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.

Italy’s NPLs Still the Global Banking System’s Weakest Link

I last discussed the vulnerabilities in the Italian banking system in our April 12, 2016 blog post (“Strengthening the Global Banking System’s Weakest Link“), where I asserted that–given its global inter-connectivity  today–the world’s financial system can only be as strong as its weakest link. Typically, a liquidity or solvency issue can linger on indefinitely, simply due to the absence of external shocks or because the overall global economy is doing well. In the case of the current NPL issues with the Italian banking system, an effort in January to encourage sales of NPLs by providing government-backed guarantees unfortunately attracted investors’ attention to Italian banks’ NPL issues. When we last covered this issue three months ago, Italian banking stocks were “only” down 20% YTD; today, they are collectively down by 55% YTD.

The vulnerability of the Italian banking system–and by extension, that of the Western European banking system–has come under increased scrutiny over the last several months, exacerbated by: 1) the unexpected, ongoing deflationary malaise in much of the developed world; the May 2016 Italian inflation reading was -0.3% year-over-year, worse than market expectations of -0.2%. June 2016 Italian inflation is expected to hit -0.4% year-over-year, resulting in six straight months of deflationary readings, 2) the dramatic flattening and downshift of the Western European yield curve; globally, nearly US$12 trillion of government bonds now have negative yields, and 3) an unexpected vote for “Brexit,” equivalent to a negative growth shock within the EU, as well as heightened political and economic uncertainty.

The Italian banking system in particular is saddled with 360 billion euros of NPLs, equivalent to about one-third of all of the Euro Zone’s NPLs. Moreover–as efforts since January have demonstrated–a concerted sales effort in NPLs in Europe is not a simple task. Firstly, EU rules explicitly ban the use of government-backed guarantees to cushion NPL losses. Secondly, the average restructuring period for Italian bad loans is an abnormally long 8 years; a quarter of cases take 12 years. Finally, the European market for NPLs is small and underdeveloped relative to the overall stock of NPLs in the banking system. In other words, the market for selling Italian NPLs is relatively small, and is almost non-existent without government-backed guarantees (e.g. A proposal by Apollo to purchase 3.5 billion euros of NPLs held by Italian bank Carige back in March made no progress). Italy’s NPL issues are especially concerning given the lack of core profitability of the Italian banking system (see Figure 1 below).

Figure 1: Return on Regulatory Capital of European Banks by Country – June 2015 (source: EBA, Goldman Sachs)

returnoncapitalEBA

It is generally agreed upon that an Italian government-led recapitalization of 40 billion euros into some of Italy’s largest banks (Unicredit, BMPS, and Intesa, for example) would be adequate to resolve the Italian NPL issue, as long as Euro area growth re-accelerates; at the very least, the immediate probability of a Euro-wide banking contagion would be reduced by an order of magnitude. There are two real obstacles to this “happy scenario,” however: 1) the EU, backed by Germany, is resistant to any Italian government-led efforts to recapitalize the banks at no cost to Italian bank debt holders, as this directly goes against EU rules. Any attempt to “bail-in” Italian banks would increase contagion risks among all of EU banks as both depositors and debt holders will likely take their capital and flee to either the U.S. or other safe haven asset classes, such as gold, and 2) Italian Prime Minster Matteo Renzi has promised to resign if he loses the constitutional referendum to be held in October. Recent opinion polls suggest Renzi’s campaign will fall short; this will likely lead to significant Italian and EU-wide instability given the surge of the populist Five Star Movement in recent opinion polls. Seen in this light, the fragility of the Italian banking system is an ongoing cause for concern.

U.S. Consumer Spending Yet to Overheat: Fed to Pause

According to the CME Fed Watch, the chance of a Fed rate hike this Wednesday is virtually zero. The reasons for the Fed to “stand pat” have been well recited but here they are again: 1) ongoing, elevated global systemic/slowdown risks due to the recent decline in global financial stocks, a Chinese economic slowdown, and chronically low oil prices resulting in fears of higher corporate defaults, 2) despite a recent pick-up in the U.S. core inflation rate (the 12-month change in the January core CPI is at 2.2%), the Fed’s preferred measure of core inflation, i.e. the 12-month change in the core PCE, remains tolerable at 1.7%, and 3) Since the late 1990s, the world’s developed economies have mostly grappled (unsuccessfully) with the specter of deflation; e.g. over the last 3 years, the Bank of Japan expanded its monetary base by 173%, and yet, the country is still struggling to achieve its target inflation rate of 2% (Japan’s January core CPI was flat year-over-year). As such, the Fed should err on the side of caution and back off from its recent rate hike campaign.

As of today, the CME Fed Watch is suggesting 50/50 odds of a 25 basis point rate hike at the Fed’s June 15 meeting. Historically, the Fed has only hiked when the odds rise to more than 60/40, and I believe this is the case here. Many things could change from now to June 15; however, given: 1) lingering fears over a Chinese slowdown and the loss of Chinese FOREX reserves, and 2) the fact that core PCE readings have not yet registered a +2.0% reading (I need the year-over-year change in the core PCE to sustain a level of over +2.0% for many months before I am convinced that inflation is a problem), I remain of the opinion that the next rate hike will mostly likely occur at the FOMC’s September 21 meeting.

