Don't Bet On Crises To Keep Bond Rates Lower

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


Despite the recent dip in the 10-year Treasury note yield back below 3%, don’t count on it staying there. Lately, it seems, the only thing keeping the rate below that level is some sort of international crisis – Italy, North Korea, trade wars, etc. But the basic fundamentals determining that rate – economic growth and supply and demand, in other words – are calling for even higher rates, well above 3%.

On the supply side, more Treasury debt is coming to market all the time, like an incoming tide in the Pacific Ocean. On the demand side, there are fewer buyers – and I mean big buyers. More about that in a minute. At the same time, the economy is growing stronger, which by itself is going to put upward pressure on rates.

In other words, if you’re betting that the 10-year yield is going lower, or will stay around or below 3%, you’re really only holding it as a safe haven. Nothing wrong with that, lots of investors do that. But if you’re hoping to profit when something in the world goes wrong, you may be playing a losing game.

First the economy. Last week on CNBC’s Squawk Box, the gold dust twins, Warren Buffett and Jamie Dimon, tried to outdo themselves in how great the U.S. economy is performing.

"Right now, there's no question: It's feeling strong. I mean, if we're in the sixth inning, we have our sluggers coming to bat right now," Buffett said.

“Business sentiment is almost at the highest level it's ever been, consumer sentiment is at its highest levels, markets are wide open, housing's in short supply, and my guess is mortgage credit will expand a little bit,” Dimon said. “If you look at how the table's set, consumers are in very good shape. Their balance sheet, their incomes, wages are going up; their debt levels are low, all the credit written since the Great Recession is pristine.”

And they’re right. May’s employment report showed a bigger-than-expected growth in jobs while the unemployment rate fell to 3.8%, its lowest level since 1969. The Conference Board, whose consumer confidence index rebounded in May to 128.0, noted that “overall, confidence levels remain at historically strong levels and should continue to support solid consumer spending in the near-term.” Its index of leading indicators rose 0.4% for the second month in a row. “April’s increase and continued uptrend suggest solid growth should continue in the second half of 2018,” the firm said, although it “is unlikely to accelerate strongly.”

Now the demand side. Last week the trustees of Social Security and Medicare said that the programs are expected to run a deficit for the first time since 1982. This year’s deficit is expected to be $1.7 billion – a relatively paltry sum – but is expected to keep growing until its nearly $3 trillion reserve fund is depleted in 2034.

What that means for the Treasury market is that the government will have to borrow even more money from investors, on top of the staggering amount it already expects to do. Until now, Social Security invests its surplus in Treasury securities, which doesn’t count as net government debt. But with that surplus slowly disappearing, the government will have to make up the difference by selling even more debt to the public (not to mention actually trying to fix Social Security. But I digress).

At the same time, the Federal Reserve is reducing its balance sheet. So far, the Fed’s portfolio has shrunk only a little bit, from a peak of $4.5 trillion to $4.4 billion currently; basically a rounding error. But the New York Fed recently estimated that the balance sheet could “normalize” to between $2.5 trillion and $3.3 trillion between 2020 and 2022. That would be meaningful.

On the supply side, the Congressional Budget Office already projects the fiscal 2018 deficit will come to $804 billion this year, followed by $981 billion next year and more than $1 trillion in 2020 – before it gets even bigger. Stronger economic growth will reduce those figures somewhat – maybe by a lot – but the deficits will still be big, and higher interest rates will only add to the debt burden.

So what we have then is the two biggest buyers of Treasury debt – the Fed and Social Security – sharply reducing their holdings at the same time the government’s insatiable need for more money continues to grow. In round numbers, about $5 trillion of purchases – $3 trillion from Social Security, another $2 trillion or more from the Fed – comes out of a $20 trillion market. That to me doesn’t add up to lower interest rates. If you want to hope for a crisis, so rates go lower, be my guest, but they won’t stay there for long.

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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.

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