The Great Divide

August 13th, 2014
in contributors

Macro Strategy Review for August 2014

Written by with David Martin and Jim O'Donnel, Forward Markets

The Great Divide

Since the end of 2009, the S&P 500 Index is up 93.25%, while wages have increased 9%. The "Great Divide" between how the average worker has benefited over the past four and a half years and how the stock market has performed is primarily the result of monetary policy. This statement is not to dismiss the role of corporate earnings, which have risen considerably since 2009. However, monetary policy has certainly affected psychology and indirectly contributed to the increase in earnings.


Follow up:

Since the end of 2011, the price-earnings (P/E) ratio for the S&P 500 has soared 32%, climbing from 13.6 to its current level of 18.0. It is hard to attribute investors' willingness to pay 32% more for each $1 of earnings based on economic growth. Gross domestic product (GDP) rose 2.00% in 2011, 1.95% in 2012 and 2.60% in 2013.

Even if GDP averages an increase of 3.3% in the second, third and fourth quarters of 2014, growth for all of 2014 would be an underwhelming 1.95%. The performance of the economy during the past four years hardly justifies the 32% increase in the S&P 500's P/E ratio. Clearly, monetary policy has had an impact on investor mentality toward equities, spawning the slogan "There is no alternative (TINA)."

By maintaining its zero interest-rate policy (ZIRP) since 2008, the Federal Reserve (the Fed) has dictated a change in asset allocation toward equities, high yield bonds and the behavior of corporate treasurers. With money market and certificate deposit yields well below 1%, some conservative investors have felt compelled to invest in dividend-paying stocks, which typically provide more income. The search for yield has prompted others to invest in high yield bonds. In 2007, the average junk bond yielded 7.5% versus 5.0% today. That sounds more like a stretch than a reach for yield.

While dividend-paying stocks and high yield bonds may satisfy an investor's immediate need for income, they can be more volatile and potentially lead to loss of capital that some investors may not fully appreciate. Corporate treasurers have been able to reduce interest costs significantly since 2008, which has added hundreds of billions of dollars to profitability. Lower interest expense is a good thing and has helped moderate the level of the S&P 500's P/E ratio by adding to earnings. However, some treasurers have gone so far as to borrow money cheaply so their company can buy back even more stock.

Companies spent $598.1 billion on stock buybacks in 2013, according to money management and research firm Birinyi Associates. That was the second highest annual total in history. The pace picked up in the first quarter of 2014 when companies spent $188 billion, the highest quarterly amount since 2007. LPL Financial and Brown Brothers Harriman estimate that half of the increase in first quarter S&P 500 earnings came from declining share count, not from increases in actual earnings. Since 2010, companies in the S&P 500 have bought back $1.95 trillion of their stock. These purchases have incrementally reduced the number of shares outstanding and boosted earnings per share.

Earnings derived from financial engineering are not the same as earnings generated from higher revenue growth. Overlooking the source and quality of earnings can lead to a false sense of security about the market's valuation. The stock market is not as fairly valued as the current 18.0 P/E suggests once the impact of low interest rates and stock buybacks are considered.

Corporations have not proved particularly prescient in timing their buybacks. They were aggressive buyers as stock prices leapt higher in 2006 and 2007 only to curb their buying after most stocks had lost more than half of their value by the first quarter of 2009.

This track record suggests they have done a marvelous job of misallocating capital in the past. Whether the large expenditure of cash and borrowing to buy stock over the past 18 months will prove wise will only be known with the benefit of hindsight. We have our doubts since stocks are fairly expensive if one reviews other measures of valuation beyond the standard P/E ratio.

According to Ned Davis Research Group, there have been 35 bull market peaks since 1900. By quantifying how other valuation measures have performed over time, it is possible to calculate the percentage of times the market peaked below the market's current valuation. Using Robert Shiller's cyclically adjusted P/E ratio, the current market's valuation is more expensive than 86% of prior peaks and exceeds 89% of previous peaks based on Tobin's Q ratio since 1900. The price-book ratio measures a company's stock price by its per-share book value since 1925 and shows that 82% of prior peaks occurred with the stock market lower than it is today.

