Higher Bond Yields In 2018?

George Yacik - INO.com Contributor - Fed & Interest Rates

As a homeowner in a high-tax Blue state, I’m not sure I have a whole lot to be personally happy about in the Trump tax reform bill. My state’s government, which is already teetering financially, isn’t likely to reduce its own taxes to compensate for the cap on deducting state and local taxes. Nevertheless, I’m happy that the measure passed.

For one thing, it’s heartening to see the Republicans stand fast for a change and actually follow through on something their constituents have demanded and expected from them, rather than caving in the face of criticism from their liberal opponents in Congress and the press. I’m also getting a lot of enjoyment listening to the breathless hyperbole by Nancy “Armageddon” Pelosi, Chuck “Fake Tears” Schumer and the gang denouncing the bill, plus the stories by their allies in the press about the “victims” of tax reform, neglecting to mention the “victims” at AT&T, Wells Fargo and all who are being given immediate raises as a result of the measure.

Not a whole lot has been written or said about one of the more likely consequences of the package, and that’s that interest rates are going to move higher in 2018.

Already, in just a few days leading up to the passage of the bill, the yield on the 10-year Treasury note jumped 15 basis points to 2.50%, its highest level since last March and just 10 or so bps below its high for the year. It’s likely to rise further in 2018. Here’s why.

First, as Nancy and Chuck never seem to notice, the economy is on fire. Last week the government confirmed that GDP growth exceeded 3% for the second straight quarter, while the Federal Reserve Bank of Atlanta’s GDP Now forecaster is expecting 3.3% growth in the fourth quarter, which would make it three straight – that hasn’t happened since 2004. And that’s just in anticipation of tax relief becoming a reality. What happens in 2018 when the lower rates actually kick in?

As we know from our Economics 101 class, economic growth usually leads to higher interest rates, as more consumers and businesses borrow, therefore raising its price. How we escape the basic laws of supply-and-demand this time around, I don’t know.

The one body capable of overruling that law – the U.S. Federal Reserve Board – isn’t likely to intervene anymore. As we know, it raised its benchmark federal funds rate another quarter of a percentage point at its December meeting and has signaled at least three more rate hikes next year, while some prognosticators – count me among them – wouldn’t be surprised at a fourth.

But rate hikes are only one thing on the Fed’s agenda. The other is its intention to start reducing its massive $4.5 trillion balance sheet. That has its own possible (upward) impact on interest rates, but it could be aggravated by the Treasury’s borrowing needs, which – as always – are going up, only more so going forward due to higher deficit spending as a result of the tax cuts.

As reported by Bloomberg, government debt sales are expected to more than double next year to $1.3 trillion, the most since 2010, according to JPMorgan Chase. With the Fed largely out of the market for new issuance, someone’s going to have to pick up the slack, and yields are going to have to rise to make bonds attractive, which they most likely will. Advantage, bond buyers.

However, I wouldn’t get overly worried or carried away that interest rates are going to head into the stratosphere unless you think a 3% 10-year bond yield is the stratosphere.

As we have been told over and over, there is a lot of investor money parked on the sidelines waiting for the right opportunity to put to work. Following 25%+-plus returns in 2017, its hard to imagine the stock market replicating that performance in 2018, or anything close to it. I see equity investors taking profits next year and moving some of that money into higher-yielding bonds.

Corporations, which have been heavy borrowers the past few years as long-term interest rates hit record low levels, are now likely to turn into bond buyers. While it would be nice to believe that corporations are going to take all of that extra money they’ll have after their tax rates are cut to 21% from 35% and give it away to their employees and shareholders, that’s probably unlikely to happen. Some of that money will be invested in government bonds.

In particular, commercial banks are likely to ramp up their purchases by about $150 billion, according to Credit Suisse forecasts quoted by Bloomberg. Insurance companies, too, have been starving for higher-yielding bonds to fund their obligations, so they’ll be active buyers as well. Then there are foreign buyers, like the Chinese, or U.S. retail investors, either directly or through mutual funds and ETFs.

So, we can expect most of the bigger supply of bonds to find a home. Yes, yields will rise from here, but not as much as some people expect. So relax and enjoy the holidays.

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George Yacik
INO.com Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.