The recent spike in interest rates over the last few months is a hot topic among financial news and media outlets. And it should be – it’s alarming.
The rate on the 30-Year U.S. Treasury Bond shot up from 2.10% in early July to over 3% where it now sits. Many, including myself, are now calling for the end of the 35+ year bond bull market.
I believe when we look back in 20 years, the 177’11 July high in bonds will mark the beginning of a new long-term bear market in bonds.
Although in the short term, I think bonds are very oversold and subject to a powerful bear market rally, most likely lasting the rest of 2016 and much of 2017. Once complete, the bear market will resume and bring with it much higher interest rates.
If my assessment is correct, the questions that should be answered are: which asset classes will do well? How should you position your portfolio? How high could rates go? Which assets will perform poorly?
I will attempt to briefly answer these questions just ahead. But I want to be clear, I believe this bear market will be quite different than the last bear market in US Treasuries and has the potential to bring with it much higher levels of inflation than we saw back in the late ‘70s and early ‘80s.
The reason being is the US has never had such large national debt which now sits at a record $19.8 trillion and growing. Nor have interest rates ever been this low for this long, which is the only reason the US has been able to “comfortably” afford the interest payments on the debt.
As of September 2016, the cumulative interest paid on the $19.8 trillion national debt over the prior twelve month period was $432 billion. The average interest rate was 2.30%.
The Federal Government estimates revenue from tax receipts for 2016 to be roughly $3.34 trillion. An annual interest expense of $432 billion equals about 12% of the total revenue, which seems manageable provided rates remain low right? The problem is, they didn’t and have started to climb.
The current yield now sits at just over 3%. Of course, rates will fluctuate over the next twelve months. They could go a little higher, they could go a little lower, but probably won’t stay at exactly 3%.
But for the sake of this example, and to keep the math simple, let’s assume the average rate over the next twelve months was 3%. That would mean the amount the US Government would pay in interest alone would be $594 billion – a 37% increase over the prior twelve month period.
And to think, it only took 129 days for interest rates to jump nearly 50% – that’s shockingly fast. Not to mention, historically a 3% yield is still incredibly low.
If revenue (tax receipts) remained roughly the same ($3.34 trillion), the “interest only” payment at 3% would now eat up 17.78% of total revenue.
At a 4% interest rate, the amount paid in “interest only” would be $792 billion or 23.71%. A 5% rate equals a $990 billion or 29.64%. And a rate of 6% would mean the Federal Government would be required to make a nearly $1.2 trillion “interest only” payment or 35.56% of total tax receipts – assuming tax receipts were still around $3.34 trillion.
However, a 4% rate of interest (not that far off) could easily drop the S&P 500 from 2,200 to 1,475 and bring with it a recession which significantly lowers total tax receipts.
During The Great Recession of 2008 – 2009, Federal Government revenue plummeted by -44%. If we assume a milder recession, where tax receipts only drop by -25%, it would mean total revenues would fall from $3.34 trillion to $2.5 trillion.
Under this scenario, the $792 billion annual “interest only” payment, with rates at 4%, would eat up 31.61% of total revenue. If rates were at 6%, it would take nearly half of all Government revenues to make the $1.2 trillion “interest only” payment.
And don’t think 6% rates are out of the question. Jeffrey Gundlach, CEO of DoubleLine Capital and one of the world’s most successful bond investors, believes the 10-Year yield will hit 6% within five years. Scary right?
Keep in mind, all of my assumptions have the total national debt staying at $19.8 trillion. Yet, since 2009 it has nearly doubled from $10 trillion. What do you think the odds are it stays the same? I say 0%.
What other choice does the Government have to pay the interest, the mandatory spending on Social Security and Medicare, other discretionary spending, other than to increase the national debt even further. Not to mention we have just elected a very “inflationary” President – at least that’s how the market sees Donald Trump.
As the issuer of the world reserve currency, the US will not “default” (only de facto) on its outstanding debt. That would be an immediate “go to jail” card and lose the status as the provider of the world reserve currency. We would rather die a thousand deaths by attempting to inflate the debt away, but bondholders won’t just stand idly by and watch.
At some point contagion and panic set in as bond holders sell in a frenzy over worries of outright currency debasement or what’s now being discussed as “helicopter” money?
