Revising Our 2017 Outlook on U.S. Treasuries: From 2.25% to 2.50% on the 10-Year

In our earlier 2017 outlook on the U.S. 10-year Treasury yield published on December 21, 2016 (see “Our 2017 Outlook on U.S. Treasuries: 2.25% on the 10-Year“), we argued that the U.S. 10-year Treasury yield will close at around 2.25% at the end of 2017. Our target at the time was very much out-of-consensus, as most analysts (including those from Goldman Sachs, Morgan Stanley, and PIMCO) were expecting the 10-year to rise to 2.75% or above, driven mostly by late-cycle inflationary pressures and the promise of U.S. corporate tax cuts and a $1 trillion infrastructure spending package by the Trump administration.

Since the publication of our 2017 outlook on the 10-year Treasury, U.S. economic growth has disappointed, with the “advance” estimate of U.S. Q1 2017 real GDP growth hitting an annual rate of just 0.7%. As a response, the U.S. 10-year yield sank to a trough of 2.18% on April 18, before rebounding to a close of 2.33% earlier tonight.

Figure 1 below shows our timing calls as discussed in our weekly global macro newsletters on the U.S. 10-year from June 2015 to the present. Note that prices of the 10-year Treasury rise as yields decline.


Instead of our previous target of 2.25%, I now expect the U.S. 10-year Treasury yield to rise steadily from 2.33% today to around 2.50% by the end of this year. Note this target is still slightly out-of-consensus (e.g. Goldman Sachs is expecting the 10-year to rise to 3.00% by the end of this year). Given the still-uncertain U.S. political outlook, I am looking for significant, tradeable volatility on the 10-year for the rest of this year; on a net basis, however, I believe there will be an upward bias on the 10-year yield for the following reasons:

  • When our earlier 2017 outlook was published on December 21, 2016, speculators were holding a record short position on U.S. 10-year futures with the exception of a brief period in early 2005. An ensuing rally in the 10-year (a decline in yield) developed as a result; as of this writing, however, the net speculative position on U.S. 10-year futures has reversed dramatically from that of five months ago. In fact, net speculators’ bullish bets rose earlier last week to their highest levels since early 2008. From a contrarian standpoint, this should put downward pressure on the 10-year Treasury–in turn resulting in higher yields;
  • In our April 30, 2017 newsletter (email me for a copy), we switched from a “neutral” to a “bearish” positioning on German/French sovereign bonds, as: 1) after experiencing a near-Depression during the 2011-13 period, European economic growth was finally accelerating, and 2) ahead of the May 7th French run-off vote between Macron and Le Pen, it was clear that European political risk was dissipating. In fact, European forward rates at the time were showing a 60% chance of an ECB rate hike in March 2018. An acceleration in European economic growth is also being confirmed by the latest readings of our proprietary CBGDI (“CB Capital Global Diffusion Index”), as seen in Figure 2 below.


I have previously discussed the construction and implication of the CBGDI’s readings in many of our weekly newsletters and blog entries. The last time I discussed the CBGDI on this blog was on May 12, 2016 (“Leading Indicators Suggest Further Upside in Global Risk Asset Prices“).

To recap, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD-constructed leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. Moreover, the CBGDI has historically led the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%; and has led or correlated with the MSCI All-Country World Index, with an R-squared of over 40% (which is expected as local stock prices is typically a component of the OECD leading indicators).

The latest reading of the CBGDI has continued to improve after making a trough in late 2015/early 2016  (see Figure 2 above). Both the 1st and the 2nd derivatives of the CBGDI have continued to climb and are still in (slight) uptrends, suggesting a stabilization and in many cases, an acceleration (e.g. the economies of Austria, Canada, Denmark, France, Germany, Norway, South Korea, New Zealand, Brazil, and Russia ) in global economic activity. With Chinese RMB and capital outflows having stabilized in recent months, global economic growth around the world seems to be synchronizing. This should lead to higher U.S./German/French sovereign rates from now till the end of 2017.

Our 2017 Outlook on U.S. Treasuries: 2.25% on the 10-Year

Last year at around this time, we published our 2016 outlook on the 10-year Treasury yield (“Our 2016 Outlook on U.S. Treasuries: 2.5% on the 10-Year“). To recall, we model our 10-year Treasury yield expectations with the following “building blocks” model:

10-year Treasury Yield = expected 10-year U.S. inflation + expected U.S. real GDP growth + global central bank purchases (including U.S. QE) + geopolitical premium

Note that the current “arbitrage” between the German & Japanese 10-year (typically done with a “dirty hedge” by hedge funds) with the U.S. 10-year is being taken into account in the above model, to the extent that ECB and BOJ purchases are driving such hedge fund “arbitrage” activity.