The price-sales ratio divides a company's stock price by the company's per share sales, and it indicates that the market today is more expensive than 89% of prior highs since 1955. The P/E ratio is the outlier, with just 69% of previous market highs below today's prices. As discussed earlier, the current P/E ratio has been distorted by enormous stock buybacks in recent years and lower interest expense provided by monetary policy interest rate suppression.

The message conveyed by a range of valuation methods indicate that the stock market is currently at one of the most expensive levels in history and certainly more expensive than the P/E ratio suggests.

Just because the stock market is currently expensive does not mean it can't get more expensive or that it must begin a large decline soon. The most important takeaway is that returns in coming years are very likely to be anemic compared to the historical average. Of course, anything that upsets the apple cart could result in a substantial decline since valuations are high by historical standards. Increasing the tactical allocation within a portfolio seems warranted.

Federal Reserve

The Fed expected that asset price appreciation in stocks and home values would trickle down into the economy, boosting job growth and wages. Accommodative monetary policy certainly lifted Wall Street, but not the fortunes of those living on Main Street. The risk going forward is the Great Divide becomes even wider, as the Fed waits for inflation to rise and the labor market to further improve. In her congressional testimony on July 15, Chair Yellen said that social media, biotechnology and small cap stock valuations were stretched, but the overall market was fairly valued. It seems as if the S&P 500's P/E ratio must be her only valuation metric.

Yellen also said the Fed was watching the leveraged loan market. In 2007, $100 billion of leveraged loans were issued and 38% carried a B rating, or were rated highly speculative. In 2013, issuance of leveraged loans soared to $260 billion and 58% were B rated. Leveraged loan issuance is running at a pace of $300 billion in 2014. Watching a boiling pot won't stop it from boiling over.

There isn't a single member on the Fed board that anticipated the housing bubble or the scope of the financial crisis once it began. Members of the Fed were certainly surprised by all the problems they did not see coming in 2008. Understandably, knowing there may be unknown factors now that could prove crucial later on is likely to unnerve the Fed members and make them more prone to postpone action for fear of inciting an outsized market reaction. Once burned, twice shy and the 2008 financial crisis was a firestorm. Ironically, the potential for an outsized reaction will only increase the longer they wait and the more stretched valuations become.

Whenever the Fed increases its policy rate, it is very unlikely that it will actually tighten policy. Many investors conclude that an increase in the federal funds rate automatically constitutes a tightening of policy. That interpretation fails to recognize that there is a significant difference between the Fed raising the cost of money and actual tightening that results in a reduction of liquidity in the financial system. Between June 30, 2004 and August 8, 2006, the Fed increased the federal funds rate from 1.0% to 5.25%, after 17 consecutive 0.25% increases.

Despite the significant increase in the cost of short-term money, the stock market continued to rally and spreads between Treasury yields and corporate bonds narrowed to all-time lows by the spring of 2007. This was possible because the availability of liquidity and credit had not been restricted, even though the cost of money had risen. We are confident that liquidity and monetary policy will remain quite accommodative after the Fed begins to raise rates.

In early July, the Bank for International Settlements (BIS) warned in its annual report that financial markets had become unhinged from economic reality and "euphoric." The Great Divide between income growth for the majority of workers in the U.S. and an almost doubling in the S&P 500 lends credibility to BIS's assessment.

However, markets are not just euphoric in the United States. In June, Spain was able to sell government bonds at the lowest yield since 1789, even though the Spanish economy is barely growing and unemployment is 24.5%. Although the Fed is winding down its quantitative easing (QE) program, other central banks may soon be picking up the slack.


We discussed in depth the new actions announced on June 5 by the European Central Bank (ECB) to spur economic growth and increase inflation in our July Macro Strategy Review (MSR), so we won't review the details again. Our conclusion is the actions are unlikely to have much economic effect before year-end. In May, eurozone industrial production fell 1.1%, the largest decline in two years.

The four largest eurozone economies (Germany, France, Spain and Italy) all experienced declines so the weakness was widespread. Inflation was just 0.5% in June, so it remains well below the ECB's 2.0% target. If our forecast is correct, growth and inflation are likely to remain tepid during the balance of 2014, which will increase the odds of the ECB launching a QE program before year-end. As we've discussed previously, the operational difficulties the ECB will face are far more daunting than the Fed had to deal with. The ECB will be working in 18 different bond markets and Europe's securitization market is one-quarter of the U.S.'s securitization market, so buying securities in volume will be challenging.

