The US 10 Year over the past several days has pierced the 3.11% level for the first time since May of 2011, seven years ago to the day when the 10 year closed at a yield of 3.12% on its way downward to all-time lows in the 1.50% range in the summer of 2012 and again in 2016.
This chart pattern is indicative of a clear shift in trend, one where it is unlikely that the ultra-low depths charted 2 and 6 years ago will be re-visited. What is the driving force behind this trend reversal and why is the 10 Year rate accelerating higher so quickly? Not surprisingly, the force for change has a very clear impetus, the Trump economic policy passed in December 2017 which squarely puts in place a plan which as executed will unravel the past 25 years of trade and fiscal policy – if the new policy stays in place long enough.
The 10 Year Treasury breaking out above 3% in yield is actually not a historical anomaly. In fact, 83.74% of the time the 10 Year has posted month end close levels above 3% since April 1953. The average yield from 1953 to the present has been much higher, 5.85%. These facts become abundantly clear when you view the historical Treasury yield curve dating back to WWII.
The question on many investors’ minds is whether the rate trend higher will continue, and indirectly, will a trend higher be detrimental to stocks? I believe the answers to these questions are yes and yes.
First, the reason rates have been so low the past 8 years is attributable to the doubling down on US fiscal and trade policies by the Obama administration which were implemented initially in the early 1990s under President Clinton, and extensive capital controls put into action not only by the US Fed, but also by Central Banks throughout the world. All of this was done under the auspices of a financial landscape that was being described as the “worst recession since the financial depression”.
As a result of the political backdrop, the Fed policymakers, Ben Bernanke in particular who was succeeded by Janet Yellen, had complete freedom to push US interest rates to the ground floor – zero. The historical data scream that using the Great Depression as a reference model was completely off the mark. We were not engaged in a World War at the time which required the US fiscal budget to be expanded by a factor of 10 in 4 years’ time like FDR did from 1941 to 1945 in order to win WWII. During the 1940s, major “repressive” interest rate controls were implemented by the Federal Reserve, and short-term rates were left on the zero bound for many years, to provide an in-direct means of financing the War and thereby not bankrupt the US government.
What the US faced in 2008 was not a World War scenario that required a major fiscal stimulus package followed by repressive interest rates pushed to the zero bound. In 2008 the US was facing the consequences of the unsustainable trade and fiscal policies initiated post the fall of the Berlin Wall in 1989, but really accelerated beginning in 1993 and 1994. With the passage of NAFTA, China’s devaluation of the Yuan by 30% and then perpetually pegging it around this level, the US trade balance with the rest of the world began to balloon. From 1992 until the present day the cumulative trade deficit grew from around $1T to over $11 Trillion. And 90% of the deficit is with 10 countries in particular - China, Vietnam, Mexico, Japan, Germany, South Korea, Taiwan, Malaysia, Thailand and India.
And the big reason the financial system buckled in 2008 was that the policies unleashed in the early 1990s were great (for the short term) for the capital markets, but a dismal failure for Main Street businesses in America. And the real growth GDP figures make this point clear throughout this time frame (including 2008 to 2018) as GDP growth steadily decline even as stocks sky-rocketed leading up to the year 2000, and then again as 2008 approached. Now the stock market sits on a high perch in 2018, and investors look with a wary eye because many investors are fully aware that the market is juiced with liquidity from sources (foreign central banks) that have little to do with on-going earnings potential and may quickly disappear.
The break-away from the repressive rate policies in the 1950s which saw the 10 year Treasury push well above 3% and stay there for the next 50 years, and the accompanying stock market rally, was accompanied by strong real GDP growth and low unemployment, fueled in part by on-going trade surpluses. Although President Trump would like to believe that a similar scenario beginning in 2018 is in the offing. The economy is a long way from such a break-out, but government policies are at least now addressing the issue. However, I doubt the financial market is going to be able to stomach the change without a serious valuation re-set, and here is why.
