Market Update


Market Update


photo-1420745628365-ba93c07cb5caAfter setting a new record low of 1.36% on July 8, the 10-year US Treasury Note yield has averaged 1.54% over the past month. The 30-year bond has also moved off its record 2.10% low yield of a month ago. The low yields were brought on by a run up in the price of Treasury securities. Demand for Treasuries from investors foreign and domestic has been red-hot. The reasons are many – from concerns over economic Armageddon (due to war, pestilence, politics, and a general fear for the health of the global economy), to a search for yield in an investment landscape where a number of sovereign debt yields like Japan and Germany have dipped into negative territory.

In 2016, the US economy started yet another year with Q1 growth barely above zero. Since 2010, the initial Q1 growth report has averaged just under 0.5%, while the economy has grown an average 2.1% over the course of those same years. Beginning each year with a thud sends investors to the sidelines, and their investment funds into the relative safety of US Treasuries. This drives up Treasury prices, and drives down the interest rates on those securities.

The rest of the global economy was performing even worse than the US, especially once GDP growth in China slowed (with the exception of Germany and some developing nations). The flight to government bonds by panicked investors (worried both over the economy and terrorism) drove global sovereign bond yields close to zero (and below for Germany, Japan, Switzerland, France, Sweden, and The Netherlands).

A look at a sampling of Treasury rates around the globe (as of Friday’s close):
Screenshot 2016-08-19 at 7.05.30 AMIt’s little wonder why a global investor looking for a safe place to invest money for 5 years would opt to buy a 5-year US Treasury at a 1.10% yield, versus a 5-year German Treasury at a minus 0.55% yield – and they have been doing so in a big way.

However, things are changing. If you’re an investor in Switzerland, and you decide to buy the 10-year US Treasury Bond at a 1.51% yield, you have to convert your Swiss Francs into US Dollars to buy the bonds. When the 10-years are up, you will receive your investment back (with interest) in US Dollars, which you will have to convert back into Swiss Francs. Since most investors want to avoid the risk that a change in the US / Swiss foreign exchange (FX) rate would wind up losing them money, they hedge all their FX exposure at the beginning.

The cost of doing this has been steadily increasing of late. Last month, yields on U.S. 10-year notes turned negative for Japanese buyers who pay to eliminate currency fluctuations from their returns, something that hasn’t happened since the 2008 financial crisis. It’s even worse for Euro-based investors, who are locking in sub-zero returns on US Treasuries for the first time in history – thanks to FX hedging costs.

The fact that yields on 10-year Treasuries are still well above those in Japan or Germany is part of the reason foreigners are now having such a hard time profiting from the difference. Negative interest rates outside the U.S. have caused a surge in demand for dollars and dollar assets, pushing up the cost to get into and out of the US Dollar, with no FX risk, to levels rarely seen in the past.

Ten-year Treasury yields in the US are currently about 140 basis points (1.40%) in yield above a basket of bonds from Australia, France, Germany, Italy, Japan, Spain and Switzerland on an unhedged (FX) basis. However, once you hedge the FX risk, the return on the US 10-year Note is 23 basis points (-0.23%) below the same basket of foreign bonds.

Screenshot 2016-08-19 at 7.05.57 AM
This hedging cost is starting to impact the record foreign demand for US Treasuries, which has underpinned the run-up in prices and pushed rates to record lows in recent years. Instead, some fund managers are opting to buy French and Italian Treasury Bonds because they offer a bit of positive yield at much lower FX hedging costs than the US.

As such, we have begun to see net foreign flows to the US begin to slow. Foreign central banks and sovereign wealth funds have been selling US securities in order to raise cash to put to work at home. In May, official institutions abroad took $26 billion out of US stocks and bonds. And, while private investors abroad were net buyers of US securities in May, it wasn’t enough. Total foreign flows out of US securities totaled $11 billion in May – sharply reversing April’s $80.4 billion of inflows.

When we look at the trend, on a rolling 12-month basis, inflows to the U.S. from foreign investors fell to $47.2 billion as of May, which is the second-lowest reading since May 1992. Overseas institutions (led by central banks and sovereign wealth funds in China and the Middle East) have been dumping US Treasuries and stocks over the past year to support their weakening currencies and stem capital outflows (as “once-hot” economies like China and India start to slow, investors take their capital elsewhere).

