Thursday, August 2, 2018

Tug of War In the Bond Market

Helping stocks to recover from the year’s lows in early February is the eerie calm in the US bond market. The Bond Vigilante Model suggests that the 10-year Treasury bond yield tends to trade around the growth rate in nominal GDP on a y/y basis (Fig. 1). It has been trading consistently below nominal GDP growth since mid-2010. The current spread is among the widest since then, with nominal GDP growing 5.4% while the bond yield is around 3.00% (Fig. 2).

Why isn’t the bond yield closer to 4.00% or even 5.00%? After all, the Tax Cuts & Jobs Act enacted at the end of last year and additional fiscal spending passed by Congress earlier this year are projected by the Congressional Budget Office to result in federal budget deficits averaging about $1 trillion per year for the next 10 years (Fig. 3). Furthermore, the FOMC commenced tapering its balance sheet last October and plans to continue doing so through the end of 2024 (Fig. 4). The Fed is on track to slash its holdings of Treasuries and MBSs by $2.5 trillion and $1.7 trillion, respectively, over the next seven years! Oh and by the way, the FOMC is on track to raising the federal funds rate to 3.00% by the end of next year from 1.75%-2.00% currently.

Let’s review some possible explanations for the nonchalant performance of the bond market. Is it the calm before the storm or the calm that calmly continues? Consider the following bullish offsets to the bearish factors just mentioned above:

(1) Near-zero yields in Germany and Japan. The 10-year German government bond yield has dropped from this year’s high of 0.77% on February 2 to 0.45% 0n Tuesday (Fig. 5). Germany may have been hit by uncertainty created by Trump’s trade war. The IFO Business Confidence Index has been falling all year, with its expectations component the lowest since March 2016 (Fig. 6). In any event, the ECB has indicated that the bank’s key interest rates will remain at historical lows at least through the summer of next year!

Meanwhile, there was some anxiety last week about a rumored change of course by the BOJ. The 10-year Japanese bond yield jumped from 0.035% on Friday, July 20, to 0.104% on Monday of this week. It was back down to 0.048% on Tuesday after the BOJ kept its policy steady. It maintained its target for the 10-year government bond yield at around 0.00% and the short-term interest rate target at minus 0.1%. The bank announced one minor tweak: In a statement, it explained that the yields may move up or down “to some extent mainly depending on developments in economic activity and prices.”

Wow, lots of agita about nothing! The BOJ also acknowledged that it will take “more time than expected” to achieve its inflation target of 2%. You think? The BOJ’s monetary base has more than quadrupled since April 2013, when Haruhiko Kuroda, the new head of the bank back then, slammed on the monetary accelerator and never took his foot off of it (Fig. 7). Most of the time since then, through June of this year, Japan’s CPI inflation rate has remained closer to zero than 2.0% (with the exception of 2014, when the sales tax was raised significantly) (Fig. 8).

(2) Subdued inflation. Back in the USA, the latest inflation figures remain relatively benign: Not too hot, not too cold, just warm enough to allow the Fed to proceed with the gradual normalization of monetary policy. The headline PCED rose 2.2% y/y through June, while the core increased 1.9% over the same period (Fig. 9).

The wage component of the Employment Cost Index held at 2.9% y/y during Q2 (Fig. 10). That’s the highest pace since Q3-2008, but still relatively low given the tightness of the labor market.

(3) Record wealth, with lots set on risk off. That still leaves an important question: Why aren’t bond yields rising in anticipation of all the debt that will need to be financed? There is already a record amount of debt everywhere, and more coming can’t be good for bonds. There is also a record amount of wealth in the world. Some of it tends to be managed with a risk-off bent. Ironically, people who expect that “this will all end badly” tend to buy government bonds because they are deemed to be among the safest assets.

No comments: