Dec 8, 2017 - It seems to me these days the flattening yield curve is our only constant. Perhaps I'm tired and ... unemp
Confessions of a Yield Curve Junkie Title December 08, 2017 By David Ader, Chief Macro Strategist for Informa Financial Intelligence
Ader’s Musings… * Flatter curve is the market’s constant -- themes of a hawkish Fed vs. low inflation resonate -- tax plan stimulus seems likely to meet a less receptive monetary policy * How similar is current state of economy to late 1960? -- Not much at all and it’s more than demographics. * Ray Dalio warns of tax migration stressing already stressed states. It seems to me these days the flattening yield curve is our only constant. Perhaps I’m tired and certainly uninspired, but then a glance at a 10-year yield chart would tell you I have company. This could reflect how little new, critical, information is in the market; we have more Fed hikes being priced in, against still subdued inflation, and we can debate what the tax plan will actual do to boost GDP. The flattening is taking place even as we enter into years of a growing Federal Deficit that will boost all Treasury issuance. Despite their goal to keep the average maturity of outstanding debt at its current level, 66 months for publicly held debt, Treasury’s going to have a hard time doing so given that such debt as a % of GDP is going to skyrocket. It stands at 74.9% today and the CBO projects it will rise to 91.2% in 10 years, and that doesn’t account for any increase as a result of the GOP tax ‘reform’ plan. It’s possible that the market really believes Treasury and that increasing debt will be concentrated in the front end of the curve. In the event, there’s that justification for the recent action. Too, we have a Fed that is clearly bent on further hikes and the market is doing an abundant job of pricing in more. And if the GOP plan goes through and does boost GDP, well given the level of equities and unemployment (the Phillips Curve apparently lives!), the Fed is likely to err on the side of more hikes even if inflation remains subdued. The flattening of the curve makes even more sense in that context. And I think that’s about right, too.
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Title In a recent SF Fed Economic Research Paper, “What’s Down with Inflation?”, at least one thing was accomplished in explaining why the authors didn’t pursue a standup comedy career. More relevant to this discussion is their dive into spending categories that show ‘procyclical’ core inflation has been considerably stronger than ‘acyclical’ inflation. Procyclical inflation is pretty much where it was in 2002-7 while acyclical is some 60 bp less than during that era. Very specifically, they point to healthcare costs which have been held down by legislated changes in Medicare payments. The upshot is that the procyclical measures are back to prerecession levels and serve, along with asset prices and tax-cut stimulus, as ample cover for the Fed move to normalization. It’s not solely about the Fed or Treasury issuance. The infamous market measures of inflation compensation remain remarkably stable as evidenced by Break Even Inflation Rates and the Fed’s own 5-yr/5-yr forwards. This is to say that market doesn’t have the same angst over inflation as the Fed. This also hints that the market thinks the Fed may be getting too aggressive.
I buy that argument. Fed officials have warned about elevated asset prices, the risk of stimulus when the economy was already near full-employment, expectations that wages would pick up, but, frankly, scant evidence that inflation really is bubbling. It may be premature to say the Fed is ‘too’ aggressive, but more aggressive is sufficient for the yield curve’s behavior. What will it look like in a year’s time? I err on the side of a 2% Funds rate next December. The 10s/Funds spread has been trading around 110 bp for the last several months. I think that could narrow to 50-60 bp in a year for a 2.50-60% 10-year note. At least for the 10-year sector that’s nothing dramatic, but the slightly higher rate does accommodate added supply (from the Fed curtailing reinvestment and generic deficit financing) and even a wee bit of inflation.