Expanding the securitization market in Europe will take time, since most lending to small- and medium-sized companies has been local within each country and there is little credit history available to rate securitized loans of small- and medium-sized companies.In July 2012,opinionating that perception has been more important than reality in Europe, in his presentation to the European Parliament the ECB President Mario Draghi made his famous comment in his presentation to the European Parliament that the ECB would do

"whatever it takes"

On July 14, 2014, Draghi stated that quantitative easing

"falls squarely in the ECB's mandate,"

and reiterated that the ECB was ready to undertake large asset purchases to stimulate the European economy if needed.1


Japan's economy has pretty much followed the path we laid out in the February 2014 MSR:

"Demand will be pulled forward into the first quarter, as consumers buy before the April 1 increase in the sales tax from 5% to 8% in order to save 3% on their purchases. First-quarter GDP will be lifted by the surge in consumer demand, only to be weakened in the second quarter by the double whammy of lower demand and higher taxes."

First-quarter GDP jumped a whopping 5.9%, but consumer spending has since fallen 4.6% in April and 8.0% in May. Orders for machinery plunged 19.5% in May, which indicates that demand from businesses was also pulled forward into the first quarter. As noted in the February 2013 MSR, Japan produces only 16% of its energy needs, and is the largest importer in the world of natural gas, second largest importer of coal and third largest importer of oil, according to the Energy Information Administration. Since these commodities are priced in dollars, we expected the decline in the yen to increase the cost of these imports, resulting in more inflation and a larger trade deficit.

In May, Japan's Consumer Price Index (CPI) was 3.7% higher than in May 2013. As of March 31, 2014 (latest data available), Japan's trade deficit as a percentage of GDP was the largest in decades. Prime Minister Shinzo- Abe has succeeded in reversing deflation, but he may have succeeded too well since the cost of living is rising faster than the increase in wages. This may hurt future consumption, resulting in slower GDP growth in coming quarters. If Japan's economy does not shows signs of recovering from the tax increase before year-end, the Bank of Japan may instigate another round of QE to cheapen the yen further and boost Japan's stock market.

U.S. Economy

In 2012 and 2013, the consensus among economists and the Fed was that economic growth was poised to accelerate above 3% in the second half in both years. There were a number of reasons we did not expect the economy to pick up steam in the back half of 2012 and 2013 and pointed to the lack of improvement in average hourly earnings as one reason. As American baseball player Yogi Berra might say about economists' forecasts for the second half of 2014,

"It seems like déjà vu all over again."

After a dismal first quarter, the second-quarter rebound in the economy has encouraged economists to expect GDP growth to comfortably hold above 3% for the balance of 2014. One of the better ways to assess how Main Street is doing is to look at the annual change in average hourly earnings, which is why we have presented this chart almost every month in recent years. As you can see, income growth has failed to accelerate and we don't think housing will add much to growth in the second half of the year.

In the summer of 2013, economists were quite positive about housing and cited the strength in housing as one of the main reasons for their bullishness about the economy in the second half of 2013. We discussed housing in detail in the July 2013 MSR, explaining why we disagreed with the widespread optimism and why we expected housing activity and price gains to moderate  in the second half of 2013.

Since their peak of $5.38 million in July 2013, existing home sales have declined 6.3% to $5.04 million in June, and the rate of price appreciation has also slowed. The S&P/Case-Shiller 20-City Composite Home Price Index peaked last November with a year-over-year gain of 13.7%, but has slowed to show an increase of 9.3% as of May. The National Association of REALTORS® (NAR) Metropolitan Median Area Prices and Affordability report broadly measures housing activity and does not use a three-month moving average that is used in the S&P/ Case Shiller 20-City Composite, so it provides a more accurate assessment of current prices. NAR data showed only a 4.3% increase through June, which indicates that prices have decelerated significantly in recent months.

A review of the factors that led to the slowdown in housing since July 2013 may provide clues as to whether a pickup in housing can be reasonably expected in coming months. One of the reasons we expected housing activity to cool was the significant decline in the NAR's Housing Affordability Index. The jump in home prices during 2012 and the first half of 2013 and the increase in mortgage rates in the spring of 2013 caused the Affordability Index to drop from over 200 in late 2012 to 168.5 in June 2013. The moderation in price increases and a decline in mortgage rates since the end of 2013 have stabilized affordability. At the end of April, the NAR's Housing Affordability Index was 167.8.