The reasoning behind our 2016 outlook of 2.5% (the 10-year is trading at 2.54% as of this writing) included: 1) higher U.S. inflation driven by the combination of a tightening U.S. job market, rising U.S. housing prices, and higher healthcare costs, and 2) the peaking of certain deflationary effects around the world, e.g. Chinese CPI was no longer declining while fears surrounding a larger-than-expected Chinese yuan devaluation would turn out to be unfounded.

Figure 1 below shows our timing calls on the U.S. 10-year from June 2015 to the present (note the prices of the 10-year Treasury rise as yields decline).


For 2017, I am targeting a 2.25% rate on the U.S. 10-year yield. The target is slightly out-of-consensus (Goldman, Morgan Stanley, and PIMCO are all expecting the 10-year to rise to 2.75% or above). The outlook, however, is very uncertain and I am again looking for significant (tradeable) volatility on the 10-year in 2017; by and large, however, I believe the factors that will drive the 10-year yield lower slightly outweigh the bearish factors on the 10-year:

  • As of this writing, speculative shorts on the U.S 10-year futures are–with the exception of early 2005–at their highest level since the collection of COT records beginning in 1992. From a contrarian standpoint, this should provide some short-term support for the 10-year (in turn resulting in lower yields);
  • Much of the recent up-move in the U.S. 10-year yield occurred after the U.S. presidential election as investors speculated on a combination of higher growth and higher inflation, driven by the promise of: U.S. corporate & personal income tax cuts, a promised $1 trillion infrastructure spending package by President-elect Trump, potential repeal of the ACA and Dodd-Frank along with a myriad other U.S. “regulatory burdens.” As a reminder, however, this is all conjecture at this point. The Republicans are likely to pass their promised corporate & income tax cuts and to repeal the ACA through the reconciliation process (this is needed to avoid a Senate filibuster by the Democrats). However, such tax cuts passed through the reconciliation process needs to be revenue-neutral. Even with the potential to use “dynamic scoring” (where it is assumed lower taxes will result in higher GDP growth in order to offset some of the tax revenue lost), a significant part of the promised tax cuts will likely be scaled back in order to meet fiscal budget targets. E.g. The much discussed 15% or 20% statutory corporate income tax rate will likely be revised to 25%;
  • In the long-run, the U.S. economy is still limited by the combination of slowing population growth (the current 0.77% annual population growth rate is the lowest since the 1930s), older (and less productive) demographics, and a potential stall in immigration–the latter of which has historically benefited the U.S. disproportionately (immigrants are twice as likely to be entrepreneurs than native-born Americans). Another historic tailwind for the U.S. economy actually peaked in 1999: women participation in the labor force has trended down since 2009.

Unless productivity growth jumps over the next several years (not likely; the “fracking revolution” was the last enabler of U.S. productivity growth), the U.S. economy is likely to stall at 2% real GDP growth, especially given the recent 14-year high in the U.S. dollar index–which will serve to encourage import growth and restrict export growth. Note this outlook assumes that the long-term U.S. inflation outlook remains “well-anchored” at 2.0%–should the U.S. Congress adopt a more populist outlook (i.e. higher fiscal spending that is likely to be monetized by the Fed in the next recession), then the 10-year could easily surpass 3.0% sometime in 2017.

The Fed Paves the Way for Running a “High-Pressure Economy” (Along with Higher Inflation)

Since the beginning of last year (see my February 4, 2015 commentary “U.S. Inflationary Pressures Remain Muted” and my March 1, 2016 Forbes commentary “Why Federal Reserve Tightening Is Still A Distant Event“), I have consistently asserted that the Fed’s ultimate tightening schedule would be slower than expected–from both the perspective of the Fed’s original intentions, as well as those of the fed funds futures market. Indeed, the most consistent theme since the beginning of the 2008-09 global financial crisis has been this: The tepid recovery in global financial conditions and global economic growth has consistently forced the Fed to ease more than expected; and since the “tapering” of the Fed’s quantitative easing policy at the end of 2013, to tighten less than expected. E.g. the October 2008 Blue Chip Economic Indicators survey of America’s top economists predicted the fed funds rate to rebound to 4.0% by late 2010. Subsequent forecasts were similarly early.