International Trade is Not Presently “Free”
In a normal, “free trade” world, if a country runs perpetual current account deficits, it must fund the deficits through its capital account (borrowing). This is precisely what the US Treasury has had to do over the last 25 years as this graph shows:
But in a true “free trade” world, a country cannot expect its cost of borrowing to steadily decline as it runs its own economy into the ground by choosing to consume rather than invest. Eventually the creditors wise up and start to charge higher rates and / or the value of the country’s currency gets pummeled until the rates do rise.
But strangely, these rules of “free trade” do not seem to apply to the U.S. over the past 25 years. In fact, the inverse has happened instead, to the severe detriment of capital formation in the form of domestic production oriented businesses, and thereby good paying jobs within the US. And the reason for this paradox is simple. The US preaches free trade, but a segment of the rest of the world uses a different trading model – principally the 10 countries I noted above which account of over 90% of the US current account deficit - China, Vietnam, Mexico, Japan, Germany, South Korea, Taiwan, Malaysia, Thailand and India.
These countries, which I refer to as the “notorious trade cheating 10”, developed a more comprehensive trading process which entails feeding their fiat currency into US Capital markets through Wall Street that they “freely” print in their own country, converting it into US dollars (strengthening the dollar) and then using the export of traded goods from their country to recover the “invested” dollars through time. The US initially sponsored this activity by opening up the Treasury to major inflows of foreign capital in the 1990s.
Most of the export activity is done through the auspices of multinational corporations which have established market positions in the US but have been lured overseas to do their production on the promise of cheaper production costs, but also for tax reasons. The process is known as “dirty float”.
If only the interest rates in the US or the USD exchange rate, or both would adjust to reflect the trade imbalance between the rest of the world and the US, this process would be incapable of working on a perpetual basis because the financial system would quickly stress and break. However, sovereign countries have a way of perpetuating incongruous financial practices that “free markets” would quickly eradicate. And in this case, the ability of a sovereign country to institute capital controls within their own borders and print their own currency, and then simultaneously trade capital through Wall Street, allows this arbitrage to perpetuate – at least until there is a major impetus for change.
Tax Reform will Promote Trade Reform by Changing Dirty Float Incentives
And the impetus for change in to the present “Non-Free Trade” model being utilized by the “notorious trade cheating 10” countries may have finally arrived after 25 year in the widely ridiculed President Trump. Trump has made several “unconventional” moves which are currently stirring up the international trade market, and may put a dent in the dirty float practices, which is ultimately the only way to eventually remedy the problem.
First, the corporate tax rate on foreign earnings was taken to zero. Previously the rate was the same as the US corporate tax rate and could be off-set by foreign taxes paid. Although taking this rate to zero does not encourage any multinational company to actually move or return and production to the US (in fact, it appears to do the opposite), it does take away the need for corporations to set aside money to pay the future tax bill in US dollars. This money was accumulating on many corporate balance sheets over time and re-cycled into the Treasury and other Fixed Income markets rather than being repatriated in order to dodge paying the US tax. This indirectly meant there was a constant bid for US Treasuries from overseas, implicitly causing Treasury interest rates to move lower even as the trade deficit widened. Going forward, this bid is likely to be much lower as foreign earnings are diversified into other currencies like the Euro and even Yuan, and as a result US interest rates will be higher and/or the dollar lower as trade deficits continue.
The second thing that Trump has done with the Tax Bill that passed in December 2017 is that he has pushed both the fiscal spending level and annual rate of public financing need in the US much higher simultaneously, and the projections show that these increases are not going to subside over the next 10 years. If the US enters a time period in which its debt financing needs begin to break out to levels which cause foreign investment in the US to be a higher risk, due to potential losses from exchange rate exposure, interest rate increase or both, then the capital flows that have been so instrumental in funding the perpetual US trade deficits since 1992 will reverse. This happened briefly post year 2000 and also in the 2006 time periods. History shows that the result was an eventual break down in the stock market.
