Updating My Thoughts of Two Years Ago

Two years ago in the RealMoney Columnist Conversation, I wrote the following:

Yield curve be nimble, yield curve be quick, yield curve go under limbo stick.Okay, no great allusion in the song there, but I sit watching the long end of the yield curve rally as the short end falls slightly. Is the FOMC back in play that fast after yesterday? I don’t think anything has shifted, but Mr. Market is manic.

It’s times like this that make me want to review the full set of reasons why the long end is rallying:

  1. The supply of long bonds is shrinking, and the Treasury hasn’t decided to reissue the 30-year bond yet.
  2. Pension Reform is happening in Europe, and some Europeans are buying long U.S. debt together with currency swaps.
  3. Pension reform might happen in the U.S. as well.
  4. The PBGC is buying long investment grade debt (it likes to immunize, because it’s risk-averse), particularly Treasuries and Agencies like a madman, and it just got a new slug of cash in with the takeover of the UAL (UALAQ:OTC BB) plans.
  5. Mortgage refinancing tends to depress rates as originators hedge.
  6. Speculators that were previously short longer bonds are now long. (uh oh)
  7. An aging population wants income and increasingly favors bonds.
  8. Neomercantilistic economies buy U.S. bonds because they can’t find anything better to do with their export earnings.
  9. Market players trust the FOMC (however misguidedly) to control inflation in the long run.
  10. There aren’t a lot of other places to get incremental yield, so extending maturities is a temptation for bond investors.
  11. The U.S. economy is anticipated to be growing at a slower rate.
  12. The marginal efficiency of new capital is falling because of the introduction (in principle) of 2 billion laborers to the global capitalist labor pool.

This last point I covered in parts of the articles, “Implications of a Low-Nominal World,” and “The Economy, Seen From Many Angles.” When labor is abundant, more capital isn’t needed to produce a greater output, until labor is scarce again. The returns to the employment of additional capital fall, which leads market players to bid up the prices of fixed claims on the economic system, i.e., bonds, because they can’t find better places to assure a return for the future.

This also explains the increase in buybacks and debt reduction on the part of corporations, relative to increases in plant and equipment. That said, it’s a tough environment, but on the bright side, previously poor areas of the world are developing, and that bodes well for those countries, and the global economy 20 years out, once the labor that is new to the capitalist world is productively deployed.

What a difference two years makes. The above post was meant to justify low rates, and it did a fair job of making the case. Later I added a reason 13, that suggested that there was no other currency that could serve as the world’s reserve currency. Unless we move to a gold or commodity standard, that is probably still true.

So what among the above reasons are still valid? Let’s go through them:

  1. 30-year bonds are being issued now, though not in great abundance.
  2. Still a factor, but small because the initial surge has worn off.
  3. Only 40% complete in the US, but FASB may fix that within a year, which would intensify demand for long bonds as defined benefit plans attempt to match liability cash flows.
  4. The bankruptcy wave is past. Not a factor now.
  5. With rates higher, the mortgage hedging flows favor higher rates.
  6. Kind of a wash. Speculators are long the 10-year and short the 30-year. Not a factor on rates now.
  7. Still a factor. Yield seeking on the part of retirees is big, and Wall Street i catering to that search. (Hold onto your wallets.)
  8. Still true.
  9. Still true.
  10. False; can’t get much incremental yield at all through extension of durations now.
  11. True, but the degree of the slowdown is open to question, and foreign financial flows are a bigger factor.
  12. Still true, though the marginal effect at present is probably smaller.

So where does that leave us on interest rates? Muddled. Most of the big demographic and international effects on rates still favor lower rates. A new factor that was only partially understood by me two years ago has become a bigger factor: rising inflation in countries that fund the US current account deficit. That favors higher rates, both here and abroad. The question is whether foreign countries bite the bullet and allow their currencies to rise against the dollar or not. To the extent that they allow their currencies to rise, so will rates in the US. But if they keep their currencies artificially weak by buying US dollar bonds with their own currencies, it will continue to depress US long interest rates.

Human nature being what it is, I would expect that most countries continue their policies of buying US fixed income until a crisis forces them to change. Those don’t come on schedule, so I will not try to predict timing. I continue to keep a large portion of my fixed income investments in foreign currencies, which has not been a winner in the last month, but has served me well over the last two years.

4 Comments

  • AllanF says:

    Hello David,

    Very interesting blog of late! Are you free to explain how you’ve put your fixed income into foreign currencies? As a follow-up, in case you can’t be overly specific as to your own situation or your’s doesn’t scale down well, how would a mid 5 figure individual investor do the same?

    It could well be I’ve missed something obvious, but I’ve not had much luck tracking down country-specific bond funds. Sorry if this should be a “go ask your broker” question. FWIW, I’m inclined toward Chile, maybe India, and maybe Russia.

    At the risk of giving away my level of ignorance in this regard, I’ll admit I bought stock of HDB a year and half ago thinking dividend-paying banks are a good way to accomplish foreign currency exposure. It’s worked for me, but I’m getting the feeling it was inspite of myself.

    Best,
    -Allan

  • Ron says:

    Yes; excellent post. Much appreciated by those of us who care about this stuff and, while perhaps not knowledgeable enough to lay it all out for ourselves, can get the picture when it’s explained so well.

  • Ron, thanks for the comments.

    Allan, about foreign stocks: Foreign stocks give a degree of currency diversification when their revenues and costs are inside their own country. The profits that they make in their currency are unaffected by currency movements, but to us, foreign investors, if their currency appreciates, the value of their profits is greater to us.

    A company that receives most of their revenues in dollars, but costs in local currency terms acts more like a domestic US stock. As the dollar depreciates, so do their revenues and profits. In US dollar terms each situation will be different, but it would be difficult to say categorically whether the US investor would be better or worse off from the depreciation.

  • AllanF says:

    David, as you describe was pretty much my way of thinking.

    Perhaps I was being too harsh to say HDB worked in spite of myself. :-) It’s worked as I thought it would. I’m rethinking the volatility I get with it when what I set out for was a simple (for me) to execute dollar hedge.

    Best.