According to the CME Fed Watch, the probability of a 25 bps Fed rate hike on December 14 is now over 70%. I expect the December 14 hike to occur as the Fed has been prepping the market for one 25 bps hike for months; however–similar to what I asserted last year–I do not believe this rate hike will signal the beginning of a new rate hike cycle. Rather, the timing of the Fed’s third rate hike will again be data-dependent (more on that below). Fed funds futures currently peg the Fed’s third rate hike to not occur until more than a year from now, i,e. at the December 13, 2017 FOMC meeting. This is the most likely timing for the third rate hike, for the following reasons:

1. U.S. households remain in “deleveraging” mode. Haunted by the 2008-09 global financial crisis, record amounts of student loans outstanding (currently at $1.3 trillion), and a shorter runway to retirement age and lower income prospects, U.S. consumer spending growth since the bottom of the 2008-09 global financial crisis has been relatively tepid (see Figure 1 below), despite ongoing improvements in the U.S. labor market;


2. The developed world & China are still mired by deflationary pressures. While the Fed had not been shy about hiking rates ahead of other central banks in previous tightening cycles, the fact that all of the world’s major central banks–with the exception of the Fed–are still in major easing cycles means the Fed has no choice but to halt after its December 14, 2016 hike. Even the Bank of England–which was expected to be the first major central bank to hike rates–was forced to reverse its stance and renew its quantitative easing policy as UK policymakers succumbs to the rise of populism. In a world still mired by deflationary pressures, the U.S. could easily succumb to another deflationary cycle if the Fed prematurely adopts a hawkish stance;

3. The Fed is no longer in denial and finally recognizes the uniqueness of the 2008-09 deleveraging cycle that is still with us today. In a June 3, 2016 speech (titled “Reflections on the Current Monetary Policy Environment“), Chicago Fed President Charles Evans asserted why this isn’t a normal recovery cycle and because of that, argued why the Fed should foster a “high-pressure” economy (characterized by a tight labor market and sustained inflation above 2%) in order to ward off downside risks in both economic growth and inflation. Quoting President Evans: “I view risk-management issues to be of great importance today. As I noted earlier, I still see the risks as weighted to the downside for both my growth and inflation outlooks … So I still judge that risk-management arguments continue to favor providing more accommodation than usual to deliver an extra boost to aggregate demand … One can advance risk-management arguments further and come up with a reasonable case for holding off increasing the funds rate for much longer, namely, until core inflation actually gets to 2 percent on a sustainable basis.

President Evans’ speech was followed by similar dovish sentiment expressed by Fed Governor Daniel Tarullo in a September 9, 2016 CNBC interview, Fed Governor Lael Brainard in a September 12, 2016 speech at the Chicago Council on Global Affairs, as well as the September 2016 FOMC minutes. Finally, Fed Chair Janet Yellen explored the potential benefits of running a “high-pressure economy” after a deep recession in her October 14, 2016 speech at a recent conference sponsored by the Boston Fed. Quoting Chair Yellen:

If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects. In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient–and, hence, more-productive–job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.

Bottom line: The Fed continues to back off from committing to an official tightening schedule. After the December 14, 2016 rate hike, probability suggests the next rate hike to not occur until the December 13, 2017 FOMC meeting. Until the year-over-year PCE core rate rises to and maintains a rate of 2.0% or over, the Fed will not recommit to a new rate hike cycle. This also paves the way for higher U.S. inflation; as such, clients should continue to underweight U.S. long-duration Treasuries and overweight gold.

Our 2016 Outlook on U.S. Treasuries: 2.5% on the 10-Year

In our June 28 global macro newsletter (please email me for a copy), I upgraded our outlook on U.S. Treasuries when the 10-year Treasury yield closed at 2.49%. We believed the 10-year was too high given the ongoing deflationary pressures stemming from the European sovereign debt crisis, the Chinese economic slowdown, and lower commodity prices. I subsequently downgraded U.S. Treasuries in our August 30 newsletter–when the 10-year Treasury yield closed at 2.19% (after dipping to as low as 2.00% during the August 24 global equity market correction)–as I believed global deflationary pressures were in the process of peaking. At the time, I noted that: 1) Chinese disposable income was still growing at high single-digits, 2) the Chinese CPI for the monthly of July sat at 1.6% year-over-year, and 3) fears over a further, deeper-than-expected devaluation of the Chinese yuan against the US$ was unfounded, as Chinese policymakers still have political incentive to support the country’s currency, along with the firepower to do so (as of today, China’s FOREX reserves stands at $3.43 trillion, while its November 2015 trade surplus is still near a record high at $54 billion). This means any further deflationary pressures from the Chinese economy were dissipating.

