are not a heavily traded contract and the reasons for this price drop may eventually relate to reasons endemic to the industry in addition to macroeconomic reasoning.
Data Source: Chicago Mercantile Exchange
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013
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01/1996 03/2013
EXPANSION
2% 0% 1996 -2% -4% -6%
Data Source: Eurostat
Great Depression and Japans lost decades are that deleveraging will become structural (i.e. Pimcos New Normal theory), last a very long time (10yrs or more), and likely overshoot to an underleveraged position. For the U.S. consumer to reduce their debt to 90% of disposable income (a reasonable level chosen for an example), they will pay down a further $1.8 trillion of debt. If this were spread over the next five years, it is a drag on GDP averaging about 2% per year (fig.9).
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Europe represents an even bigger percent of world GDP than the US, 23.1%. This will eventually exert a drag on the U.S.
CONTRACTION
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fig.8 China is slowing and the risk of a sharp slowdown is ever present
Chinese Manufacturing Purchasing Managers Index (PMI)
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100% 90% 80% 70% 60% 50% 1960 1970 1980 1990 2000 2010 2020
01/2005 05/2013
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EXPANSION CONTRACTION The latest data point (an estimate published by HSBC) showing contraction was cited as a reason for the Nikkeis sudden 7% drop on May 23, 2013
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As an aside, this is a helpful explanation for why the Fed has been so aggressive, but they cannot control consumer behavior or demographics, they can only try to offset them. 2. Weve written about the Output Gap many times before but it is still relevant and wide. By the Congressional Budget Offices estimate of the economys potential, the economy is operating more than 5% below its potential. This is important for estimating when demand will equal supply to create inflationary pressures in the economy as well as for when it would make sense for the Fed to tighten policy (fig.10).
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Data Sources: China Federation of Logistics and Purchasing, HSBC
In the long-run: 1. There is no indication that the consumer is finished deleveraging. While there is no way to know when this turns around, unless this time is different, the experiences from the
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013
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fig.10 The output gap is not closing with ongoing 2%-type GDP growth
U.S. Real GDP (2005 dollars) actual and potential
gro wt h
fig.11 The often used mirror chart to suggest an end to the bull market in Treasuries
10yr UST Yields
18% 16% 14% 12% 10% 8%
01/2007 01/2022
$17tn $16tn $15tn $14tn $13tn $12tn
TH OE ER
NP TIO
RE
T AL T IC
ES HR
L HO
E UR SS h wt gro % 3 th wi w th
wit h
01/1950 05/2013
4%
w i th
ro %g
The implication is that yields will begin climbing in a mirror-like fashion from this point.
2.1
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th row %g
r... o fa
6% 4% 2%
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0%
3. Many commentators point out the mirror-like symmetry of US Treasury yields round trip from 2% to 16% to 2% with roughly 32 years on each side. The implication is that going forward should look like putting up a mirror to the last 32 years. What is rarely brought out is that US Treasury yields did not make their trough of 1.55% until 16 years after the 1929 stock market peak and if the recent 0.44% 10yr JGB yield proves to be a cycle low, this is 23 years past the Nikkeis stock market peak. But also, the high rates of the 70s and 80s were a one time anomaly in the entire history of interest rates (fig.11 and fig.12). Consider this quote from Sidney Homer and Richard Syllas highly regarded A History of Interest Rates,
..yet extending the chart back to 1920 shows it was anything but mirror-like prior to 1950.
10yr UST Yields
18% 16% 14% 12% 10% 8% 6% 4% 2% 0%
01/1920 05/2013
...recent peak yields were far above the highest prime long-term rates reported in the United States since 1800, in England since 1700, or in Holland since 1600. In other words, since modern capital markets came into existence, there have never been such high long-term rates as we had all over the world a quarter century ago.
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013
1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Data Source: Bloomberg
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fig.12 Past experiences of interest rates after major credit crises show that they take decades to work out. We think that the Bernanke Fed has accelerated this process but not by as much as is commonly thought. 10yr Government bond rates calibrated to the beginnings of deleveraging cycles
JAPANESE LOST DECADES 10yr JGB starting 12/1989 THE GREAT DEPRESSION 10yr UST starting 08/1929 NOW 10yr UST starting 10/2007
n
9% 8% 7% 6% 5% 4% 3% 2% 1%
Now
0% 00yrs
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We cannot know if this yield backup has run its course but from our perspective, it isnt a question of if, but when yields resume their downward trend. As always, we look forward to the time when economics deem a shift from being fundamentally long to fundamentally short interest rates, but we do not see this yet.
Prepared by Kessler Investment Advisors, Inc. and Kessler & Company Investments, Inc. | 5/30/2013
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