10-Year US Treasury Yield Will Break Out Of 35-year Range By Yearend 2016! (Part 1)

Why Interest Rates Will Break Out: Illiquidity, NO Vote Italy And Increasing Risk

Gundlach believes that Trump’s policies can raise the bond yields to 6% in the next 4 to 5 years. I believe that the recent surge in interest rates worldwide, with global bonds posting the biggest two-week loss ($1.8trn) in 26 years (since 1990) as President-elect Donald Trump sent inflation expectations surging, will rise above 3% before the end of 2016. Why? Because investors, mainly the hedge funds, and not so much the life insurance and pension companies that often hold their bonds until maturity, must get wary that the 10y Treasury Yield might break the 2.5% (we have already reached the 2.40% level on Wednesday November 23) and subsequently the very important 3% - see below.

Since 1981 when Volcker raised the Fed Funds Rate from 11.2% in 1979 to 20% in June of 1981, interest rates have been trending downward. Consequently, when the yield rises above the 3% level it breaks the declining range which has been intact for the last 35 years. Subsequently with the tremendous illiquidity in the market, caused by the Central Bankers and new regulations, we could very quickly see yields of 4%, 5%...and even 6%. The 35-year break out will not be gradual…as that is the nature of patterns breaking out of long-term trends.   

Do you think investors want to stay in the bond market with the Italian NO vote on December 4? This is almost a certainty with all its potential unwanted consequences of breaking up the EU and much higher Italian interest rates with as first culprit the Italian retail investors (bail-ins) and huge losses for the French banks on their Italian bond positions. International banks have lent Italian banks €550bn of which €250bn was lent by the French banks. This could force worldwide bond CDS (Credit Default Swaps) and interest rates much higher. Everybody will go for the gates because breakouts of long-term (35 year) ranges are very violent and extreme. Consequently, funds don’t want to incur even bigger losses before the end of the year and annihilate bonuses or what is left of them. On top of that we have the Fed meeting on December 13-14 with an almost 100% certainty that the Fed Funds Rate will be raised.

In my opinion the rising interest rates will not be a consequence of the anticipated rate of inflation (stemming from the low base effect of commodities), as is normally the case, but will be the result of the increasing risks (the status is changing everywhere) and poor market conditions such as illiquidity.

Risk being an integral part of the calculation of interest rates has been neglected for far too long because of the false guarantees (quantitative easing measures) of the Central Banks. I use the word false because their policies were never a viable option capable of correcting the structural problems.

And guess what turned out to be the end-result of the Central Banks? Asymmetric peak markets based on completely flawed and manipulated conditions, the opposite of a free market. A free market is described as a system in which the prices for goods and services are determined by the open market and consumers, in which the laws and forces of supply and demand are free from any intervention by a government, price-setting monopoly, or other authority. In fact, it is closer to the truth to say that all prices are manipulated, equities (buy backs), bonds (QEs, NIRP and ZIRP and ESF), Libor, gold and silver (paper futures and no registered inventories) and real estate (historical low interest rates). At one stage this bubble of bubbles will come to an astounding and spectacular end. If people value something, it has value; if people do not value something, it does not have value. It is as simple as that, although that also means that when a switch turns off in people’s mind and they don’t trust their currency any longer it will be goodbye currency. People awareness is the crucial factor determining if money has credibility or not and when the trust/credibility gives, it is almost impossible to restore. You can then kiss goodbye then to the “lender of last resort” trusting in God or not.

I believe, as mentioned in earlier articles that as a result of the resurging risk profile of the markets, people will increasingly replace paper or intangible assets with tangible assets. I ask you what do you think has more value? $1,000 in paper notes that are constantly being diluted in terms of purchasing power or $1,000 in physical gold, which can’t be printed at random by irresponsible politicians and monetary authorities? What do you think embeds lower risk?

With bond losses at $1.8trn so far and with almost near certainty that the Fed will hike the Federal Funds Rate on December 14, whilst the economy is weak a raise could finally break the camel’s back (back to reality).

So far the losses in the bond market worldwide are estimated to be already in excess of $1.8trn. The Bloomberg Barclays Global Aggregate Index has fallen 4% since Nov. 4. And Federal Reserve Chair Janet Yellen contributed to the decline by saying on Thursday Nov. 18 an interest-rate hike could come “relatively soon.” I don’t know what good that is going to do to the economy based on Government statistics that as we all know are heavily “managed” like everything else. To restore credibility? Don’t make me laugh!