Combined with the Greek government’s 11th hour deal with the European Commission (i.e. Germany and France), fears over a more catastrophic financial market dislocation was adverted. This means that U.S. Treasury yields should rise further in the coming months. In our August 30 newsletter, I slapped a target yield of 2.50% for the 10-year Treasury over the next six months.


For 2016, I am reiterating our 2.50% yield target for the 10-year Treasury. We model our 10-year Treasury yield expectations with the following “building blocks” model:

10-year Treasury Yield = expected 10-year U.S. inflation + expected U.S. real GDP growth + global central bank purchases (including U.S. QE) + geopolitical premium

While both energy and base metal prices have either broken or are approaching their December 2008-March 2009 lows, I am of the opinion that U.S. inflation will be higher next year as the combination of a tighter U.S. job market, rising U.S. housing prices, and higher healthcare costs overwhelm the deflationary effects of lower commodity prices on the U.S. consumer economy (of which the CPI is based on).

As the markets price in higher U.S. inflation and a more hawkish Fed policy next year, I expect the 10-year Treasury yield to rise to 2.5% sometime in the next several months. For now, I remain bearish on U.S. Treasuries, but may shift to a more bullish stance should: 1) the Chinese economic slowdown runs deeper-than-expected, 2) the U.S. stock market continues to weaken, or 3) the Fed adopts a more dovish-than-expected bias post the December 16 FOMC meeting.

Why China Will Not Cut Rates Any Further This Year

In response to a slowing property market, lower consumer spending growth, and a slowing global economy, the People’s Bank of China (PBOC) has cut its one-year policy rate five times and its reserve requirement ratio three times over the last 12 months. Last November, the PBOC’s one-year policy rate sat at 6.00%–today, it is at 4.60%. Moreover, the PBOC’s cut in its reserve requirement ratio–from 20.0% to 18.0% since February–has released more than $400 billion in additional liquidity/lending capacity for the Chinese financial system.

I believe Chinese policymakers will maintain an easing bias over the next 6-12 months given the following:

  1. As I discussed a couple of years ago, a confluence of factors–including China’s debt build-up since the 2008-09 global financial crisis, slowing population growth, as well as natural limits to an export- and CAPEX-driven growth model–means China’s real GDP growth will slow to the 5%-8% range over the next several years. Consensus suggests that China’s real GDP growth will be lower than the official target of 7% this year. Given China’s significant debt build-up since the 2008-09 global financial crisis, policymakers will need to do more to lower lending costs and to encourage further lending as global economic growth continues to slow;
  2. Most of the debt build-up in China’s economy over the last 7 years has occurred within the country’s corporate sector–with real estate developers incurring much of the leverage. In other words, both real estate prices and investments are the most systemically important components of the Chinese economy. While real estate prices and sales in Tier 1 cities have been strong this year, those of Tier 2 and Tier 3 cities have not yet stabilized. This means policymakers will maintain an easing bias unless Chinese real estate sales and prices recover on a broader basis;
  3. Chinese credit growth in August met expectations, but demand for new loans did not. Real borrowing rates for the Chinese manufacturing sector is actually rising due to overcapacity issues and deteriorating balance sheets (China’s factory activity just hit its lowest level since March 2009). No doubt Chinese policymakers will strive to lower lending costs to the embattled manufacturing sector as the latter accounts for about one-third of the country’s GDP and employs 15% of all workers. This will be accompanied by a concerted effort to ease China’s manufacturing/industrial overcapacity issues through more infrastructure investments both domestically and in China’s neighboring countries (encouraged by loans through the Asian Infrastructure Investment Bank, for example).