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Title There will be a point where all this flattening will compel Treasury to shift their view on holding the average maturity at current levels and extend it via more long-term issuance and, watch this space, the addition of 40- or 50-year paper. Isn’t that what prudent debt management is about, and especially so given where the deficit is likely to be in a very short while? That doesn’t extract in the slightest from a strategic view to more flattening in the coming year, perhaps coming two years. But let’s keep it on the radar. CHARTS AND THEMATICS: The FT carried a piece by John Plender, “The Trump bear market for bonds is fast approaching,” ( https://goo.gl/1Cb6PM). Plender’s challenge to the bond market is that the period unfolding looks a lot like the latter half of the 1960s with a low unemployment rate, little economic slack and a ‘complacency’ around low inflation. The upshot was higher inflation (6.4% in early 1970) and bond investors losing 36% in real terms. Thus, he writes that with the tax plan soon to be signed, “it seems almost certain that the President will be definitively putting an end to the 36-year bull market in (Treasuries).” To be fair, he does make note of differences such as the fact that many Treasuries are held by rateinsensitive buyers like pensions and central banks, and that the Fed is quite different now than it was then, including targeting inflation and being more open about its goals. Fiscal policy, too, he notes is more transparent compared to the ease with which Johnson expanded spending for the Vietnam war. Still, he raises concern with the current tax package as fiscal stimulus when the economy is hot along with a grossly (my term) expanding deficit. Let me offer some counterpoints. First, my theme is that while the bond bull market is probably over, i.e. thinking about 1.37% 10s, I’m not sure that the bear market has started or has far to go. There are some striking differences between now and then that warrant visual evidence.
Having graduated from college and grad school at the far left side of the above chart, it strikes me that the grand bond rally went hand in hand with the grand equity rally. Recession-driven corrections aside, the trends are evident. This begs the question that if bonds were to enter a severe bear market then surely stocks would follow suit which would put a brake on the bond retreat, hit the economy, and compel an easier monetary policy. This is, of course, a glib set of generalities, but I put them out there. Some 50 years ago, i.e. the 1960s, about 1/3 of the US workforce belong to unions; today that figure is just over 10%. Bear in mind that the high percentage of union workers were getting those cost-ofliving-adjustments propelling wage growth even as we entered a period of stagflation. COLAs are not a factor anymore meaning that higher inflation, if we were to get it, would not automatically cause wage inflation. 3
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The median age of the US was 28.1 years at the end of the 60s. Today it is 37.9 and rising to, estimate, 39.3 in 10 years. Meanwhile, the percent of the population over 55 was 26% in the early 80s and today is 35%. I’ve written a good deal about how workers get decreasing income gains once they cross 50 (less productive, made their wage gains when moving up the ladder, less mobile) and also are more conservative in both spending and investing habits, all the more so, one would think, if they don’t have those nice union pensions. In short, the demographics I think will dominate economics and keep inflation, growth, and rates down for years to come. It may not be a bull market any long for bonds, but it sure is for geriatrics! A part of that idea is Labor Participation, which has been shrinking though not exclusively due to retiring baby boomers. Indeed, their participation has held up rather well. My sense is that it will continue to do so. But here’s the thing; these older folks want more flexible time, medical benefits, and naturally are less mobile, especially if there are two people working or aging parents around. The point is that that the aging working population demands less in terms of wages and more in terms of other benefits. Another aspect to this could be the difference between real median household income and real mean household incomes. There you see the mean is up a bit from 1999, but the median is a tad less. Why? This shows a skew between a group at the very top who’ve done well and everyone else. Surely, older workers have less of the tech skills that pay well and so fall into a category where they’re less likely to see significant income gains that would prove inflationary. 4
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Another thing that’s different from that distant period is our use of energy. I’m thinking about the oil embargo and all those shortages that went with the early 1970s – I vaguely recall an anchovy crisis, no kidding. Today we use far less energy for every dollar of GDP than we did back then, and in any event, we are as a country less vulnerable to oil shocks for obvious reasons. The chart below shows you energy intensity and its decline from over 10,000 BTUs back in the late 60s to 3,880 today. Wow. We are far less dependent on energy as a result of moving from a manufacturing economy to a service one, and more efficient cars and the use of fleece to keep us warm at home (I made that up). I’m sure education and, until recently, medical costs have provided some staggering contributions to inflation, but at least this one, energy, as a shock to the system that lifted rates to their peaks at the start of the bull market is a marginalized issue.
