Friday, December 2, 2016

The Five Year

This Treasury maturity is often ignored in favor of either the 10 year or the 30 year, but it is the portion of the curve that has been an enigma.  The 5 year is most closely tied to the intermediate term expectations for the Fed funds rate.  But the problem is that those intermediate expectations have been wrong.  For 8 years. They have been too optimistic about the path and timing of interest rate hikes.  And yet the 5 year note still hasn't performed well despite that reality.

Usually you don't get a five year yield that is too far from the current Fed funds rate, unless the current rate is viewed as long term unsustainable.  Thus, with the 5 year at 1.8%, the market is viewing rates below 1% as long term unsustainable.  But to me, interest rates below 1% seem much more long term sustainable than interest rates at 2% or higher.  The growth in government debt supply over the past 10 years makes it unlikely that you can have a big rate rise without hurting a lot of investors.  Add in higher duration on that debt compared to 10 years ago and it amplifies the leverage.  And when you hurt a lot of investors, what does the Fed do?  They start easing.   Which is what happened in Japan.  They tried to get off the zero bound and they failed miserably.

Japan is an extreme case in being stuck at zero when there is little growth and so much government debt.  That is the only way that economy can survive.

There is a lot of Treasury supply.  It is not like the German Bund, or other European government bonds.  The US government debt to GDP ratio is over 100%, and likely going to rise even faster with Trump and his massive tax cuts.  While you would think a lot of supply would cause bond prices to go down, and stay down, but bonds aren't completely priced off of natural supply and demand.  There is a little institution called the Fed that intervenes when it thinks there is too much supply.

Along the yield curve, probably the best risk/reward would be the 5 year.  It is closely tied to intermediate term Fed rate expectations so with the Fed unlikely to raise too many times before the economy goes sour, there isn't as much downside as the 10 or 30 year, but with enough duration to benefit from a move back into risk free assets when equities get weak.

I believe this bond market selloff cannot continue for the long term.  The US is just not growing fast enough, and with worsening demographics, no new revolutionary tech innovation, and a lot of debt, you cannot compared this time period with anything like the last 100 years.  As I mentioned yesterday about tax cuts, they act like a hit of crack.  Fast acting, but short lived with lots of side effects.  Yet, you hear random financial "experts" talk about a possible 6% Fed funds rate like we are back in 1999.

What you are seeing is a slow liquidation and repricing of fiscal policy uncertainty risks associated with big tax cuts and a concurrent big increase in Treasury issuance.  Once all the blood is shed in the bond market, there will be an opportunity waiting on the other side.  The question is how much more blood needs to be shed.

I am guessing we reach a top in yields sometime in early 2017, when the optimism about Trump's economic plan reaches its peak.  Until then, I would be careful buying bonds.  I initially thought 2.35% would hold and the market would consolidate between 2.15% and 2.35%.  I was wrong.  I underestimated the amount of money and long speculative positioning built up this year.  The liquidation is still ongoing, although it looks like we hit a climax of selling yesterday.  I expect another wave of selling as we get closer to the FOMC meeting in two weeks.  I think we go higher in yields into January.  Under a worst case scenario, we could have 10 yr yields go up to 2.80-2.90%.  But under my base case scenario, I expect yields to top out at 2.60-2.70%.

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