I contend, however, that the PBOC is done with cutting its one-year policy rate for this year, as Chinese policymakers are dealing with a more pressing issue: stabilizing the Chinese currency, the yuan, against the US$ in the midst of recent capital outflows (Goldman Sachs estimates that China’s August capital outflows totaled $178 billion). Simply put–by definition–a country cannot prop up its currency exchange rate while easing monetary policy and maintaining a relatively open capital account at the same time. With the PBOC putting all its resources into defending the yuan while capital outflows continue, it will be self-defeating if the PBOC cuts its policy rate at the same time. The PBOC’s current lack of monetary policy flexibility is the main reason why Chinese policymakers are trying to find ways to stem capital outflows.

Rather than easing monetary policy, Chinese policymakers are utilizing other means to directly increase economic growth, such as: 1) Cutting minimum down payment requirements for first-time home buyers from 30% to 25%, 2) Approving new subway projects in Beijing, Tianjin, and Shenzhen worth a total of $73 billion over the next six years, and 3) Cutting sales taxes on automobile purchases from 10% to 5%, effective to the end of 2016. I expect the PBOC to regain its monetary policy flexibility by early next year, as the combination of record-high trade surpluses and still-low external debt should allow China to renew its policy of accumulating FOREX reserves yet again.

Leading Indicators Suggest Lower U.S. Treasury Rates

In two of our most recent commentaries (April 10, 2015: “Our Leading Indicators Still Suggest Lower Asset Prices” and March 12, 2015: “The Weakening of the CB Capital Global Diffusion Index Suggests Lower Asset Prices“), we discussed why Goldman Sachs’ Global Leading Indicator was giving highly misleading leading signals on the global economy given its over-reliance on components such as the Baltic Dry Index and commodity prices–both of which could be highly impacted by idiosyncratic factors such as supply disruptions or technological substitutions. Indeed, Goldman itself has been highly transparent and critical over the last six months about the distortions created by an oversupply of dry bulk shipping capacity and an impending wall of additional supply of industrial metals, such as copper and iron ore.

Indeed–because of these distortions–Goldman’s GLI has been highly volatile over the last six months. Last month’s GLI suggested the global economy was “contracting” from January-March 2015–which in retrospect, does not make much sense. Meanwhile, our own studies had suggested that global economic growth was still on par to hit 3.5% in 2015–while our earlier studies suggested U.S. economic growth could hit as much as 3.0%–with energy-importing countries such as India projected to accelerate to as much as 7%-8% GDP growth.

Because again of such idiosyncratic factors, Goldman’s GLI this month suggests the global economy is now moving into “expansion” mode. January data was revised and now suggests the global economy was merely “contracting” that month, with February-March barely in contraction phases. None of these make sense. The latest upbeat data is due to: rising base metals prices, a bounce in the AU$ and the CA$, and a bounce in the highly volatile Baltic Dry Index. Copper’s latest rise was arguably due to Chinese short-covering–Chinese property starts/fixed asset investments remain weak, although we are optimistic that both Chinese commercial and residential inventories are re-balancing.

Our own studies suggest the global economy has been slowing down significantly since the 2nd half of last year; more importantly, the negative momentum has not abated much (despite the re-acceleration of Western European economic growth). Specifically, we utilize a global leading indicator (called the CB Capital Global Diffusion Index, or CBGDI) where we aggregate and equal-weight the OECD leading indicators for 29 major countries, including non-OECD (but globally significant) members such as China, Brazil, Turkey, India, Indonesia, and Russia. The OECD’s Composite Leading Indicators possess a better statistical track record as a leading indicator of global asset prices and economic growth. Instead of relying on the prices of commodities or commodity currencies, the OECD meticulously constructs a Composite Leading Indicator for each country that it monitors by quantifying country-specific components including: 1) housing permits issued, 2) orders & inventory turnover, 3) stock prices, 4) interest rates & interest rate spreads, 5) changes in manufacturing employment, 6) consumer confidence, 7) monetary aggregates, 8) retail sales, 9) industrial & manufacturing production, and 10) passenger car registrations, among others. Each of the OECD’s country-specific leading indicator is fully customized depending on the particular factors driving a country’s economic growth.

The CBGDI has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%, while leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally as stock prices is typically one component of the OECD leading indicators).