This next chart may be a sideshow to the big show, but I’ll give it a whirl. I refer to Household Formation. Household formation has been slow in the last decade plus, in part because men and women are postponing the age of marriage, staying more urban, having few children and having those later in life and ‘non-traditional’ relationships have increased their share of families, certainly compared to the 1960s and 70s. Slower household formation and cultural shifts means less conventional interest in, say, moving to large homes in suburbs and accumulating all the stuff we did at another age; thinks toys, cars, that kayak in the garage (what was I thinking?). 5
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Lastly, for my purpose I will point out for the umpteenth time the state of debt in the US. Total US Government debt held by the public amounts to 74.9% of GDP today and is going to 91.2% in 2027 per CBO projections. Total debt is 104% and will rise to over 120% by 2027. Note these figures don’t allow for any increase in the deficit due to the GOP tax plan. For context, debt help by the public was 25% in 1970 and overall public debt was 37%. The soaring debt as a % of GDP hasn’t propelled the 10-year expansion quite into the phase of escape velocity and the litany of academic work that shows high deficits lead to slow growth is out there. So, as you look at this chart imagine the cost of debt service in the coming years and especially so if we see rates rise. That is surely a drag on growth and inflation which serves as another reason to think the coming bear market in bonds will be more Teddy-bear than grizzly.
IN OTHER NEWS: Productivity looked okay with the Q3 release, but let me throw some cold water on the ostensibly good news. Non-farm productivity did rise 3% as Unit Labor Costs dropped 0.2%. Alas, if you dig a bit you’d see that it was concentrated. Non-financial Productivity was flat while Unit Labor Costs rose 2.5%. Real compensation was up 0.5%. These are QoQ AR, by the way. Manufacturing Productivity fell 4.4% with real compensation down 1.8%. Real Non-farm compensation dropped 0.6% YoY and 0.4% for the Business Sector.
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Which reminds me of the latest Liscio Report. Amongst the many gems one finds in that report, they noted the results of a BoA/ML survey of CEOs which led me to that Washington Post piece on the same topic. The latter was coverage of the WSJ’s CEO Council meeting last month where Gary Cohen got a rather dismal response to his question as to who would invest more if tax reform went through; “Cohn looked surprised. ‘Why aren't the other hands up?’ he said.” That lack of enthusiasm dovetails with the BoA/ML survey which found the #1 response to that question was to pay down debt. Given the high level or corporate debt this is a sound thing to do. The second response was for more stock buybacks. Third was to use money for mergers. Needless to say, these are not job-creating ventures. Just to add my two cents to the mix, given the level of the stock market and corporate profits heretofore, you would think businesses already had ample cash to use for investments if they deemed that important over these last several years. From the WP article, “Actual investments in new factories and more research were low on the list of plans for how to spend extra money.” Fellow Westporter (Connecticut) Ray Dalio wrote a piece on LinkedIn warning of tax migration due to the differences in state and local tax rates (https://goo.gl/zHFZbr). It goes without say that the tax package underway would exacerbate those differences as state and local tax deductions go away, and Dalio goes into painstaking detail, visually via charts and in his narrative, to portray the situation. (NB, he cites the elimination of the SALT deduction as an effective $1 trillion tax on those staying in high-tax locales.) The upshot is obvious. 1) state and local taxes will rise due to increasing debt that can’t be reduced, 2) the higher taxes will incentivize the well-to-do people to move to low tax states, 3) which will lower the value of homes in the offending location, with 4) the consequences that departing high earners, who are also high spenders, will further stress the economies of high tax areas. He hints at political and social unrest, too. The idea is that those left in the highly taxed states will raise tensions, potentially to inhospitable levels, furthering the motivation to move. Meanwhile, where they’re moving to, will also see more polarization between the haves and have nots.
