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).

10yeartreasury2016

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;

Fig1PCE.png

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.

The Education of the Millennials

Published in 1907, The Education of Henry Adams is a meditation of the immense shifts in the political, economic, social, and technological landscapes of 19th century America during the Second Industrial Revolution. While granted a first-class education, Henry Adams–the great-grandson of John Adams and grandson of John Quincy Adams–would lament throughout the book that his formal education in the classics and history never prepared him for the scientific and technological revolution of the late 19th century. Quoting the book (narrated in third-person):

At any other moment in human history, this education, including its political and literary bias, would have been not only good, but quite the best. Society had always welcomed and flattered men so endowed. Henry Adams had every reason to be well pleased with it, and not ill-pleased with himself … Only on looking back, fifty years later, at his own figure in 1854, and pondering on the needs of the twentieth century, he wondered whether, on the whole the boy of 1854 stood nearer to the thought of 1904, or to that of the year 1 … The calculation was clouded by the undetermined values of twentieth-century thought, but the story will show his reasons for thinking that, in essentials like religion, ethics, philosophy; in history, literature, art; in the concepts of all science, excepts perhaps mathematics, the American boy of 1854 stood nearer the year 1 than to the year 1900. The education he had received bore little relation to the education he needed. Speaking as an American of 1900, he had as yet no education. He knew not even where or how to begin. (emphasis mine).

A cursory review of U.S. history suggests that the Millennials (a demographic group typically defined as those born between 1980 and 2000) have already experienced profound political, social, and technological changes in their short lifetimes unmatched by previous generations, with the possible exception of those who: 1) fought the American Revolutionary War, 2) the American Civil War, 3) experienced the Gilded Age, or 4) experienced the Great Depression and fought in World War II. Many historical seismic shifts in the American cultural fabric were bloody; some not (e.g. the influx of more than 25 million European immigrants from 1850 to 1930).

Further review of these societal shifts suggests one common, and very important, attribute: With the exception of the various waves of immigration, none of these were uniquely American. However, all of these have ultimately made America stronger on the global stage, beginning with American independence in 1776.

Fast forward to today, and the Millennials (also known as the Gen-Ys) are struggling. We believe we could distill this into three major causes:

  1. The U.S. labor market is no longer protected: Relative to Europe and Asia, the U.S. has always had a chronic shortage of labor, resulting in relatively high wages and the subsequent creation of a middle class. Post Civil War and Slavery as an institution, the Gilded Age was a glaring exception, as waves of immigrants served to depress wages for manual labor. The creation of a U.S. middle class after WWII was enabled by a significant curb in immigration beginning in the late 1910s, as well as the democratization of higher education and a general shortage of labor after WWII. The fall of the Berlin Wall in 1989, and the subsequent commercialization of broadband internet and cellular networks, has resulted in an unprecedented shift in the old Labor vs. Capital debate. We believe the acceleration of automation in the U.S. economy will shift this debate further as more manual labor (including those who engage in complex, but repetitive tasks, e.g. fast-food workers or coffee baristas)  is replaced by machines over the next 5-10 years;
  2. The rapid pace of change in the U.S. labor market: Most of us fear change; however, we also secretly crave it, but only if implemented gradually. The rapidity of the shift in the labor market caught many Americans by surprise. In 1901, the Wall Street Journal summarized the immense consolidation of U.S. industry with the comment: “God made the world in 4004 B.C. and it was reorganized in 1901 by J.P. Morgan.” Carnegie Steel–which formed the basis of the $1.4 billion IPO of U.S. Steel in 1901–was founded only just 25 years before, while Standard Oil was founded as recent as 1870. With the exception of Google and Microsoft, many of today’s largest companies were founded more than 50 years ago. However, business practices have shifted immensely over the last 25 years. The mass adoption of outsourcing and automation by U.S. companies–along with an influx of college-educated Gen-Ys into the labor market–has depressed wage growth significantly. Defined benefits pension plans are no longer offered (or valued), and unemployment among young, college-educated workers are near record highs. Such experience by the Millennials is encapsulated by a recent NY Times article chronicling “the rise of the serial intern.”  The world has been reorganized and rearranged in a way such that today’s U.S. labor market bears no resemblance to that of 1989, when the Gen-Ys were still being educated on the wisdom of obtaining a college degree at all costs.
  3. The lack of a 21st century education and the rise of a highly educated global workforce: Year after year, the OECD PISA (Programme for International Student Assessment) shows that American kids are continuing to fall behind their global counterparts in terms of K-12 education. There are many reasons for this (lack of accountability by schools and teachers, lack of respect for the teaching progression, different cultural emphases for formal education, etc.); but more important, even kids who graduate with a four-year college degree have had little preparation to compete in today’s highly educated global workforce. I believe the main problem is this: The modern university system does not sufficiently prepare college graduates to compete in the 21st century global economy as it was engineered with the 20th century industrial economy in mind. Even the emergence of college entrepreneurship programs is a relatively recent phenomenon. e.g. The Arthur Rock Center for Entrepreneurship at Harvard Business School only opened in 2003, and the Polsky Center for Entrepreneurship and Innovation at University of Chicago opened in 1998. Furthermore, only a selected number of universities offer undergraduate courses or experiences in entrepreneurship (neither Harvard nor University of Chicago does). Moreover, most Americans remain U.S.-centric in nature; most U.S. college graduates have never resided or worked overseas. The challenge of working and collaborating with those from foreign cultures will be one of the main challenges for Gen-Y workers over the next 5-10 years.

The ongoing struggles by Millennials are exemplified by the following charts, courtesy of Goldman Sachs.

 Chart 1: A Sign of the Times… Today’s Millennials Are Less Employed

(16-24 Year Olds Labor Force Participation Rate)

 MillennialsLaborParticipation

Chart 2: And Millennials’ Average Income Have Been Declining Relative to that of the U.S. Labor Force

(15-34 Year Olds’ Average Income as a % of U.S. Labor Force Average Income)

 MillennialsAverageIncome

The struggles of the Millennials are real, and will have real implications for U.S. society and the global economy. In our last commentary (“Engaging with China as a Global Economic Superpower“), we addressed the need for U.S. leaders to engage with China as the latter rises to become the world’s biggest economy over the next 6-8 years. This is a job for the Millennials, as most baby boomers and Gen-Xers are too far entrenched in their attitudes and work habits to adapt to a globalizing workforce. Most important, U.S. consumer spending will be driven by Millennial spending growth over the next five years (3.4% annualized), easily crowding out the impact of the Gen-Xs (only 0.6% growth). In fact, total consumer spending by Millennials should surpass that of the Baby Boomers by 2020, making Millennials the largest spending cohort in U.S. history. Just as the Baby Boomers dictated every major societal and economic trend since the end of WWII (from the adoption of disposable diapers to the Civil Rights movement), the Gen-Ys will be driving similar trends for decades to come. The Education of the Millennials continues…

Chart 3: Projected U.S. Annualized Spending Power Growth by Generational Cohort

(2014-2019)

MillennialsSpendingPower