Since we last discussed the CBGDI on April 10, the 2nd derivative of the CBGDI has gotten weaker. It also extended its decline below the 1st derivative, which in the past has led to a slowdown or even a major downturn in the global economy, including a downturn in global asset prices. Figure 1 below is a monthly chart showing the year-over-year % change in the CBGDI, along with the rate of change (2nd derivative) of the CBGDI, versus the year-over-year % change in WTI crude oil prices and the MSCI All-Country World Index from January 1994 to May 2015. All four indicators are smoothed on a three-month moving average basis:


The CBGDI has also led the U.S. 10-year Treasury rate on most occasions over the last 20 years. Whenever the 2nd derivative declines to near the zero line (and continues down), U.S. 10-year Treasury rates have declined 86% of the time over the next 3, 6, and 12 months. Yes, we did enjoy a secular bull market in the U.S. long bond over the last 20 years, but 86% upside frequency is still a very good track record during a secular bull market. The track record is especially attractive considering that: 1) when this indicator was wrong, the worst outcome was a 27 bps rise (over 3 months beginning December 2004); 2) when this indicator was dead on, the best outcome was a highly-profitable, and highly-asymmetric, 168 bps decline in the U.S. long bond (over 12 months beginning December 2007).


As of this writing, the U.S. 10-year rate is trading at 2.18%, which is 14 basis points higher than the average 10-year rate of 2.04% during March 2015, when the 2nd derivative of the CBGDI essentially touched the zero line. As we discussed in past newsletters (and will further elaborate this weekend), we do not believe the ECB has lost control of the Euro Zone’s sovereign bond market. Combined with the ongoing BOJ easing, both central banks are still projected to purchase another $1 trillion of sovereign bonds over the next 12 months. With the U.S. federal budget deficit still near its lowest level over the last six years–and with the People’s Central Bank of China proactively lowering interest rates–I do not believe the U.S. 10-year Treasury rate has any room to move higher from current levels. As such, we are advocating a long position in long-dated U.S. Treasuries; our Absolute Return Liquidity strategy now has a sizable position in the long-dated Treasury ETF, TLT.

The Re-leveraging of Corporate America and the U.S. Stock Market

The U.S. stock market as of the end of 1Q 2015 is overvalued, overbought, and overleveraged. As we discussed in our weekly newsletters over the last couple of months, the S&P 500 is trading at its highest NTM (next 12 months) P/E and P/B ratios since early 2001, just prior to the bursting of the bubble in U.S. technology stocks. Note that today’s record P/E ratios are being accompanied by the highest corporate profit margins in modern history, which in turn are supported by ultra-low borrowing rates and a highly accommodative environment for corporate borrowing.

On the demand side for stocks, we also know that global hedge fund managers are now holding the largest amount of long positions in U.S. stocks (56% net long as of year-end 2014) since records have been kept. With the global hedge fund industry now managing $2 trillion in assets, we believe it is a mature industry–as such, we believe the positions of hedge fund managers could be utilized as a contrarian indicator. In addition, note that no major U.S. indices (e.g. Dow Industrials or the S&P 500) have experienced a 10%+ correction since Fall 2011. Coupled these with the immense leverage on U.S. corporate balance sheets–as well as the U.S. stock market–this means that U.S. stocks are now highly vulnerable to a major correction over the next several months.

According to Goldman Sachs, U.S. corporate debt issuance averaged $650 billion a year during the 2012-2014 time frame, or 40% higher than the 2009-2011 period. U.S. corporate debt issuance is on track to hit a record high this year, supported by the ongoing rise in M&A activity, sponsor-backed IPOs (companies tend to be highly leveraged upon a PE exit), and share buybacks and increasing dividends. In fact–at the current pace–U.S. corporate debt issuance will hit $1 trillion this year (see figure 1 below). Over the last 12 months, member companies in the Russell 1000 spent more on share buybacks and paying dividends than they collectively generated in free cash flow. Across Goldman’s coverage, corporate debt is up 80% since 2007, while leverage (net debt / EBITDA)–excluding the period during the financial crisis–is near a decade-high.

Figure 1: U.S. Corporate Debt Issuance at Record Highs ($billions)


We believe the combination of high valuations, extreme investors’ complacency, and near-record high corporate leverage leaves U.S. stocks in a highly vulnerable position. The situation is especially pressing considering: 1) the high likelihood for the Fed to raise rates by 25 basis points by the September 16-17 FOMC meeting, and 2) the increase in financial market volatility over the last six months.