According to RealtyTrac, institutional buyers have bought more than 386,000 single-family homes across the country since 2011. Blackstone has spent $8.6 billion over the last three years purchasing 45,000 homes in 14 cities and is the largest institutional homeowner. Last July, we noted that surveys of investment pools indicated they were planning to purchase fewer homes in the second half of 2013, which would lessen one of the drivers of demand and price increases in a number of major markets.

Last summer, Blackstone was spending $140 million a week to buy homes, but is now down to just $30 million a week. Blackstone and a number of the big institutional buyers have moved away from buying more homes toward generating income through the securitization of existing properties. According to Morningstar's credit rating division, Blackstone, American Homes 4 Rent and Colony American Homes have brought five rent-backed securitization deals worth $3 billion. The bond issues are backed by loans issued on 20,741 rental homes and operated by the three companies. This shift in emphasis suggests these large institutional investors are not likely to ramp up their buying of new properties in coming months.

Other institutional home owners have begun selling a portion of the homes they have acquired. Waypoint Real Estate Group was one of the first companies to raise money from private investors to buy foreclosed homes. In recent months, it has begun to sell up to 2,000 of the 4,000 homes it has acquired in recent years. It also manages more than 7,000 homes for a publicly traded real estate investment trust. The coming supply of homes from institutional owners like Waypoint has the potential of being both a positive and a negative. The additional supply may increase inventory and the number of existing home sales, but the additional supply may also dampen future price appreciation in coming years.

The unprecedented decline in home values between 2007 and 2011 created a negative psychology among existing homeowners, but for institutional investors an opportunity. The double-digit price gains seen in 2012 and the first half of 2013 reversed the negative psychology and lured individual investors who were looking to buy a property, fix it up and then sell for a quick profit. We cited RealtyTrac estimates in our July 2013 MSR that 136,000 homes had been flipped (bought and sold within six months) during the 12 months ending May 2013, an increase of 19%. According to PropertyRadar, 6,000 homes in California had been flipped in the first four months of 2013, which was the highest level since late 2007. With mortgage rates rising, homes more expensive and the rate of change in price increases expected to slow, we thought the positive psychology and flipping activity in the existing home market would diminish in the last half of 2013.

The preceding information explains why we expected housing to soften last July and we don't expect these factors to change much. Although affordability has stabilized, it has not improved and won't unless mortgage rates decline more and home prices stop rising or decline. Obviously, if mortgage rates rise, affordability will weaken. Institutional investors are not likely to materially increase their acquisition rate of existing homes and some may do more selling than buying. Purchases by individual flippers are likely to wane, while selling increases, especially in those markets that have experienced the largest price gains.

There are a number of additional reasons why any improvement in housing in the next year is likely to be modest, as the supply of homes for sale is likely to remain constrained during the next year. According to Zillow, a real estate research firm, 19% of homes were worth less than the mortgage on the property at the end of the first quarter. If selling costs and the need for a down payment to purchase another home are considered, the effective rate of negative equity jumps to 37%.

Although hard to quantify, there is another group of homeowners who either refinanced an existing mortgage or bought a home when mortgage rates were at historic lows in 2012 and early 2013. Moving and losing their existing low mortgage rate could be an impediment, especially for those thinking of purchasing a larger home, which may come with a larger mortgage, higher mortgage rate and monthly payment.

As the Fed cautiously moves toward normalizing interest rates over the next two years, mortgage rates will climb, increasing the number of homeowners facing mortgage rate sticker shock. Higher mortgage rates will lower affordability, potentially curbing future demand from those wanting to buy a home in coming years.

When housing prices were soaring during 2004 and 2007, many homeowners tapped into their escalating home equity by taking out home equity lines of credit (HELOC). Many HELOCs allowed homeowners to make interest-only payments for 10 years. For the 807,000 homeowners who took out $23 billion of HELOCs in 2004, the day of reckoning has arrived. A homeowner who owes $100,000 on a HELOC with a 3.5% interest rate could see their monthly payment jump from $292 to $715 when the interest-only loan converts to a 15-year amortizing mortgage.

In 2014, more than $23 billion of HELOCs are coming due, according to credit reporting firm Equifax. More than $40 billion will come due in 2015, with $50 billion estimated to reset in 2016 and 2017. Over the next three years the drag on income for homeowners with HELOCs will more than double. If interest rates rise during the next three years, the increase in monthly payments will climb further. For many of the more than 4 million homeowners with HELOCs, the combined total of the mortgage and HELOC is greater than their home's market value, making it more difficult for them to move.

The ramifications of having so many homeowners trapped in their home are mostly negative. Those stuck in their current home may not be able to trade up to a larger home, even as their family size grows. The capacity to trade up has historically been an important dynamic in the housing market. The lack of supply of homes for sale from underwater homeowners and those blessed with a historically low mortgage rate makes it more likely that home prices could continue to rise faster than incomes. While higher home prices will gradually reduce the number of underwater homeowners, it will also reduce affordability, especially for first-time homebuyers.

According to the Fed's senior loan officer survey, banks have been far slower to lower lending standards for mortgages than other types of loans, and have actually tightened them in recent quarters. This makes it more difficult for any prospective homebuyer, but especially tough on the first-time buyer.

In June, existing home sales increased 2.6% to 5.04 million units, according to the National Association of REALTORS®. First-time buyers accounted for 28% of the transactions, compared to a normal level of 40% to 45%. The headlines that trumpeted that existing home sales rose 2.6% in June after jumping 5.3% in May, failed to mention that sales, even after May and June's increases, were still 2.3% below their May 2013 level and 6.3% below the July 2013 peak. Existing home sales represent 90% of housing activity.

The rate of first-time home buyers has been negatively impacted by the surge in the least expensive homes since March 2012 in many major cities. There are 16 cities that the S&P/Case-Shiller 20-City Composite breaks down by least expensive, average and most expensive. In 15 of the 16 cities tracked since March 2012, the least expensive homes have experienced the largest percentage increase, dwarfing the 5% rise in median income.

The following are a few examples comparing the percentage increase by the least expensive to the most expensive: Atlanta 103% to 30%, Phoenix 64% to 29%, Miami 55% to 24%, Las Vegas 74% to 38%. These cities were some of the hardest hit when home values swooned and where institutional investors were active. The top price of homes in the least expensive category ranged from $152,926 in Atlanta to $184,946 in Miami. This is one reason why many first- time homebuyers have simply been priced out of the housing market. Unless home values decline or income growth materially accelerates, the affordability issue for many first-time homebuyers is unlikely to improve much.

According to Edvisors, an online financial educational site for students, 41 million students had student loans outstanding as of March 31, totaling $1.2 trillion. According to the Federal Reserve  of New York, 11% of all student loans are more than 90 days past due. However, the student loan problem is more concentrated than widely perceived. After reviewing student loan data back to 1992, the Brookings Institution found that only 24% of those with student loans have a balance exceeding $20,000. The share of income that a typical student debtor has to devote to payments was 3.5% in 1992, 4.3% in 1998 and 4.0% in 2010.

However, according to Edvisors, the average graduate in 2014 had $33,000 in student loan debt, so the percentage of those with debt exceeding $20,000 is going to increase, as will the share of income devoted to repaying their student loans. There has been a large increase in the number of students that have taken out a student loan during the last 20 years. In 2014, 70% of bachelor's degree recipients graduated with a student loan, up from less than half in 1994. However, for the 24% of borrowers with student debt of more than $20,000 and the 7% with over $50,000 in debt, keeping up with payments and saving to purchase a car or the down payment for a home is certainly a challenge.

According to the Brookings Institution, the biggest problem is former students who have amassed student debt but do not have a college degree. There are far more former students with student loan debt and no degree, than those with a bachelor's degree and a heavy debt load. The debt-but-no-degree group is actually struggling more to stay current with their student loan payments than those with larger student debt.