Finally–despite an ongoing rise in U.S. employment levels (see Figure 1 below)–both U.S. wage growth (see Figure 2 below) and consumer spending growth (See Figure 3 below) remain anemic. Note that both U.S. wage growth and consumer spending growth do not “turn on a dime”; this means that–until or unless we witness a sustained rise in both U.S. wage and consumer spending growth–the Fed should err on the side of caution and back off on its rate hike campaign. At the earliest, this will mean a 25 basis point hike at the FOMC’s September 21 meeting.

USemployment

Figure 2: Nominal Wage Growth Remains Below Target Despite Year-end 2015 Push

 

nominalwagegrowth

PCEgrowth

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.

10yeartreasury

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.

U.S. Inflationary Pressures Remain Muted

In our January 25, 2015 weekly newsletter (please email me for a copy), we pushed back our forecast for the first fed funds rate hike (25 basis points) to the September 16-17, 2015 FOMC meeting as long-term (both 5- and 10-year) inflationary expectations in the U.S. continued to decline after the official end of QE3 on October 29, 2014. 80% of all forecasters at the time expected a rate hike by the July 28-29 FOMC meeting. Just a few days later–in the midst of the January 27-28 FOMC meeting–a new CNBC Fed survey suggests that most analysts now expect the first fed funds rate hike to occur at the September 16-17, 2015 FOMC meeting. Our prediction for the first fed funds rate hike is now the consensus.

10yearbreakeveninflation

Surveying both the data and the U.S. economy, there still seems to be no rising inflationary pressures, despite a pick-up in U.S. housing activity (due to the recent decline in mortgage rates) and a noticeable improvement in the U.S. job market. In fact, the U.S. CPI–even outside of energy–has continued to trend down over the last several months. E.g. the 12-month change in the U.S. CPI (less food and energy) declined from 1.9% in July to 1.6% in December, while neither the 16% trimmed-mean CPI nor the Median CPI have shown any signs of rising to a level that would justify a new rate hike cycle.

The $64 trillion question is: When will the Fed impose its first rate hike, and what does this mean for global asset prices (or the U.S. dollar)? The picture becomes even murkier when one takes into account the recent strength in the U.S. dollar (since we penned our Traderplanet.com ‘Euro Parity” article on September 24, 2014, the dollar has rallied from 1.27 to 1.14 in just a little over four months). Any new Fed rate hike cycle will likely reinforce the recent strength in the U.S./euro exchange rate (note: we now expect the euro to stage a bounce against the U.S. dollar as we believe the Euro Zone economy will surprise on the upside), especially given the open-ended nature of the European Central Bank (ECB)’s sovereign QE policy.

I am going out on a limb and predicting either one of the following scenarios: 1) The Fed hikes by 25 basis points at the September 16-17 meeting, but states that future rate hikes will be data-dependent, i.e. a rate hike will not signal the beginning of a new rate hike cycle, or 2) The Fed pushes back its first rate hike to its October 27-28 meeting, if not later.

The Fed must understand that capitalism is inherently deflationary. Ever since the Paul Volcker-led Fed slayed the U.S. inflation dragon in the early 1980s, the U.S. economy has consistently experienced disinflationary pressures. This accelerated with the German re-unification and the fall of the ‘Iron Curtain’ 25 years ago, and of course, Chinese entry into the World Trade Organization in 2001. Moreover, with the exception of three short bull markets (World War I, the 1970s and 2001-2008), commodity prices (adjusted for the U.S. CPI) have been on a 150-year downtrend in the United States as U.S productivity growth triumphed over the disciples of Thomas Malthus.

Finally, academic studies have time and again proven that there are no consistent reliable leading indicators for U.S. inflation. Common factors cited by analysts–such as M2, capacity utilization, and the cost of housing–all scored poorly relative to a simple auto-regressive (i.e. momentum model). Others, such as U.S. industrial production activity and the 10-year treasury yield, scored better. Surprisingly, the data shows that the rise in food prices have historically been the best leading indicator of U.S. inflation, which we do not believe will apply going forward.

Our analysis and our recent trip to four different cities in India has convinced us of this: What China did to global manufacturing India will do to the global services industry. I.e. We believe India–over the next 5-10 years–will unleash a wave of deflationary pressures in service wages across the world as the country builds up its 4G infrastructure, and as its smartphone adoption grows from 110 million to over 500 million handsets over the next 5 years. Unlike other countries under the traditional Asian development model (where a country will leverage its low-cost labor to industrialize and export goods to developed countries, such as the U.S.), India has no language barrier and is well-versed with technology, computer programming, and providing global services already. This is a hugely deflationary force to reckon with and I believe the Fed must take this into account as U.S. service wages (finance, legal, and IT) will consequently continue to be compressed over the next 10-20 years (while tens of millions of educated Indians will join the global middle class for the first time since the 1700s).