This would create a self feeding “loop” where persistent selling pressure in bonds pushed rates even higher, costing even more in annual interest, corporate profits would suffer and unemployment would jump, as tax receipts, needed to pay for all of this, continued to decline.
It’s not all that different from what happened in 2008 with Lehman Brothers. In 2006, the bank was already insolvent, but the public confidence remained, so the bank stayed open for business. It wasn’t until confidence was lost in 2008 that public opinion shifted and the game was over for Lehman.
By any reasonable accounting method, the US Government is already insolvent, especially when you consider the “off balance sheet” items of Social Security and Medicare which are not calculated in the $19.8 trillion national debt.
Right now the only thing propping up the bond market is “confidence,” which has been the culprit for record low interest rates and made the “interest only” payment on the national debt manageable, although it continues to be rolled forward through new debt issuance.
But I believe that “confidence” has now cracked as rates have jumped nearly 50% over the last five months. And contrary to popular belief, the Fed doesn’t control long term rates the way they do short term rates. Yes, their influence may be felt, but the Fed only holds about 20% of the outstanding debt. Foreigners hold the most at 44%, with other US investors holding 22%, and mutual and pension funds holding 14%.
So the “market” outside of the Fed currently holds 80% of all outstanding US debt. If some of these investors decided to sell, or the Government needed to auction large amounts of new debt, once market psychology has shifted for good, the only willing buyers might require much higher rates of interest.
Here’s the Financial Times:
The day after the election of Donald Trump as the next US president, the 10-year term premium made its biggest single-day jump since 2011. The move was within the biggest 1 per cent of all daily term-premium changes based data that date back to 1961. The term premium is an estimate of how much extra return investors demand — or borrowers are willing to pay — for long-term debt, as opposed to short-term securities over the same period. Essentially, it is an attempt to model the risk of unexpected changes in real interest rates or inflation.
The global bond rout intensified Monday, with a gauge of Treasuries volatility surging to the highest since February, on expectations that President-elect Donald Trump will increase government spending to boost economic growth and stoke inflation.
For those still skeptical, that don’t believe the market is in control of long term rates, how does one explain the recent 50% spike in the 30-Year Treasury yield where the Fed has yet to hike short term rates thus far in 2016, even if there is a 100% expectation of a 25 basis point hike in December?
As deficits continue to explode higher and the “interest only” expense becomes ever more burdensome, rates will continue to climb and the only “perceived” solution will be outright currency debasement.
Some mistakenly believe we can grow our way out of the current debt overhang. Even the Congressional Budget Office optimistically shows GDP growing from $18.5 trillion in 2016 to $27.7 trillion in 2026. That’s an annual growth rate of just over 3% and is laughable.
According to data released by the Bureau of Economic Analysis, the United States has now gone a record 10 straight years without 3 percent growth in real Gross Domestic Product. In the 85 years for which BEA has calculated the annual change in real GDP, there is only one ten-year stretch—2006 through 2015—when the annual growth in real GDP never hit 3 percent. Over the last ten years, real annual growth in GDP peaked in 2006 at 2.7 percent and hasn’t been that high since. The US economy would be lucky to grow GDP at an average rate of even 2% over the next decade.
Black Swan events are just that – an event or occurrence that deviates beyond what is normally expected of a situation and is extremely difficult to predict.
Less than a year ago, the prevailing market opinion was fixated on deflation; believing rates could only continue to decline. The “deflation” trade was overcrowded, providing the ultimate contrarian play based on rising rates and inflation.
Now the immediate fixation on rising inflation is overdone and needs a breather. Thus, in the near term, we will most likely see rates subside and bonds rally over the remainder of 2016 and probably most of 2017, but probabilities would suggest it will only be a bear market rally before rising interest rates and the “inflation” trade really gains momentum.
Rising interest rates are the new Kingpin. Stocks may initially climb higher, but at some point in the not too distant future will get clobbered. Bonds may actually be one of the best performing assets in 2017 after which they’ll puke and if you’re still holding them you might too. Cash will come in real handy over the next several years – since the Weimar style inflation is still several years off and cash acts as the ultimate call option with no expiration date until Weimar.
As Dennis Gartman once said, you want to start accumulating “things that hurt when you drop them on your foot.”