According to the Federal Reserve Bank of New York, annual wages for those with a bachelor's degree averaged $65,820 in 2013, versus $46,324 for those holding an associate's degree and $37,897 for those with a high school diploma. Over the course of a 30-to-40- year career, getting a degree is still worthwhile. Those with some student debt but no degree probably don't make much more than a high school graduate, which is why their student debt is more burdensome. Clearly, former students with student loans and no degree will have a harder time saving enough money to make the required down payment, even on the most inexpensive home. Saving for a down payment for former students with a bachelor's degree and more than $20,000 in student loans will simply take more time and will likely delay when they start a family.

We remain skeptical that the economy will sustain a growth rate of 3.25% to 3.75% for the second half of 2014 as many economists have forecast. Income growth has failed to accelerate, even though monthly job growth has picked up. Over the past year, consumer prices have risen just as fast as wages, so most consumers are barely keeping up with the cost of living, let alone getting ahead. Housing is not likely to add much to growth. Although the economy may not accelerate after the second quarter rebound, a pronounced slowdown is not likely either.


As discussed in recent months, one of the ways the eurozone economy could receive a lift is for the euro to decline. A cheaper euro should boost demand for European exports in general, and especially help Italy, Spain and France, which have much higher production costs than Germany. The stronger euro has put downward pressure on inflation since it bottomed in July 2012, in the wake of Mario Draghi's "whatever it takes" comment.

Technically, the euro reversed lower during the week of May 9  and fell beneath the rising trendline during June from the low in July 2012 . Although the euro may experience a bounce in coming weeks, any rally is not likely to exceed 137.00-137.50. We believe the intermediate trend is lower and could accelerate if growth falters, inflation remains low and it becomes obvious that the ECB will be pressed to launch QE before year-end. The euro has the potential to decline to 131.00-132.00 in coming months, where there is a trendline connecting the lows during 2013.


We last discussed gold in the April 2014 MSR, and our view has not changed. Since its bottom in June 2013, gold appears to be tracing out a contracting triangle (see A, B, C, D and E in the nearby chart). The interesting thing about this technical pattern is that it often occurs just before a final thrust in the direction prior to the start of the triangle. From its peak in September 2011, gold was clearly in a downtrend before the June 2013 low near $1,180.

As long as gold does not trade above $1,400, the high of C, the triangle is valid and suggests that gold will trade below the June 2013 low of $1,180. If gold does indeed fall below $1,180, we have no idea at this point if it bottoms at $1,178, $1,150 or $1,100.

The key point is any decline below the June 2013 low will likely be the ending move of the decline from the September 2011 high at $1,920. As such, it would represent a great buying opportunity and potentially a significant rally in gold ($300-$500). More support to this conclusion would come if the gold stock indexes (HUI, XAU, GDX) do not fall below their December 2013 lows, as gold drops below $1,180.


As discussed earlier, based on a broader set of valuation measurements than the P/E ratio, the stock market is fairly expensive. Investment returns over the next five years are likely to be less than historical returns and many investors' expectations. Another cautionary signal comes from the Investors Intelligence weekly survey of bullish and bearish investment letters. Those with a bullish bias have outnumbered the bears by more than 40% twice in 2014, which is very unusual. Prior to this year, bulls outnumbered the bears by more than 40% during the week of April 8, 2011 and October 19, 2007. In 2011, the S&P 500 declined by almost 18% between April 8 and early October. After October 19, 2007, the S&P 500 plunged by 56%.

These were scary declines, but it is important to remember that investors were provided good reasons to sell following those excessively bullish readings. Standard & Poor's downgraded U.S. Treasury debt from AAA to AA in August of 2011, and the financial crisis swamped the financial markets in 2008.

Barring a geopolitical crisis, the underlying fundamentals are in decent shape so the odds of a correction deeper than 12% seems unlikely in the next few months. However, if investors begin to actively worry about the Fed raising rates much sooner than mid-2015, or that the pace of rate hikes will not be gradual, the stock market could experience a decline of 7% to 12%. If the economy fails to maintain growth comfortably above 3% as many are expecting, the market could easily fall by 4% to 7%. As we have stated numerous times, the stock market doesn't go down because it is too expensive or due to excessive bullishness. The stock market declines modestly when expectations aren't met, or significantly if a systemic threat develops.

