I want to start the week by saying I believe ‘secular stagnation’ is bulls**t’. As a believer in free trade and comparative advantage and thus with hopes that no trade battles take place in the next 4 years, I want to reiterate my optimism over the potential liberation of the US economy via lower and more competitive tax rates and an easing of the regulatory strait jacket all around the economy. This said, before we get to that economically better place (which we no doubt will I believe) I can’t help but be on alert about what the implications are of an unwinding of the biggest bubble ever created, that of credit via the helping hands of our central bankers. As a reminder, back in October the IMF quantified the extent of this credit bubble by saying that global debt reached $152 Trillion in 2015 or 225% of world GDP (see attached chart), a record high. They said “about two thirds of this debt consists of liabilities of the private sector.” Thus, simply stated, this is the context that a rise in global interest rates comes in. The caveat on this debt build up though is stated by the IMF, “there is no consensus about how much is too much.”
Sources: Abbas and others 2010; Bank for International Settlements; Dealogic; IMF, International Financial Statistics; IMF, Standardized Reporting Forms; IMF, World Economic Outlook; Organisation for Economic Co-operation and Development; and IMF staff estimates. Note: U.S. = United States.
According to SIFMA (Securities Industry and Financial Markets Association), US bond market debt of which will be impacted by the rise in rates totaled $40.7T at the end of Q2 (a similar ratio to GDP as the world ratio). This debt consists of Treasury, municipal, mortgage related, corporate debt, federal agency securities, money markets, and asset backed.
Direct to consumer, higher rates will of course influence autos and housing (negatively on the cost of funding a home purchase but positively for first time buyers where hopefully higher rates slows down the persistent 5%+ rate of home price gains).
Corporate earnings will be helped by faster revenue growth in coming years from lower tax rates and reduced regulations but the lever of lowered interest expense, likely a slowdown in debt driven stock buybacks, multiple compression and the negative impact of a higher cost of capital for both businesses and individuals will be an offset.
Bottom line, central banks have been suppressing the beach ball under water for nearly 10 years and that ball finally saw some air. In particular, a gradual rise in rates is the choice of the Fed stated a multitude of times but gradual is of course not what we’ve seen from the market. In a world of epic debt levels, it would be naïve not to worry about the end of the 35 year bull market in bonds irrespective of the economic positives that a Trump presidency will bring.
To today. The 2 yr note auction was soft. The yield of 1.085% was a touch above the when issued. The bid to cover of 2.73 was below the previous 12 month average of 2.81 and the level of direct and indirect bidders totaled 49%, well less than the one year average of 62%, leaving dealers the 3rd most of an auction since mid 2014.
Bottom line, the 2 yr note auction is very sensitive to Fed policy and the Fed is definitely raising rates next month and the bond market may be in the process of forcing their hand more than once next year if this rapid rise in long rates is any indication. The Fed has two choices, fall behind with hikes relative to the data and the markets or get ahead of it and contain the rise in long rates. The rise in oil today is helping lift 10 yr inflation breakevens by another 1 bp to 1.95%, up for the 9th day in the past 11 and at the highest since October 2014. I noted last week that the recent rise in inflation breakevens has been happening without a rise in oil prices. Imagine if OPEC comes to an agreement and oil prices move above $50 from here. Headline inflation will quickly be moving above 2% on a y/o/y basis. The 2 yr note yield in response to the auction at 1.08% is knocking on the door of 1.09% seen last December 29th which was the highest since April 2010. The 2s/10s spread is narrowing by 3.5 bps after touching its widest on Friday since mid December.
With respect to markets, we enter the week with extreme overbought and oversold readings in many key asset classes. I’ll simplistically use the Relative Strength Index to quantify. One has to go back to June 2007 to see the US 10 yr Treasury as oversold as it is now (I looked at the overbought read of the yield). With the Russell 2000 up 11 days in a row, the 14 day RSI is the most overbought since January 2013 and the 7 day is the most extreme since February 2012 at 88 (it can’t go above 100). The DJIA is the most overbought since March. The S&P 500 is just off the most overbought since July. The investment grade ETF is the most oversold since June 2013 during the taper panic. High yield worked off its oversold condition last week. Lastly with FX, the euro heavy dollar index is the most overbought since March 2015 when everyone thought the Fed was going to embark on a multi hike rate cycle more than just once per year. The Asian currency index (vs the US dollar) is the most oversold since August 2015 when China’s devaluation panicked the world.
Japanese exports got no help from the yen weakness in October (went from about 101 to near 105) as exports fell 10.3% y/o/y, worse than the estimate of down 8.5%. Export volumes also were down but much more modestly by 1.4% y/o/y with exports higher to China and the EU but lower to the US and rest of Asia. Imports plunged by 16.5% y/o/y, a touch more than forecasted and import volumes were also down. Bottom line, as the yen is now trading around 110, let’s assume November exports improve. With respect to the JGB response, many eyes are on the 10 yr as its around zero at .03% as the BoJ will do its best to keep it there but the 40 yr JGB is now up to .73%, the highest since March.