Interest rates have moved up significantly. The yield on the 10-Year Treasury, as of February 15th, stood at 2.9% which is the highest level in four years. This represents a dramatic upward move from the 1.4% low reached on July 8, 2016.
Many investors are pointing towards increased inflation fears fueled by recently published statistics of average hourly earnings and consumer price indices.1 If the Federal Reserve adheres to its mantra of “data dependence,” then it should continue raising interest rates.
But the impact of any rate hikes by the Federal Reserve may be relatively benign compared to the forces of supply and demand. As we previously discussed in our last Insights commentary (Autumn 2017), the commitment to “unwind” its balance sheet may curtail Treasury demand while significantly adding to supply – a recipe for lower Treasury prices (and thus higher interest rates).
This action by the Federal Reserve is truly unprecedented. In a recent roundtable hosted by WindRock, the noted financial expert John Mauldin described Federal Reserve policy as having moved from “quantitative easing” to “quantitative experimenting.”
Worse, at the same time this buyer of Treasuries becomes a marginal seller, other influences on supply and demand are afoot. Namely:
1) Increased supply due to ballooning deficits. Budget Director Mick Mulvaney himself stated the recently agreed-upon budget deal should increase government spending by almost $300 billion with the potential for the deficit to increase to $1.2 trillion in 2019;2 and
2) Decreased demand from traditional foreign buyers. The financial markets were rightfully distressed when Bloomberg recently reported that: “senior government officials in Beijing . . . have recommended slowing or halting purchases of U.S. Treasuries.3 China is not the only other major foreign bondholder to potentially pull back from this market, for both Japan and Saudi Arabia have substantial fiscal issues which could be ameliorated by selling Treasury holdings.
For too many years, investors have assumed that either the stock and bond markets appreciate in tandem, or perhaps, at worst, they act as counterbalances; if one went down, the other would go up. Financial yin and yang. But a downturn in the face of rising interest rates may very well result in something like the financial carnage of the 1970s.
Yet, despite these risks, the Federal Reserve appears intent on continuing its “unwinding.” If so, while it may very well be data dependent, it is also judgement deficient.
1) “The Ghost of Inflation Reappears” Up & Down Wall Street. Forsyth, Randall. 19 February 2018. Barron’s.
2) “U.S. Budget Director Warns Interest Rates May ‘Spike’ on Deficit” John, Arit and Niquette, Mark. 11 February 2018. Bloomberg.
3) “China Weighs Slowing or Halting Purchases of U.S. Treasuries” 10 January 2018. Bloomberg.