The Treasury 10-year note yields climbed five basis points, or 0.05% point to 2.35% as of 5pm in New York Friday November 18, reaching the highest level since November 2015, according to Bloomberg Bond Trader data. 10Y Treasury yields are up an astonishing 65bps from the Trump-win lows, spiking to 2.35% - the highest since Dec 2015 because of the anticipation that the future looks bright despite the fact that current economic circumstances are really weak. Although the markets always discount future anticipated conditions 6-12 months ahead, we should take into account that with current debt levels it will be impossible to get a recovery without first resetting the incredible obstacle of $220trn+ in global debt. With everything intertwined as never before one domino such as the NO vote in Italy could easily cause the domino effect. Another domino could of course be the Fed’s decision to raise rates based on their own faulty figures, which could be the final straw that would break the camel’s back.

As is famously being quoted, “It is the economy stupid!” For example, the quality of jobs has been deteriorating severely in terms of the types being added. Next to that more and more people are leaving the workforce simply because they can’t find jobs. Since 2014, the US has added 547,000 waiters and bartenders (low quality jobs), and has lost 32,000 manufacturing workers. Not something to write home about is it?

In October, both the labor force participation rate, at 62.8% (civilian population over the age of 16 is either employed or are actively looking for work), and the employment-population ratio, at 59.7%, changed marginally. According to the BLS (Bureau of Labor Statistics), 94,609,000 Americans are not in the labor force, 425,000 more than 94,184,000 in September, and the second highest number on record. The number of people employed dropped 43,000, declining from 151,968,000 in September to 151,925,000 in October. The Cass Freight Index, tracking US shipment volumes by all modes of transportation, fell 3.1% in September from a year ago, the 19th month in a row of year-over-year declines, and the worst September since 2009! Finally look at the chart below, which shows the divergence between the demand for durable goods and the performance of the S&P500. Do I need to say more about our so-called “improving economy” and the need for an interest hike?

Source: ADM ISI, Bloomberg

Central Banks Have Lost Their Mojo With Their Counterproductive And Exhausted Policies

Donald Trump’s victory “sparked” a tremendous sell-off in the Treasury market, from an expectation of fiscal stimulus and business-friendly policies interest rates that were already on the rise, with the Central Banks having lost credibility to keep interest rates down. Big banks such as Citi, HSBC etc. finally came to the conclusion (you don’t need their research for their foresight!!) that the CBs had failed miserably in trying to restart the economies.  And on October 20 some Central Banks clearly admitted failure.

• “Bank Of England (BOE) admits QE 'economic' benefits are temporary, more effective as plunge-protection for markets.”
• “ECB not discussing an extension of QE beyond March" and that "extraordinary policy support won't last forever."

Translated: “expect much higher interest rates because our suppression policies don’t work any longer”! They have never worked because they were destined not to work from the beginning. Negative interest rates!!! How desperate can you be? The former CEO of the two largest Swiss banks (UBS and Credit Suisse), Oswald Grübel warned that central banks have "crossed the point of no return" which will ultimately “end in a crash." Joining Deutsche Bank in slamming NIRP, Grubel said that banks are losing hundreds of millions of francs each year to negative interest rates paid to central banks. Worse, he warned that central banks will eventually lose their credibility in the markets but that this could take 10 years or more, at which point it will "all end in a crash." What happens then? The former CEO believes that the final outcome will be wholesale financial nationalization: “after that all banks could belong to the state”. In my opinion the Governments don’t have any choice but to nationalize the banks because they hold 100’s of billions in government bonds.

I completely disagree with his assumption that it could take 10 years or more next to that all these so-called bankers suddenly have all the wisdom in the world whilst many people have been cautioning that you can’t solve the problem with issuing and printing more debt, especially considering the current high debt levels that have passed the tipping point assumed to be at the 75% (Debt/GDP) level. Anyway, it is highly unlikely that it will take 10 years or more before we witness a huge crash because, at present, we are already witnessing the failing of the Central Banks in order to suppress interest rates. They are losing their credibility. Investors have lost too much money with negative interest rates to step into that trap again. The tools are clearly getting exhausted. It will be more likely months than years before we see the collapse. You have to ask yourself how much longer can the Central Banks keep all the balls in the air before the ball drops?