Screenshot 2016-08-19 at 7.07.26 AM

In other news, following last week’s July employment report, this was a relatively quiet week. We did get another look at US consumers with the July Retail Sales report. Following a very strong (+0.8%) performance in June, July sales were essentially flat (however, including upward revisions to prior months, sales were actually up 0.2%), as consumers flocked to auto dealers at the expense of other merchants. We reported last week that July auto sales surged 6.8% to the fastest sales pace this year. However, retail sales, ex-autos, fell 0.3%.

Retail sales have grown up to a 4.4% annual rate over the past six months, versus a 2.3% gain over the past twelve. In addition to autos, non-store retailers were up 1.3%. Non-store (internet) retail sales are up 14.1% from a year ago – tied with June as the largest yearly gain since 2006 (and explains why Macy’s will be closing another 100 stores). Sales at gasoline stations fell 2.7% in July, and “core” sales (which exclude autos, gasoline stations, and building materials) declined 0.1% in July, but remain 3.6% above year-ago levels.

The first of the twin inflation reports showed that Producer Prices (PPI) fell 0.4% in July after the fastest three-month growth in nearly four years. Prices for services led the index lower in July, as retailers and wholesalers both saw falling margins, while prices for goods also fell, with both food and energy costs declining. Despite the price drop in July PPI, producer price inflation is showing a pick-up – rising at a 2.2% annualized rate over the past three months compared to a 0.2% decline a year ago.

We’re half way through Q3 and the US economy is stepping up after another slow start. The Atlanta Fed (which has a wide following for its GDP estimates) has upped its forecast for third quarter real GDP growth to a 3.8% annual rate, based on recent data (GDP rose at a 0.8% annual rate in Q1, and 1.2% in Q2). The 3.8% forecast assumes a strong rebound in inventories (which lowered growth in the first half) and further strong growth in consumer spending, which may or may not occur. By comparison, the NY Fed projects 2.6% growth in Q3. Either way, both show the improvement over the first half of 2016.

It helps explain the bounce in stocks of late. With nearly all of the S&P 500 reporting, over 70% of those firms have reported Q2 earnings that were above estimates, with another 11% meeting expectations (about 17% missed their targets). The NASDAQ closed the week at a new high, while the Dow and S&P 500 set new highs on Thursday, before easing back a bit on Friday.

The rally in interest rates that has taken the 10-year Treasury from 4.00% in 2010 to a record low of 1.36% a month ago has been driven by a number of factors – most have which have run their course:

  • The Fed lowering short rates
    The Fed is now trying to determine when to hike short-term rates
  • US economic conditions
    Fears that the US economy would not recover
  • Global economic conditions
    That China, Greece, Brexit, et al, problems would lead to a global melt-down
  • Mortgage refinancings
    Portfolio managers bought long Treasuries in droves to bolster their portfolios as home- owners refinanced their 6% mortgages to 5%, then 4%
  • The search for yield
    Foreign investors bought US Treasuries because their own sovereign debt was below zero.

Think about the US Treasury yield curve like a diving board at a pool. Today, short rates (Fed Funds and LIBOR) are near 0.50%, with the 10-year Treasury near 1.50%. The 100 basis points (1.00%) difference between the two rates is narrow, historically (what is called a flat yield curve). Without the 5 issues listed above weighing on the “diving board” (yield curve), that spread would be wider, and the yield curve steeper. If a few of these concerns were to jump off the diving board, the board (and rates) would snap sharply higher.
Short and long US interest rates are below “normal,” given growing employment, rising inflation, and constant (albeit tepid) 2.1% GDP growth. The Fed controls short rates by moving the Fed Funds rate. However, long rates are driven by the markets’ expectations for growth, demand for capital, and inflation. Long rates have been held down by a perfect storm of the worries listed above, plus other concerns (like global conflict – the Ukraine, the Middle East, etc.). And, we can’t forget the elephant in the room – who will take over the White House in January and what that may mean for US economic growth prospects in 2017 and beyond? The effects of monetary policies from central banks, like the Fed, have reached their limit and, going forward, fiscal policies will determine how well the economy will fare. The presidential candidates offer very different plans for their fiscal programs.

Borrowers and investors alike have become complacent with low long-term interest rates here at home, and many believe the trend will continue. But, trends don’t last forever. While US long-term rates may not rise sharply in the near term, we may well have seen the low point for long-term rates for this interest rate cycle.