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posted on 16 January 2018

Bond Bears Still Wrong

Written by , Clarity Financial

    Below are just a few of the latest, but a quick Google search will produce a litany more.

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    Of course, those headlines are not the first time we have seen such calls made. One of the biggest issues with predictions of rising 10-year bond yields since “bond bears" came out in earnest in 2013, is they have been consistently wrong. For a bit of history, you can read some of my previous posts on why rates can’t rise in the current environment:

    (Of course, we have been avid buyers of bonds on “rate pops" in our portfolios during that time frame as well.)

    As we head into 2018, and beyond, there are many reasons why rates will remain subdued all of which are economic and fundamental in nature. As for Bill’s call for the end of the “bond bull," this isn’t the first time he has made that call.

    Yet, rates have continued to trend lower.

    “The Death Of The Great Bond Bull Market Has Been Greatly Exaggerated."

    As I have written many times previously, rates are a function of economic, wages and inflation.

    “Okay…maybe not so clearly. Let me clean this up by combining inflation, wages, and economic growth into a single composite for comparison purposes to the level of the 10-year Treasury rate."

    “As you can see, the level of interest rates is directly tied to the strength of economic growth, wages and inflation. With roughly 70% of economic growth derived from consumption, the trend of wage growth should not be readily dismissed."

    The Fed believes the rise in inflationary pressures is directly related to an increase in economic strength. However, as I will explain: Inflation can be both good and bad.

    Inflationary pressures can be representative of expanding economic strength if it is reflected in the stronger pricing of both imports and exports. Such increases in prices would suggest stronger consumptive demand, which is 2/3rds of economic growth, and increases in wages allowing for absorption of higher prices.

    That would be the good.

    The bad would be inflationary pressures in areas which are direct expenses to the household. Such increases curtail consumptive demand, which negatively impacts pricing pressure, by diverting consumer cash flows into non-productive goods or services.

    While inflation ticked-up in December, unfortunately, it came from rising prices in all the WRONG places as shown below.

    (Thank you to Doug Short for help with the design)

    As shown, the cost of Housing, Medical Care, and Transportation have all risen sharply over the past 5-months with those three components comprising 67% of the inflation calculation.

    Clearly, the surge in “health care" related costs, due to the surging premiums of insurance due to the “Un-affordable Care Act," pushed both consumer-related spending measures and inflationary pressures higher. Unfortunately, higher health care premiums do not provide a boost to production but drain consumptive spending capabilities. Housing costs, a very large portion of overall CPI, is also boosting inflationary pressures. But like “health care" costs, rising housing costs and rental rates also suppress consumptive spending ability.

    Importantly, while households may be receiving a modest “tax cut" over the coming year, given the rise in three of the biggest expenditures in most households, whatever increase in incomes maybe received has likely already been absorbed by higher costs and debt service payments.

    “For the middle-class and working poor, which is roughly 80% of households, rent, energy, medical and food comprise 80-90% of the aggregate consumption basket." - Research Affiliates

    The problem for the Fed is that by pushing interest rates higher, under the belief there is a broad increase in inflation, the suppression of demand will only be exacerbated as the costs of variable rate interest payments also rise.

    With households already ramping up debt just to make ends meet, another increased expense will only serve to further suppress “consumer demand."

    This is particularly the case given that wages have not kept up with the pace of inflation as shown below.

    And even the addition of additional debt isn’t closing the gap between the incomes and the median standard of living in the U.S.

    The bottom line is that credit markets have been, and continue to be, right all along the way. At important points in time when the Fed signaled policy changes, credit markets have correctly interpreted how likely those changes were going to be. The perfect example is the initial rate hike path set out in December 2015. This was totally wrong and the credit markets were telling us so, right from the start.

    It was the analysis of the credit markets which has kept us on the right side of the interest rate argument in repeated posts since 2013.

    This time is likely to be no different, particularly as the Fed continues to hike rates into an environment where credit markets continue to scream secular stagnation.

    Since 2009, asset prices have been lofted higher by artificially suppressed interest rates, ongoing liquidity injections, wage and employment suppression, productivity-enhanced operating margins, and continued share buybacks have expanded operating earnings well beyond revenue growth.

    The Fed has mistakenly believed the artificially supported backdrop they created was actually the reality of a bright economic future. Unfortunately, the Fed and Wall Street still have not recognized the symptoms of the current liquidity trap where short-term interest rates remain low and fluctuations in the monetary base fail to translate into higher inflation.

    Combine that with an aging demographic, which will further strain the financial system, increasing levels of indebtedness, and lack of fiscal policy, it is unlikely the Fed will be successful in sparking economic growth in excess of 2%. However, by mistakenly hiking interest rates and tightening monetary policy at a very late stage of the current economic cycle, they will likely be successful at creating the next bust in financial assets.

    History is replete with examples of what happens when interest rates rise sharply over a relatively short period of time.

    (Pay attention to the overbought condition of rates which is also at historically high levels. With the same overbought condition is rates and stocks, the markets are set up for a full reversion from “risk" to “safety.")

    The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds.

    However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates are an entirely different matter.

    Since interest rates affect “payments," increases in rates quickly have negative impacts on consumption, housing, and investment which ultimately deters economic growth.

    Given the current demographic, debt, pension and valuation headwinds, the future rates of growth are going to be low over the next couple of decades - approaching ZERO.

    While there is little left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Therefore, bond investors are going to have to adopt a “trading" strategy in portfolios as rates start to go flat-line over the next decade.

    Of course, you don’t have to look much further than Japan for a clear example of what I mean.

    But, for now, Wall Street continues to ignore the giant “secular stagnation" sign staring them in the face.

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