Bonds & Interest Rates

The Problem With Rosy Economic Forecasts

“I have little doubt that with excess savings, new stimulus, huge deficit spending, more QE, a new potential infrastructure bill, a successful vaccine, and euphoria around the end of the pandemic, the U.S. economy will likely boom. This boom could easily run into 2023 because all the spending could extend well into 2023.” – Jamie Dimon, CEO JP Morgan Chase

There are many problems with this view looking forward.

To begin with, the vast majority of American’s do not have excess savings. If they did, then repeated stimulus payments wouldn’t be needed to support economic growth. The reality is “savings” get skewed by the top 20% of income earners, notably the 0.01% like Jamie Dimon.

The top 5%, of income earners skew the measure. Those in the top 20% have seen substantially larger median wage growth versus the bottom 80%. (Note: all data used below is from the Census Bureau and the IRS.)”

Since the top income earners have more than enough income to maintain their living standards, the balance falls into savings. This disparity in incomes generates the “skew” to the savings rate and obfuscates the ability to “maintain a certain standard of living.”

More Stimulus Not The Answer

Such remains problematic for many Americans and consistently forces them further into debt.

“The debt surge is partly by design. A byproduct of low borrowing costs the Federal Reserve engineered after the financial crisis to get the economy moving. It has reshaped both borrowers and lenders. Consumers increasingly need it. Companies increasingly can’t sell their goods without it. And the economy, which counts on consumer spending for more than two-thirds of GDP, would struggle without a plentiful supply of credit.” – WSJ

I often show the “gap” between the “standard of living” and real disposable incomes. In 1990, incomes alone were no longer able to meet the standard of living. Therefore, consumers turned to debt to fill the “gap.”… CLICK for the complete article

Good to Know (make that a must to know) – Yield Curve Control

Yield Curve Control

You’ll be hearing a lot about this if interest rates continue to edge up. Basically it means that the central banks create money to buy the government bonds needed to finance the deficit spending – and they buy them at low interest rates (yield). The Bank of Canada has bought over $300 billion in Gov bonds during the pandemic.
Many analysts think they’ll be forced to buy even more because inflation fears will precipitate more selling. After all, who wants to be stuck with a 10 year government of Canada bond that pays 1.5% if inflation is at 2% or more, which guarantees losing purchasing power.
During the pandemic interest rates would have been 3x higher or more because of the increased risk due to the pandemic fallout but 5% or 6% interest would push the government’s interest expense through the roof – plus cause massive losses in the bond market (remember bond prices drop when rates rise).
So the Bank of Canada stepped in – created hundreds of billions out of thin air and said we’ll buy the bonds thereby lending the government the money at record low rates.
But now rates on a 10 yr. Gov of Canada bond have moved from 0.46% in August to 1.5% in March. That’s a big difference when it comes to the cost of new borrowing.
So the big question is – how high will the Federal Reserve or the Bank of Canada let rates rise before they step in and create even more money and buy all the government bonds being sold in order to keep the interest rates down. In other words, CONTROL THE YIELD.

Good to Know

Real Interest Rates vs Nominal Rates – the difference between borrowing and lending rates (nominal rate) minus inflation = real rate.
ie 5 yr bond annual interest rate is just over 1% per year – you then subtract the inflation rate, 1.1% = real rate of negative 1/10th of 1%. In other word, if inflation stays the same bond holders lose 1/10th of 1% per year of purchasing power. Not a good time to lend (buy a bond) but a good time to borrow because borrowing money costs 1% per yr in interest but buying power of the money you pay back with will be 1.1% less.

(P.S. for gold owners – note a strong inverse correlation between gold and real interest rates. When real rates up, gold prices tend to drop)

World’s longest-lasting negative rate regime gets a revamp

 

(March 19): Denmark’s central bank will switch from operating one negative interest rate to three by the end of this week, joining several other peers that have overhauled frameworks in a bid to fine-tune their policy levers.

The Copenhagen-based Nationalbank, whose subzero monetary stance since 2012 is the longest-lasting such experiment, is bringing into effect changes to its regime that it announced to investors last Thursday. Its overnight deposit rate and its key deposit rate will now both be at -0.5%, while its lending rate will be at -0.35%.

The measures are designed to help fulfil the central bank’s mandate of protecting the krone’s peg to the euro, responding to fluctuations in money-market rates that flowed from the wide spread in its rates. The revamp is just one of many tweaks by counterparts in recent years aimed at enhancing control of monetary policy using multiple levers.

In Denmark, the spread between the central bank’s key lending and deposits rates has been gaping for more than half a decade, leading to market vacillations that hindered the defense of the peg, according to Daniel Brodsgaard, a fixed income analyst at Danske Bank A/S. The changes are a shift in approach that more broadly applies subzero policy.

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Rabo: Will This Look Like The 2013 Taper Tantrum… Or The 1994 Bond Massacre?

 

The Fed-dy Bears’ Picnic

“If you go down in the bonds today; You’re sure of a big surprise

If you go down in the bonds today; You’d better go in disguise!

