In 1970, the Grateful Dead gave us the song “Truckin” with the memorable line “lately it occurs to me what a long, strange trip it’s been”. It’s been a weird ten years since the “Great Recession” as central bank interventions and experiments in monetary policy have temporarily changed the way markets function.
So, it’s fitting that we experienced a strong first quarter of 2019 following the washout that was the fourth quarter of 2018. The market is up around 13% for the quarter and is up 5.5% over the past five quarters. Our accounts are “Truckin” along with the market both on the equity side and fixed income side.
All it took was a softer stance by the Federal Reserve where they backed off their pledge to continue raising interest rates. They also promised to stop reducing the size of their balance sheet by the end of this year. The equity markets rallied on the news but the bond markets are telling us a different story.
Yields on bonds in the major economies around the world have fallen. German bonds, or bunds, offer negative yields out to 10 years in maturity which is a sure sign that European investors are afraid of something.
Sovereign bonds in Europe and Japan offer negative interest rates as the European Central Bank and the Bank of Japan are desperate to ensure that another market meltdown like 2008 doesn’t happen again. As of this writing, a mind-numbing $10 trillion worth of bonds offer negative yields where the owner of the bond actually pays the borrower to own the bond. It’s insane and it’s indicative of a global financial system that never repaired itself after 2008.
To put this in perspective, the US has around $22 trillion in federal debt outstanding so $10 trillion is 45% of our national debt. And when you consider that US Treasury debt is considered to be the safest bonds in the world, which means that the United States should borrow at the lowest rates in the world, $10 trillion in negatively yielding bonds of European and Japan government obligations tells us that the world has gone crazy.
Something important is happening in the world right now and the bond market is telling us to be very careful. The Federal Reserve has been forced to reverse course on their policy of raising interest rates. At GeoVest, we’ve been expecting this change in policy; it’s why we’ve been expanding the maturity of our bond portfolio into longer dated US Treasuries and Agencies. We believe that interest rates are going much lower from current levels.
The chart below shows the yield on 10 year US Treasury bonds. As you can see, yields have fallen from 3.25% to 2.40% at present. This has made the bonds in our portfolios worth much more.
Another sign of distress is that US interest rates out to 10 years in maturity are trading below the Federal Funds Rate, which is an overnight rate. Normally, the shorter the maturity on debt the less risk is perceived. The current Federal Funds Rate is 2.50%. This means that yield curve is inverted which means that short term interest rates are higher than long term interest rates. Historically, this has been a sign of an upcoming recession in the United States.
Absent some great new technology that allows our workforce to expand productivity, the two short term primary levers of economic expansion are fiscal policy and monetary policy. A year ago, the Trump Tax Plan gave money back to tax payers, both individuals and corporations, such that the US economy received an economic boost in the first half of 2018. The plan also put a floor under the stock market by allowing corporations to spend more cash flow on stock buybacks, in lieu of tax payments.
Yet while fiscal policy gave the economy a short term boost, monetary policy was having the opposite effect. By raising interest rates since 2016, the Federal Reserve has been applying the brakes to the US economy. You can see from the chart below of the 3-month Treasury Bill that rates have risen from 0.25% to 2.40% at present.
While 2.40% still seems low by historical standards, it’s becoming increasingly clear that interest rates are too high for current circumstances. The chart below shows the Cass Freight Index, a measure of both price and volume for moving goods in the United States. It’s clear that something has changed for the negative after being strong for much of 2018.
It usually takes six to eighteen months for higher interest rates to adversely impact the economy but the Trump Tax Plan in 2018 obscured some of the impact until now. Things are weakening and the Federal Reserve will need to cut interest rates at some point.
Where the US economy is showing just a hint of weakness, the global economy is rapidly weakening. The chart below measures shipments of semiconductors – computer chips that are in everything we use these days. Anecdotally, the sharp drop in shipments is largely attributed to China by industry experts.
If you recall in my past newsletters, I suggested that China was rapidly weakening due to higher interest rates in the Eurodollar market – dollars held outside the US banking system. Eurodollars are what international banks lend to countries around the world to expand international trade. As I suggested, the sharp rise in LIBOR – the London Interbank Offered Rate – would continue to weaken China and the emerging market economies. LIBOR is the base rate for the Eurodollar market.
0.25% to 2.80% is an enormous move but it’s actually worse because the dollar has appreciated by 40% versus other world currencies over this time. When adjusting for the rise in the dollar, the effective rate on Eurodollar deposits actually rises from 0.25% to 3.9%! For countries like China that need to borrow dollars heavily to import items, this increase has proven to be an economic killer.
Interest rates matter a lot! This is why we expect interest rates to fall much lower over the next year. The global economy has weakened despite an extraordinary $10 trillion worth of bonds trading at negative interest rates. Will the Fed have to follow Europe and Japan into negative territory on interest rates? If the answer is yes, our clients should make a lot of money with the bonds we own for them.
With earnings starting to weaken in the US, the stock market is going to need lower interest rates to remain elevated. Without political pressure, I believe the Federal Reserve will wait for stocks to fall before lowering interest rates. But now that President Trump has put the Mueller investigation behind him, I expect the White House to exert heavy pressure on the Fed to cut rates immediately.
The President is highly attuned to the stock market and views it as feedback on his economic policies. I can imagine that there is great pressure being brought to bear on the financial apparatus within the US government to prevent any further meltdowns in the stock market. The past ten years has taught us to be mindful of the impact of political pressure on the market.
Intervention in the equity markets works best when there are speculators betting against a rise in the market. But when there are relatively few speculators betting against the markets, intervention programs lack the necessary leverage to succeed. It’s why the market melted down in February and October of 2018.
This is illustrated in the chart below of the Volatility Index, or VIX. When it gets to low levels, it means that few speculators are betting against the market. When it gets elevated above 20, it means that there are enough negative speculators such that buy programs driven by intervention can force negative speculators to reverse their positions to take equity markets higher.
I’ve watched this happen many times over the past ten years and it’s why I believe that we won’t get a meltdown in the equity markets until the conditions are right, despite the growing weakness of the international economy. At present, the conditions aren’t right.
This doesn’t mean that we’re returning to the old bull market. The global economy is simply too weak to support continued moves higher without much lower interest rates.
The GeoVest Approach
The last ten years really have been a “long strange trip”. Ten years ago, I couldn’t have imagined we’d see $10 trillion of negatively yielding bonds but now I can envision that number jumping much higher over the next two years to possibly include US Treasury bonds.
While it’s alarming to consider, such occurrences offer the potential to make a lot of money for clients in a short time if positioned correctly. It’s our goal to earn such returns. We’re off to a good start in 2019 and we need to just keep “Truckin” on!
Thank you for investing with GeoVest Advisors. It’s our continued pleasure to serve you.
Philip M. Byrne, CFA
Chief Investment Officer