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Title Dalio has some wonderful(?) charts and tables and I encourage you to take a look at his work and either cringe or smile, depending on where you’re reading from. But I’ll include two which underscore how important the well-off are to state tax coffers.
I suppose it’s at least worth pointing out that of the states in the chart, only Iowa went for Donald Trump. Anyway, this next chart shows the % of those high earners in terms of all taxpayers which means that they have an exaggerated impact on revenues when they move to another state.
Meanwhile, Westport is a lovely town, what with the playhouse, lots of good restaurants, top schools, beaches on the LI Sound and running past Bridgewater’s offices a decent catch and release trout stream and a surprising number of garage sales these days. Paul Newman lived here. So did Rod Serling and Rodney Dangerfield. And Marilyn Chambers! Today, you might catch a glimpse of Keith Richards, he lives nearby, and that’s cool. But then, so does Harvey Weinstein. I know a guy with a modest but lovely 1928 near the nature preserve who may soon be a motivated seller! Contact me if interested.
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Title NEAR-TERM MARKET THOUGHTS: I have two and one is not price-action related so let me start there. In advance of NFP, I saw Gillian Tett’s Comment in the FT, “Self-driving finance could turn into a runaway train.” Knowing little about Bitcoin and less about the whole concept other than the tulipmaniacal price action, I thought I’d learn something. And I did. Ms. Tett, fortunately, wrote more about electronic markets than Bitcoin. To wit, she made note of academic estimates that computers generate 50-70% of trade in equities, 60% in futures and 50% in Treasuries. “Increasingly, machine learning and artificial intelligence are being added to the mix, to analyse data, trade securities and offer investment advice,” she writes. So, it’s not just taxi and truckers losing out, huh? Let me quip that artificial intelligence has been around since as long as I’ve been in the markets, and not just me but also traders and salesmen who think they were more important than the seat they occupied. Tett’s warnings are that technology is moving ahead of controls; who, for instance, is responsible if a trading system goes bonkers, or how do you handle issues with cross-border trading when regulators and rules are local. All are legitimate and important issues to raise. But I think back to those trading desks, recalling open outcry in Chicago and a teeming mass of people in garish jackets making a living. I’m thinking about careers. It’s easy to envision an algorithm that looks in a flash at, say, NFP, tells you what it all means, weights the changes, and then who needs an economist? It can’t be a leap for a computer to but a brief narrative to the numbers either and then trade the outcome. “Now what?” he asks. Anywho, at the very start of this Musings I brought up the lack of inspiration that comes with the 10year chart. I got nothing for you. 10s are moving sideways in a confining, okay call it coiling, range and momentum measures, sentiment in the form of DSIs are all pretty middling. Despite the softish wage element to the latest NFP report (2.5% YoY or 0.5% real if inflation comes in at 2%) was certainly okay and amply firm enough to give us a Fed hike on the 13th. My resistance is a terribly lame 2.30% trendline and 200-day MA with support at 2.42+ to 2.43+%. Yawn. I continue to ‘feel’ (never a good form of analysis) that the curve risks some steepening between now and year end. That’s totally tactical. But my view is that 1) the Fed’s priced in so buy the rumor and all that, 2) if we learned anything from NFP it’s that wages continue to disappoint, 3) those seasonal patterns have been reliable, 4) Congress has a short-term spending bill, though I could argue that both ways, and maybe most important of all, 5) technical momentum favors steepening.
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Bringing 30 years of investment strategy experience to his role at Informa Financial Intelligence, David Ader has held senior positions at major investment banks and financial information firms as well as serving on investment policy committees and management teams. Most recently Partner, Head of Government Bond Strategy for CRT Capital, he headed the team voted #1 in U.S. Rates Strategy for 11 years and #1 in Technical Analysis for five years in Institutional Investor’s annual survey.
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David Ader is Chief Macro Strategist for Informa Financial Intelligence. For further information on our products and services, please see: https://financialintelligence.informa.com/
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