For every bear that ever there was will gather there for certain

Because today’s the day the Fed-dy Bears have their picnic

Picnic time for Fed-dy Bears; The little Fed-dy Bears are having a lovely time today

Watch them, catch them unawares; And see them picnic on their holiday

See them gaily gad about; They love to play and shout; They never have any cares

At 6 o’clock this trading fad-dy; Will put its books to bed; Because they’re tired little Fed-dy Bears

Every Fed-dy Bear who’s been good is sure of a treat today

There’s lots of marvellous things to tweet and wonderful games to play

Beneath the trees where *everyone* sees; They’ll hide and seek as long as they please

‘Cause that’s the way the Fed-dy Bears have their picnic”

We have a long wait ahead of us for a critical Fed meeting and one has to kill the time as productively as one can: I apologize for nothing. Yes, we can focus on weak US retail sales and industrial production data yesterday, which is bond bullish; we can focus on the risk-off North Korea leader’s sister stating “We take this opportunity to warn the new US administration trying hard to give off gun powder smell in our land” (which was not about flatulence); or the latest suggestion that US officials will bring up Hong Kong and Taiwan when they meet Chinese officials in Alaska tomorrow, which is hardly risk on. You can even mention that Germany seems to have the same negotiating tactic with the US over Nordstream2 as North Korea does with its nukes: just keep building and expect the Americans to eventually live with it.

But the long and the short of it is that it’s all about the Fed, and if they display any sign at all of shifting the dot plot towards rate hikes from as early as 2023. That’s especially true given the possibility this will be a period following not just the USD1.9 trillion stimulus package, but a USD2.0-2.5 trillion infrastructure bill too – in which case one would suppose the underlying pressure for higher rates would be strong…if things still work the way the textbook says they are supposed to re: liquidity > investment > wages > inflation. Which they clearly don’t right now.

One of the big headlines is that following a UK court loss, Uber are reclassifying their 70,000 British drivers as workers rather than self-employed capitalists en route to global transport domination. This entitles them to benefits, which would be a pay rise in kind. Is this the harbinger of labour winning vs. capital? Consider that Uber are claiming this only covers time spent driving, so waiting around for a fare doesn’t count towards pay: does that sound like a strongly-unionised working environment? As the grandson of a cabbie, it sounds like being a taxi-driver. (Uber will potentially have issues with VAT payments due to the government: but that’s another story.)

Back to the Fed. As I’ve already noted recently, it would be odd if they tried to flag inflation concerns given the Treasury are arguing these are “small” and “manageable”: surely they won’t want to show any policy disconnect? As such, and like the RBA just did, the risks appear that most members still won’t flag rate hikes by 2023 despite the recent upturn on overall data, on the US vaccination effort, in commodity prices, and in fiscal stimulus.

In which case, while short end bond yields would of course stay low, the risks are also that long yields react further to all this “running hot”. So, yes, it could be picnic time for Fed-dy bears. Could this look like the 2013 Taper Tantrum, where US 10s jumped 136bp (to 3.06%)? Could it even look like the 1994 Bond Massacre, where US 10s leaped 245bp trough to peak (to 8.05%)? However, before one gets ‘Uber-excited’, the fact that one peak was 8.05% and another was 3.06% shows you just what happened to the US structurally in the two decades in-between. It’s going to take a lot of US infrastructural changes, in many senses of the term, to get us back towards anything close to 2013 US yield levels, let alone 1994.

Nonetheless, in the meantime the rest of the world has followed that general yield collapse and new-normal path, and hence even a moderate move higher in yields could be painful – and not just to bonds. Yes, there are US stocks to worry about. But also note the headline ‘China braces for “turmoil in financial markets” following new US stimulus’. Of course, it’s not the only one. Key EM are now having to actively think about raising rates despite still being in the throes of the Covid epidemic. The higher US bond yields go, the more capital could flow back to the US and USD. That’s one form of turmoil – and very 2013.

Yet even if the Fed does not provide a picnic for bond bears today, via some form of curve action to match the dot plot, we still get turmoil anyway. How well are EM (and DM) set up for a much weaker USD (and yet higher commodity prices), for example?

It was to be expected, if deeply ironic, that Chinese officials oppose a US fiscal deficit of over 15% of GDP; the promise of massive infrastructure spending; all backed by a pliant central bank; with aims of social stability; and suggestions of protectionism to lock this liquidity in; and hopes the currency moves lower. Takes one to know one? But rather than accept the expected flood of hot capital inflows –pushing up CNY, blowing bubbles, and seeing jobs exported along with manufacturing– suggestions are they will encourage more capital to flow straight back out again. In which case, it’s more of a Fed-dy bulls picnic globally. But somebody is going to end up with an over-valued currency, hitting exports, and assets, hitting financial stability.

There are many other ways this can play out too, depending in large part on how the US reacts – but all of them suggest the risk of significant market and geopolitical volatility, to which today could well be a key milestone.

But that’s enough for now. I am a tired little Fed-dy bear, and today will likely be no picnic.

 

Stimulus Addiction Disorder (SAD): The Debt-Disposable Earnings Pyramid

 

For those who suspect the status quo is unsustainable but aren’t quite sure why, I’ve prepared a simple chart that explains the financial precariousness many sense. The chart depicts the two core elements of a debt-based, consumerist economy: disposable earnings, defined as the earnings left after paying for essentials which can then be used to service debt and debt.

In other words, if all the household earnings are spent on non-discretionary expenses (rent or mortgage, taxes, food, utilities, healthcare, etc.) then there is no money left to pay the interest and principal on a loan. Lenders consider this household uncreditworthy for the simple reason that their earnings cannot support the monthly nut of debt service (interest and principal).

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