Tuesday, January 30, 2018

Rising bond yields are a good thing

Stocks are nervous because bond yields are rising. As I noted six weeks ago, the bond market is beginning to figure things out: corporate tax cuts are going to lead to a stronger-than-expected economy, and that in turn means the Fed is going to have to raise rates by more than expected. The key 5-yr real yield on TIPS is now 0.45%, and that's 65 bps higher than it was a year ago. 10-yr Treasury yields are 2.73% today, and it looks more and more like the epic bond bull market is a thing of the past. We're still in the early innings, however.

Chart #1

Chart #1 updates Chart #4 from this post earlier this month. The downtrend in bond yields looks to have been broken, and there is plenty of room for yields to move higher still. 

Chart #2

Chart #2 compares the all-important 5-yr real yield on TIPS with the current real Fed funds rate. The spread between the two is widening, which means the market is pricing in more Fed tightening than it had previously expected. This is good.

But there are still some troubling signs which suggest the market is not yet convinced that the Fed is going to be tightening by as much as it should, given the decline in the demand for money, as I noted in Chart #5 in this post. Gold prices are down a bit from their recent highs, but I'd like to see them lower still. The dollar has been steady for the past few days, but it is still down by over 10% in the past year. If the market were convinced that the economy was strengthening and the Fed would be raising real rates in tandem, then I have to believe the dollar would be a lot stronger and gold weaker. These are things to watch carefully as the year progresses. As I say, we're still in the early innings in all of this.

I'm doing my best to keep up, despite having a great time traveling through New Zealand, a trip that has long been on our bucket list.

28 comments:

Andrew Ross said...

While tax cuts will eventually result in greater corporate profits, in the meantime the Treasury will have to sell more bonds to make up for the shortfall to the Gov't budget. The market will respond to these sales, by lowering the offer price for US bonds. The weaker dollar is also symptomatic that international investors are not too keen on buying all of the debt.

Still too early to determine if greater US economic activity will result in greater tax revenue and then a decrease in debt financing.

Scott Grannis said...

I think there is an excellent chance that revenues from corporate profits this year will exceed those of last year. Last year, federal revenues from corporate profits totaled $283 billion. That reflected zero change from 2013, and a $65 billion decline from 2014. If corporations (like Apple) repatriate just 10-15% of their overseas profits next year (a very conservative assumption, I would argue), then federal revenues from corporations could increase next year by $40-50 billion at least. That's a 15% increase, thanks to lower corporate profit tax rates!

And of course, if economic growth picks up this year relative to last year, then the tax base also increases, and that could easily offset the effect of lower tax rates. Not to mention that evasion could decline, etc.

And in any event, I have never seen evidence to support the assumption that changes in the federal deficit have an impact on interest rates. I think the evidence is far stronger in favor of growth and inflation expectations and Fed expectations impacting interest rates.

Adam said...

Treasury secretary expects that budget revenues will rise ca 2 trn next 10 years due to a higer GDP growth.

Benjamin Cole said...

Great post again, and love the numbered charts.

I also wonder if the epic bond rally is finally over. Really, this was a bull in bonds that lasted nearly four decades, going back to the early Volcker days.

Somewhat comically, nearly all of my adult life has been defined by rising bond values and falling interest rates, and strident forecasts of rising inflation.

Meanwhile, in Japan, JGB yields finally went to zero, where they are today. German bonds are at zero also.

I have long wondered about globalized capital markets. There are piles of capital globally, and plenty want to invest in the US, and buy US debt. Seems to me that will hold rates down.

Maybe the new normal is very low real interest rates, by historical standards.

I hope we never have another recession, but they tend to come unexpectedly. I expect in the next recession we see interest rates hit zero.

Inflation right now is running at about 1.5% on the PCE, so we could hit deflation rather quickly in a recession.

They say no recession in 2018, and I hope so.

Gold? The Russian and China central banks are big buyers of gold, and the biggest buyers of gold are jewelry buyers in China and India. As my grandfather once said, "All gold is fool's gold."

That sentiment may apply in the investing world.



Unknown said...

We did a 3 day hike through Milford Sound called the Hollyford track a couple years ago. Wow. Make sure you see Milford Sound; and Queenstown! And Waiheke Island off Aukland. And Rotorua. And...

Scott Grannis said...

We’ve been to Waiheke Island and Rotorua. Going to Queenstown and Milford Sound in a few days. It’s a magnificent country!

Adam said...

Gdp now forecasts 5,2% for q1 18.
https://www.frbatlanta.org/cqer/research/gdpnow.aspx

Rob said...

Scott do you have any view on crypto currencies .. eg is it a bubbke (now bursting) ? If USD strengthens then do cryptos lose their attraction? Thank you.

marcusbalbus said...

you must feel pretty dumb now having written this

Scott Grannis said...

When the market sells off on good news that is a buying opportunity. Interest rates are rising because the economy is doing better than expected. That is good news.

steve said...

Scott, I'm not nearly as sure about this as you are. Rising yields along with a protectionist president does not sound like good news to me.

Matthew Pool said...
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Matthew Pool said...

It seems to me like the markets are legitimizing and re-calculating the discount rate for future investment and risk asset values.

In other words, we may see a more dramatic re-balancing in the constant price discovery of the relative risk/return ratio of safe to risky assets.

I see many forum posts (Bogleheads) lamenting their "safe" bond funds losing value.

Some people don't realize that stock and bond values are not always inversely correlated.

Scott Grannis said...

steve: The rise in bond yields is still very modest. Real yields are still very low. Liquidity is still abundant. Credit spreads are still very low. The Fed has given no indication that a true tightening of policy is on the horizon. The rise in rates so far is perfectly consistent with the strengthening of the economy that we are witnessing. Trump has taken a baby step in regards protectionism. The overwhelming change in the outlook is tax reform and the improved incentives this brings to investment and growth. I just can't get concerned.

Scott Grannis said...

Rob: re crypto currencies. Crypto currencies are pure speculative investments at this point, since no one has any idea of their true value. I do see value in blockchain technology (which allows safe and anonymous transactions without intermediaries), but it can be applied in a number of areas, and most likely will be.

marcusbalbus said...

still feeling good about this post?

Scott Grannis said...

Yes

marcusbalbus said...

i admire your tenacity, but when the facts change.....

Charlie said...

marcusbalbus, since I'm a liberal and a layman and I guess maybe you are too, I'll suggest you read an educational post about market corrections at bonddad.blogspot.com/2018/02/a-comment-about-markets-for-average.html.

Adam said...

This forced selling episode has done good job:cleared some vol space and lenghten the expansion phase.

steve said...

I don't like what I'm seeing out of DC re spending. Literally blowing away spending caps. Couple this with rising inflation due to a stronger economy and pressure on rates will be execrable. Add to the mix a Fed that is raising short rates and a protectionist president and I'm getting a sick feeling in my belly.

marcusbalbus said...

charlie: i'm a trained economist and a bond trader. this site is erudite but panglossian. there is no money solution to our problems.

randy said...
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Benjamin Cole said...

Sometimes they say the Fed will "take away the punch bowl."

This market seems to believe the Fed has shotguns leveled at the party.

Alain said...
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Alain said...

Marcus.

Stop talking like a douche bag.

Panglossian.

Wtf man. Seriously.

marcusbalbus said...

alain: you are a trained drunk i take it?

Alain said...

How did you know?

Must have drank to many erudites.

Now I am feeling panglossian to my stomach.

It's the worst.