This is the first in a series of posts, titled ‘The Coming Bear’, that will analyse where the economy is headed. The final post in this series will look at some investment ideas that should do well if the future plays out the way I see it.
Here is a list of the posts in this series:
The first step I usually take when forecasting the level of an indicator or the price of something is to look at a long term chart and try to explain the movements. So lets look at the chart of the 10-year Treasury bond yield which has historically been considered the benchmark for long-term interest rates.
The 10-year has been in a downtrend for the past 25 years declining from over 15% in 1981 to its present level of 5%. What could be factors that affect the rates of the long-bond? While the Fed controls short-term rates, long-term rates are set by demand from investors and supply from the government. Government supply has been steadily increasing during this period due to a growing federal debt that needs to be financed. Since 2000, the rate of growth in the debt has increased due to tax cuts, the war in Iraq, defense against terrorism, and higher government spending on social programs. Debt currently amounts to $8.5 trillion.
Investor demand for bonds is affected mostly by expectations of price inflation and foreign appetite for US securities. Inflation expectations have been declining as people have watched the Consumer Price Index (CPI) fall.
I am no fan of the CPI since it is constructed to understate inflation, but most people still believe the numbers and form expectations based on it. With inflation seemingly well below the levels of the early ’80s, demand for bonds from investors should be much greater today.
The other source of demand for bonds arises from foreign purchases. As the following chart illustrates, this demand has exploded in recent years.
Approximately $5 trillion of the $8.5 trillion in current federal debt is owned by private investors — the rest owned by federal government trust funds and the Federal Reserve. What the above chart means is that foreigners now hold about 50% of the privately owned government debt. In fact, since 2001 foreigners have accounted for the entire increase in privately owned debt and then some.This means that foreigners have been the main players for soaking up additional bond issuance and causing rates to decrease. In particular, China and Japan hold about $1 trillion or 20% the outstanding federal debt. Their intention was to boost exports by keeping their currencies undervalued to the US dollar and using the dollars received through trade to invest in US Treasuries rather than convert it back into their own currencies.
Future Direction of Rates
Now that we have looked at the supply-demand factors that led to decreasing rates over the past two decades, let us analyse what the future holds. The war in Iraq and the threat of terrorism are unlikely to end anytime soon so defense spending is likely to remain elevated. Past tax cuts are unlikely to be reversed and social spending — given the economy’s current weak footing — will continue to increase. Therefore, it is safe to assume that the federal debt will grow at 5% or more over the next 2-3 years.
On the demand side, China and Japan — who have been the biggest buyers recently — will likely decrease the rate of treasury accumulation going forward. Japan has already reduced its US dollar holdings over the past year as it seeks to rebalance its foreign exchange reserves and align the currency mix with that of its trade settlement account, taking into account the increasing importance of the euro. China, too, will do the same for risk management purposes.
Furthermore, Japan — fearing that its growing economy could bring on inflation — has begun raising interest rates which will reduce the amount of funds devoted to the carry-trade. The carry-trade takes place when overseas investors borrow funds in Japan at minuscule rates and buy higher-yielding assets overseas, particularly US Treasuries. No one knows how big of a trade this is, but as it unwinds it will have some negative effect on Treasury demand.
Chinese demand for Treasuries should also fall since they will eventually be forced to take further steps to revalue their currency to appease growing anti-Chinese sentiment in Congress and to slow down their red-hot economy which is growing at over 11%. This will allow China to slow down its rate of Treasury purchases and sell more dollars. And Japan will follow suit since the yen tracks the renminbi for trade-competitiveness reasons. Since China and Japan have been major buyers of Treasuries over the past few years, all that is needed is a small decrease in their rate of buying for yields to shoot up.
How much of an effect will this have on Treasuries? Brad Setser and Nouriel Roubini of Roubini Global Economics estimate that Treasury yields would have risen an additional two percent if it was not for central bank buying.
Now let us look at how future inflation expectations will affect Treasury demand. Price inflation is currently on the uptick growing at 4.8% annually compared to 3.4% for 2005, according to the CPI. But as I said before the CPI has a bias to understate actual inflation which is much higher — just look at the prices increases over the past 12 months of gold, oil and copper which are up 30%, 10% and 49% respectively. M3, a better indicator of inflation, rose at an 8% annual rate in February before data collection was discontinued.
Inflation expectations should increase once foreigners reduce their Treasury purchases and the US dollar depreciates. This will cause the price of commodities and imported goods to increase. Also, as foreigners sell more of their dollars, that money will enter the US economy to be spent rather than be held in the form of Treasuries — this is inflationary.
However, price inflation should be dampened by the recent rise in interest rates — from under 4% in 2003 to 5% now — and its effect on decreasing consumer spending in highly indebted economy. Overall, I expect inflation to stay elevated above the Fed’s “comfort zone” during 2007 and 2008. I don’t think we will see major inflation like the ’70s, but it will be high enough to keep bond investors on the edge of their seats.
My outlook on interest rates is that the supply of Treasuries will continue to increase at the same rate, foreign demand will begin to wane, and inflation will stay around current levels. Therefore, I expect Treasury rates to head higher. For example, I would not be surprised to see the 10-year yield over 6% some time during the next two years. However, over the short-term, rates could fall as it becomes clear that the economy will enter a recession and bond investors believe that inflation will drop.