Finally, investors should note that U.S. margin debt outstanding just hit a record high as of the end of February. Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators (including ones that may not be obvious, such as the amount of leverage utilized by hedge funds through the OTC derivatives market), as well as major peaks and troughs in the U.S. stock market. Since the last major correction in Fall 2011, U.S. margin debt outstanding has increased by 69%–from $298 billion to $505 billion–to a record high. In other words, both corporate America and the U.S. stock market have “re-leveraged.” With the Fed no longer in easing mode–coupled with extreme investors’ complacency and increasing financial market volatility–we believe U.S. stocks could easily correct by 10%+ over the next several months.


Fed Refuses to Taper – Yes, it’s a Big Deal

No major firm anticipated this, but by staying on course with its $85 billion-a-month purchases in Agency MBS and Treasury securities, the Fed has sent a strong signal to global financial markets: We will stay fully committed to QE3 until inflationary expectations become well-anchored at the 2% level and until U.S. hiring begins to accelerate. These are tangible benchmarks (the former garnered from TIPS prices, and the latter from U.S. weekly jobless claims) that are disclosed and digested by investors at least on a weekly basis. In other words, investors no longer need to guess–global liquidity will continue to stay elevated until the U.S. employment picture definitively improves and inflation hits and stays at 2%.

The U.S. economy is still far away from hitting these benchmarks. U.S. inflation in August was lower-than-expected, with year-over-year CPI growth at 1.5%. According to the Cleveland Fed, ten-year inflationary expectations as garnered from TIPS prices are still near a record low, while the ECRI U.S. Future Inflation Gauge (a leading indicator for U.S. inflation) just hit a 19-month low (in the Euro Zone’s case, this indicator just hit a 40-month low).  Geopolitical events notwithstanding, certainly the U.S. economy is at no significant risk of higher inflation anytime soon.

In essence, the Fed has: 1) sent a strong signal that global liquidity will stay elevated, and more important, 2) prior to any tightening, investors would get strong signals from both market indicators and the Fed–i.e. there will be no surprises. It is thus not surprising to see India and Indonesia–two countries with strong recent outflows–spiking up immediately after the publication of the Fed’s FOMC statement. As we are writing this, India is up more than 3%, while Indonesia is up by more than 8%. Keep in mind that both markets were down earlier this morning. Asia is going to go gangbusters tonight. More important, the Fed has eliminated any potential systemic risk in Asia (prior to today’s announcement, we believed India and Vietnam were the two countries most at risk to Fed tapering). U.S. home buyers, as well as gold and oil speculators, can also celebrate.

U.S. Real Estate No Longer (That) Attractive

Note: In our July 31, 2013 post (see “Our Revised 12-Month Outlook on Major Asset Classes“), we downgraded Developed Equities from a return rating of “5” to “4.” Since then, the Dow Industrials and the S&P 500 have declined by 4.4% and 3.1%, respectively. Meanwhile, our upgrade of Emerging Markets was based on valuations. With the exception of India, Indonesia, and the Philippines, EM equities have done okay (Chinese equities have risen since July 31). Note that in general we never advocate any long positions on the weakest links–those being India, Vietnam, and probably Indonesia right now.

Please also note we will also never advocate any substantial long positions in an asset class that led the last bull market. E.g. We did not advocate much buying of tech stocks during the 2003-2007 bull market. Rather, we advocated the purchase of precious metals, commodities, etc. As a rule, the asset classes that led the last bull market (those would be U.S. real estate, U.S. financials, EM equities, and commodities) typically under perform in today’s bull market. Already–based on our deal flow and conversations with clients–we are seeing green shoots and revolutionary, but practical breakthroughs in the U.S. technology sector. We believe U.S. tech will lead the current bull market to new heights over the next several years.

In the meantime, both U.S. and global equities are undergoing a corrective phase. Based on our proprietary technical and sentiment indicators (which we will cover in latter commentaries), they are still not close to a buying point. We expect this corrective phase to last another 2 to 3 months. We also expect the U.S. and global economy to slow down for the rest of the year, given increasing anxiety over the uncertainty of U.S. monetary policy, the change in the Fed chairmanship (most likely, Lawrence Summers will head the Fed, which will not be constructive in the short-term), and uncertainty over the Chinese and Indian economic slowdowns.