Based on the historical data contained in the chart below, in periods of normal economic growth, Treasury financing growth rates (net of Fed QE and Foreign Investment) above 5% a year tend to cause sustained upward movements in the 10 year Treasury, or at least sustained rates above the historical average of 5.85%. With the Trump economic plan, the projections over the next 5 – 10 years are that the Treasury financing growth rate is going to approach 10%, much like the 1970s and 1980s. And, the Treasury will not have the FED in tow to absorb a large portion of the on-going financing need like it did post the 2008 financial crisis. Instead the Fed will be adding to the public financing need as it executes a plan to reduce the size of its balance sheet thru the year 2021 making the Treasury supply issue even worse.
Based on this trend analysis, I fully expect that the Trump economic plan will expose the “dirty float” practice around the world to risk of very large capital losses as the US Treasury financing rate of growth moves much higher throughout 2018 and remains high for the indefinite future.
Be Careful What You Wish For in International Trade…
Solving a 25 year trade imbalance problem which has been perpetuated by capital formation incentives and promoted by historically tight fiscal policy in the US is very unlikely to happen without worldwide financial market pain. In fact, the data actually show a high risk that the US equity markets will suffer a serious set-back in the near future as capital flows from abroad begin to subside and are just unable to consume the large increases like the last 25 years. One need only look at the high correlation of the BOJ asset buying program relative to the increase in the S&P 500 over the past 8 years and what happened post 2005, to draw this conclusion. What goes up together will probably come down together.
Currently the holders of long duration Treasury debt are definitely "feeling the pain" (to quote President Clinton) and I see the pain creeping into lower rated long duration debt. But the pain in the credit market, other than Treasuries, is still muted. Because both the ECB and BOJ are continuing to push liquidity into the market in areas other than US Treasuries, the US Treasury rate market rather than other risk assets appears to be taking the brunt of the market adjustment force at the moment. I believe this is just the prelude to the bubble popping moment that has been set in motion by the Trump economic plan .
The current faster increase in US Treasury rates relative to other risk assets is a clear signal to me that the big players in the world financial market, primarily sovereign governments and wealth funds heavily exposed to dollar based assets, are making significant portfolio moves in anticipation of future market pressure. The US Treasury since early April has gotten a temporary reprieve from its need to push new public borrowing needs on the market; however, it is still re-financing the maturing Treasury debt on the Fed balance sheet, which happens at known pre-scheduled times with the bulk of the maturities on the 15th and the end of each month going forward. The 15th of May was a noted down day in the stock market, and Treasury rates have continued to move higher. You can see a similar pattern dating back to January 31st.
As the borrowing need pressure builds even higher on the US Treasury through the rest of the year, I see a market showdown in the making and it appears the International Bankers have the opportunity to make the stock market scream just in time for mid-term US elections.
The paradox of riskier assets valued in US dollars holding or even increasing in value while lower risk Treasury assets are losing value at a faster pace is unsustainable. The longer the market dichotomy continues, the greater the risk of a Kamikaze crash landing of the BOJ, PBoC and ECB debt driven asset buying machines right into the middle of the US stock market (read article), with the most visible targets being long FANG holders. (FB) (AAPL) (AMZN) (NFLX) (GOOGL)
In the aftermath of what appears to be an almost certain outcome in the near future in which the International Banks withdrawal (or just slow down) from asset buying programs precipitates a crash in the US equity market, the only question will be will the International Bankers get their way in negotiating a continuation of the past 25 year US trade policy, or will the world financial system truly embark on a different path forward? And, what are the odds that the US political blame game creates a less than desirable outcome for Main Street America? I think the less than desirable outcome for Main Street is what the International Bankers are counting on, and also what the stock market is pricing in currently. What I believe the market still has not come to terms with is the unsustainable of the current asset buying policies of International Banks and the fact that the international trade process is broken and must change.
Daniel Moore is the author of the book Theory of Financial Relativity: Unlocking Market Mysteriesthat will Make You a Better Investor . All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.