While valuation and sentiment are cause for watchfulness, the trend and momentum of the market are positive. The S&P 500 continues to make higher highs and higher lows, which is the technical definition of an uptrend. Our proprietary Major Trend Indicator has reconfirmed the bull market based on the market's momentum. Bear market declines are usually preceded by a significant loss of upward momentum, and the S&P 500 falling below a prior low, often after failing to make a new high. These warning signs were present in 2007 and 2011, but not currently. As long as the S&P 500 holds above 1,900 the long-term trend is up.


As stated last month, we expect the 10-year Treasury yield will gradually climb in coming months to 2.75% to 2.84%. On July 3, it reached 2.69%, before falling back to under 2.50%. As we've stated before, the 10-year Treasury yield could dip below 2.40%, but it would likely take a geopolitical event resulting in a flight to quality, or far weaker economic data than we expect, to drop appreciably further.

As noted previously, the ECB may launch their version of QE before year-end if growth fails to pick up and inflation remains low. We suspect global investors have been front running the ECB, which partially explains why yields throughout Europe have been mining all-time lows. On July 18, the yield on the 10-year German bund dropped to 1.13%. Compared to the return on the German bund, the 2.5% available on the U.S. 10-year Treasury bond looks fabulous. However, it won't take much weakness in the euro to offset the skimpy yields provided by European sovereign bonds. Since its high on May 8, the euro has already declined by 3.5%. International investors may choose to sell European bonds, which would cause yields to rise, rather than hedging the currency risk. Higher yields in Europe would likely put upward pressure on Treasury yields.

In addition, China has been a huge buyer of Treasury bonds in 2014, as it tries to increase the value of the yuan versus the dollar. In order for China to weaken its currency, it sells the yuan, buys dollars and then buys Treasury bonds with dollars. Through May, China has purchased $107.21 billion of Treasury bonds, according to U.S. government data. China officially holds $1.27 trillion of U.S. debt, or 10.8% of the $12 trillion Treasury market. According to CRT Capital Group, the purchases in the first five months of 2014 are the most since records started in 1977, and dwarf the $81 billion for all of 2013. It is likely that the pace of Chinese Treasury purchases will slow in coming months, which would contribute to a drift higher in Treasury yields.

Definition of Terms

  1. 10-year Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year, but not more than 10 years.
  2. AA/AAA/B are Standard & Poor's long-term credit ratings that reflect a bond issuer's financial strength, or its ability to meet its financial commitments in a timely fashion. AAA is the highest possible rating and is given when an issuer's capacity to meet its long-term debt obligations is extremely strong, while AA indicates a very strong repayment capacity and B indicates a vulnerability to nonpayment.
  3. A bund is a bond issued by Germany's federal government.
  4. Consumer Price Index (CPI)is an index number measuring the average price of consumer goods and services purchased by households. The percentage change in the CPI is a measure of inflation.
  5. Currency risk is a form of risk that arises from the change in price of one currency against another.
  6. Cyclically adjusted price-earnings (CAPE) ratio is the ratio of stock prices to the moving average of the previous 10 years' earnings, deflated by the Consumer Price Index.
  7. Federal funds rate is the interest rate at which a depository institution lends immediately available funds to another depository institution overnight.
  8. Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. The GDP of a country is one of the ways of measuring the size of its economy.
  9. National Association of REALTORS® Housing Affordability Index is based on the relationship between median home price, median family income and average mortgage interest rate.
  10. Q ratio is a ratio devised by Nobel Laureate James Tobin that suggests that the combined market value of all the companies in the stock market should be about equal to their replacement costs.
  11. Quantitative easing refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.
  12. Price-book (P/B) ratio is a ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share.
  13. Price-earnings (P/E) ratio of a stock is a measure of the price paid for a share relative to the annual income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income.
  14. Price-sales ratio is a valuation ratio that compares a company's stock price to its revenues.
  15. S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.
  16. S&P Case-Shiller 20-City Composite Home Price Index is a value-weighted average of 20 metro area indexes that seeks to accurately track the price path of single-family homes.
  17. Valuation is the process of determining the value of an asset or company based on earnings and the market value of assets.
  18. Volatility is a statistical measure of the dispersion of returns for a given security or market index.
  19. Zero interest rate program (ZIRP) is a policy instituted by the Federal Reserve in 2008 to keep the federal funds rate between zero and 0.25% in order to stimulate economic activity during times of slow economic growth.

Note:  One cannot invest directly in an index.

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