One of the lead stories at Bloomberg this morning is an article about foreigners shying away from “financing the US government”. And the conclusion of this article is that it could mean higher interest rates in the US. Is this conclusion the right one though, and how should you respond as an investor? I have some thoughts on that below.
First, let me say, I see this as the fundamental value equivalent for fixed income that people are always asking about equities: How much are these financial assets really worth? And as every trader knows, it’s hard to reconcile fundamental value arguments with what’s happening in the market when they are posited in supply and demand frameworks. That’s because for every seller, there is a buyer and vice versa. And markets can rise or fall on thin or on heavy volume. None of that tells you anything about what an asset’s fundamental value is.
In the case of equities, the fundamental value is represented by the present value of the stream of cash flows that a given enterprise can throw off and be captured by owners over its lifetime. If your view of the fundamentals are markedly different from the consensus view, you have a decision to make as a value investor. And over time, if your view is proved right, you can make a lot of money. That’s how Warren Buffett has become famous.
In the case of government bonds, there is also a fundamental value. And it is represented by four things: inflation, real interest rates, maturity premia and default premia. For the bonds of monetarily sovereign nations you can drop the default risk and be left with the other three: inflation, real interest rates and the maturity (or reinvestment) risk; add those three together and you get your bond yield.
This is how former Fed Chair Ben Bernanke described it in 2015, for example:
To explain the behavior of longer-term rates, it helps to decompose the yield on any particular bond, such as a Treasury bond issued by the US government, into three components: expected inflation, expectations about the future path of real short-term interest rates, and a term premium. At present, all three components are helping to keep longer-term interest rates low. Inflation is low and expected to remain so, so lenders are not demanding higher returns to compensate for anticipated losses in their purchasing power. Short-term interest rates are also expected to remain low, as bondholders appear pessimistic about growth prospects and the sustainable returns to capital in coming years. When short-term rates are expected to remain low, longer-term rates tend to get bid down as well.
Bernanke was talking about why Treasury rates were so low – and used the fundamental value equation of expected inflation, the real short-rate path and the term premium to explain that low rates reflected consensus market expectations on all three. If any of the three expectations changed, then rates would change.
But what about supply and demand? The Bloomberg article says:
any consistent drop-off in foreign demand could have lasting consequences on America’s ability to finance itself cheaply, particularly in light of Trump’s ambitious plans to boost infrastructure spending, cut taxes and put “America First.”
This isn’t true though. Treasury yields are not dictated by foreign demand at all. Remember, for every seller, there’s a buyer. And to the degree the sellers are foreigners, either those foreigners are reallocating their dollars to other US dollar asset markets or they are selling US dollars and bidding down the currency. Right now the US dollar is strong. So obviously foreigners are moving into riskier asset classes. The fundamental value of Treasuries in terms of inflation, real yield and term premium is totally unaffected by this.
Now in 2017, we are in a different world than 2015. Where Bernanke was talking about consistently low expectations in 2015, he would now be talking about rising expectations on all three — inflation, the term premium, and maybe even real yields.
After the financial crisis, real yields dipped, causing people to talk about the Fed and financial repression. But since about 2013, real yields have reverted back to norms. But they are still well below pre-crisis levels.
The constant maturity treasury rate for 10-year TIPS is still only 0.5% versus some 2% before the crisis. That’s up from the financial repression levels of 2011 and 2013, but it is still historically low.
So, with foreign investors dumping Treasuries, the right way to look at this is to avoid making supply and demand arguments for a fundamental value question altogether. If you had made a supply and demand argument for trading the Brexit vote, for example, you would have sold Gilts. But, you would have lost a lot of money too, because after the Brexit vote, UK government bond yields plummeted as people flocked to safe assets. The supply and demand argument didn’t work. The currency was the release valve for any lack of foreign demand.
So the same applies with the US as well. The real question is whether we are still in a persistently lowflation, financial repression world. If we are, then bond yields will stop rising as the expected path of real yields, inflation and the term premium fall. On the other hand, if you think lowflation is over and the Fed is set to hike aggressively, then, yes, you want to get ready for rising rates.
My view: St. Louis Fed President Bullard’s view of the world will start to predominate at the Fed. He thinks of the monetary policy world as binary – either one in which lowflation and financial repression continue to dominate or where the Fed fully normalizes policy. Tim Duty explains:
He sees the economy as stuck in a “low-safe-real-rate regime” and forecasts it will remain in there over the near term. He owns the infamous bottom dot in the Fed’s December Summary of Economic Projections, predicting a policy rate of just 75 basis points to 100 basis points through 2019.
In the Bullard world view, a Fed that raises rates too quickly is one that flattens the yield curve and chokes off the recovery. And with the real recovery floundering, risk assets like high yield and equities would be hit hard. So, if the economic cycle continues, at some point the Fed will have to reassess its present view that focusing on interest rates instead of the balance sheet still makes sense.
Bullard is saying that the Fed will have to do some of the policy normalization by shrinking its balance sheet if it is to avoid the spectre of a flat curve. And I think this is the view that will come to the fore at the Fed. This means the Fed’s rate hike train will be less severe than the Fed has laid out. Invest accordingly.