By throwing money at the system and using the desperate step of negative interest rates, which is completely contrarian to the principle and raison d’etre of interest rates, the CBs were trying to get people to consume instead of save (so much for savers and pensioners and by the way who will compensate them?).  The CBs boosted the equity and bond and housing (mainly the top tier) markets, thereby only benefitting the top 1%, in order to create the illusion that “everything is ok” and hoping that consumers would spend. Nevertheless the middle and lower classes were still licking their wounds from the housing crash. Housing is basically the only asset class that enables the middle and lower class to increase their wealth and thus their spending power. When your house has excess value you feel “wealthy” and you are more confident that you can spend. Though when you don’t have any discretionary income it is virtually impossible to erase your losses or regain or build any wealth especially when the recovery in the economy is lackluster and doesn’t “allow” any wage increases. And because a lot of people are still under water from 2008 they don’t have the confidence or discretionary income to spend. Hence the lackluster economy, there is no escape velocity.

And instead of building confidence the Central Banks caused the opposite of what they were aiming for with people losing confidence, the pinnacle of the financial system, hence no consumption. This loss of confidence can clearly be illustrated by the deterioration in the velocity of money (M2), the number of transactions in the economy, to historic lows despite the Fed and other CBs increasing their balance sheets with trillions of dollars from $7trn in 2008 to about $20trn today. These Einsteins, used facetious of course, were the creators of the deflation they didn’t want!!

The low interest rates have also created huge underfunding for the pension plans, another disaster waiting to happen especially when the markets plunge.

And what these low interest rates have done for the pensions is another disaster to happen. The value of US pension funds at the end of 2015 was $21.7 trillion. And as we know pension funds require actuarial interest rates or yields of 7.5% to 8% to meet their long-term obligations hence why they have become hugely underfunded with the average yield on 10 and 20 years Treasuries of about 2.6% as of mid-2015. 

S&P500 corporate pensions went from being fully funded in 2007, in aggregate, to $375bn underfunded in just 8 years, whilst the corporations are still doing buy backs! Hello am I missing something? With respect to government pension plans according to the U.S. Pension Tracker at Stanford University, state and local government pensions are now underfunded by approximately $5 trillion with funding ratios of just 39%!  This is on the basis of the so-called “Market valuation method” as applied for U.S. corporate pensions, which must discount their liabilities using a corporate bond yield, which conveys that corporate pension payments carry about the same risk of default as corporate bonds.

The difference with corporate pension plans is that US state and local plans can discount their liabilities using the assumed return on investment. That assumed return on investment rule is why most state and local pensions are holding about 75% of their investments in risky assets such as stocks, private equity or hedge funds whereby they can assume annual investment returns of about 7.6%. What a twisted reasoning to have more risky investments. Based on the assumed return method, state and local plans today are about 74% funded, instead of 39%, and have unfunded liabilities of only $1.4 trillion instead of $5trn. But here’s a fact that, next to just common sense, should tell you something: almost no other pension plans in the world are allowed to use the assumed return kind of accounting that U.S. state and local plans can. As of mid-2015 the average yield on Treasuries with durations of between 10 and 20 years was about 2.6% instead of the 7.6% assumed annual investment returns. What a scam the state and local pension plans are and we should take into account that this “7.6%” assumed return and “74%’ funding is under optimal conditions with peak markets.

The primary problem, of course, is the Fed's low interest rate policies, which are crushing both sides of the pension equation. Pension funds are normally very conservatively invested for approximately 60% in treasury and IG bonds in order to secure their long term pension obligations. Though because of the historic low interest rates the funds were “forced” to lower their bond allocations and go higher risk. So just imagine what will happen to the pensions when their investments lose 50% of their value. And whilst most pension funds keep their bonds till maturation though when the market significantly corrects from their peak levels for a long period of time it will be the taxpayer that has to step in to make up the difference otherwise we will be looking at unrest on a national scale. Guess what the purchasing power of the payouts will be when the markets plunge and don’t really recover? It will be a fraction of today’s purchasing power. Hence why I have always argued the case that the only way to maintain the purchasing power of the pension plans is to keep at least 10-15% of the invested assets in the form of gold and silver investments including the appropriate mining companies.

And which country is already showing the strong change in demographics: Japan. And Japan is experiencing that aging demographics is an unmovable force against consumption. The percentage of the population 65 and over in the United States is in the midst of its steepest climb (see chart below). As older people spend less consumer demand slackens and puts downward pressure on prices and especially when they get less because of the huge underfunding. Anyway it should be clear to people that are able to connect the dots that with the higher percentage of retirees the increasing underfunding of the pension plans will be another huge headache with respect to future GDP growth and the needed allocation of taxpayers money which will be another factor that will put pressure on the US dollar.

Change is in the Air

Gijsbert Groenewegen

[email protected]

+1.646.247.1000