We believe U.S. real estate–despite its recent positive momentum–will suffer a slowdown as global investors pull back, and as U.S. interest rates continue to rise (this morning alone, the 10-year Treasury rate spiked by 15 bps to 2.9%). Since the beginning of this year, we had given a return rating of “9” to U.S. commercial real estate–our most bullish return rating this year thus far. Both U.S. commercial and residential real estate prices have significantly over-performed this year–reaffirming our bullish view. Keep in mind, however, that our bullish outlook on U.S. real estate was predicated upon: 1) ongoing monetary stimulus, 2) severely oversold valuations and dislocation in U.S. real estate, 3) an undervalued US$, which generated significant foreign interest, 4) a re-allocation by institutional investors (e.g. pension funds and sovereign wealth funds) to U.S. real estate from other global risk assets. Given the heavy investment activity and the rise in U.S. real estate prices this year, we are no longer as bullish. In addition, the recent spike in interest rates, including the 30-year mortgage rate, is generating significant concern among CB Capital.

30-year mortgage rates

The recent spike in the 30-year mortgage rate (on a % basis) is the most severe since the spike during summer 2006, which preceded the bursting of the U.S. housing/mortgage bubble in 2007. We are not as concerned this time around (we went short U.S. equities in late 2007) as the U.S. housing market–unlike the typical post WWII economic cycle–did not lead the U.S. recovery over the last several years. However, the history of the above chart cannot be ignored. As such, we are downgrading our return outlook on U.S. commercial real estate–from a “9” to “8,” and increasing our risk rating from “5” to “6.” We would also not be surprised if some kind of financial “dislocation” emerges in other parts of the world, such as India, Vietnam, or even the Euro Zone. The last time we witnessed a combination of spiking interest rates and Fed uncertainty (i.e. 1994), Orange County filed for bankruptcy, and many investment banks and hedge funds lost substantial amounts betting on the carry trade. Investors should dial back risk-taking in general for the next two to three months.

12-month Outlook September 2013

The Bank of Japan Surprises: Profound Implications for Global Risk Assets

Since the Japanese stock market and real estate bubbles popped in 1990, one of the surest ways for a portfolio manager to get fired is to go long Japanese stocks or real estate. ROEs on Japanese companies are among the lowest in the world; while Japanese real estate prices had been mired by a 23-year secular decline. There were massive policy failures–including building “bridges to nowhere” and the infamous consumption tax hike from 3% to 5% in 1997–just as SE Asia sank into a depression. While Japan’s policy rate was eventually brought down to zero, it came too little, too late. High-ranking BOJ officials eventually stopped attending the annual Jackson Hole Economic Policy Symposiums simply because they did not want to be ridiculed by other central bankers.

All this changed tonight. The Bank of Japan just announced it will double its monetary base over the next two years, as well as embark on a massive quantitative easing policy with an annual goal of 50 trillion Yen (US$538 billion) in JGB purchases. Consensus going into the meeting was in the order of an annual 15 to 20 trillion Yen in JGB purchases. A US$538 billion QE policy is massive, as Japan’s economy is less than 40% the size of the U.S. economy. Essentially, the BOJ will be purchasing JGBs at the rate of over 9% of its GDP every year. An equivalent QE policy in the U.S. would be in the realm of nearly US$1.4 trillion in Treasury purchases on an annual basis.

The policy implications are massive. For one, no living portfolio manager had ever been surprised by the BOJ in such a manner. Surprises have been many, but those have all been disappointing. The Yen is down by 1.1% as I am writing this article. We expect more competitive currency devaluations and supressions by other Asian central banks in 2013 and 2014. Such a move will no doubt generate a massive rise in global liquidity–which will drive up the prices of risky assets around the world.

For two, we know that Japanese households have continued to hold massive amounts of cash and deposits due to ongoing deflationary fears and general aversion to risk-taking. According to the BOJ’s Flow of Funds, Japanese households held nearly 800 trillion Yen in cash and deposits as of June 2012, or nearly US$8.6 trillion (see below chart). With a yield of 0%–and with the BOJ now hell-bent on a 2% inflation target–many Japanese households will no doubt start deploying their capital back into higher-yielding or riskier assets. A mere 10% shift out of cash into riskier assets would mean a wall of liquidity totaling nearly $900 billion. Keep in mind that this amount is equivalent to the sum total of ALL U.S. equity/hybrid/bond mutual fund inflows (totaling $913 billion according to ICI) during the peak tech bubble years from 1997 to 2000! We thus expect global risk assets–especially U.S. stocks and U.S. commercial real estate–to be driven significantly higher by Japanese inflows over the next few years (to be compounded by Chinese inflows as the Chinese capital account is liberalized). All corrections from hereon should be bought.