Tuesday, November 22, 2016

Trumping The Bond Market?

The rise in Treasury yields slowed this week, highlighting skepticism in some quarters that Donald Trump’s presidency will usher in a period of rising inflation.

The yield on the 10-year Treasury note, which falls as prices increase, fell Wednesday, following a muted rise on Tuesday, while the 30-year bond yield fell both Tuesday and Wednesday.

Yields had surged since the U.S. presidential election on the view that Mr. Trump’s tenure will generate a period of rising inflation, as he pursues policies such as tax cuts, regulatory rollbacks and infrastructure spending to boost economic growth (click n image below). Market-based inflation indicators were rising before Mr. Trump’s victory last week, following sharp declines earlier in 2016.

But some investors say factors including the size of the U.S. debt load could limit the effectiveness of any fiscal-stimulus efforts. The more debt that is outstanding, the less bang for any given dollar of spending, some say.

These skeptics insist the bond selloff has gone too far.

“I was rolling my eyes so many times in the past few days that I thought I was going to go blind,” said David Rosenberg, chief economist and market strategist at Gluskin Sheff & Associates Inc. “The inflationistas have a lot to account for because history is not on their side.”

Other quarrels with the pro-inflation narrative focus on the numerous premature inflation calls of the past decade.

Some economists and businessmen wrote an open letter in 2010 warning then-Federal Reserve Chairman Ben Bernanke that monetary stimulus would have inflationary consequences, a view that now seems thoroughly discredited. Inflation has failed to hit the Federal Reserve’s 2% annual target for more than four years.

The U.S. producer-price index for final demand, a measure of business prices, held flat in October compared with the prior month, data showed Wednesday. Prices were up 0.8% from a year earlier.

Lacy Hunt, executive vice president at Hoisington Investment Management Co. in Austin, Texas, has long invested his fund in Treasurys with faraway maturities, reasoning that the economy is too weak to generate inflation that would erode the gains on those securities.

Since the election, he has been bombarded with calls from clients wondering whether the bond selloff is the death knell for the bond rally that began in 1981.

On Wednesday, the 30-year yield fell to 2.925%, while the 10-year yield fell to 2.222% (last week's data).

A bond-market gauge that compares nominal Treasury yields with inflation-protected counterparts forecasts that inflation will climb at 1.88% annually over the next 10 years, up from 1.4% in July, according to Tradeweb.

Mr. Hunt’s answer: No way. “There is always this rush to judgment when there’s a major policy change,” he said. He is investing new client money in long-term Treasurys, those maturing in 10 years or more.

One reason he thinks inflation is set to stay low is the nation’s $19.8 trillion debt load. The increase in debt stands to make each dollar go less far in spurring growth, he said. From 1952 to 1999, it took about $1.70 in nonfinancial debt for gross domestic product to expand by $1. In the year through June, it took $4.90 to do the same.

The national debt could increase $5.3 trillion over a decade should Mr. Trump cut taxes and boost spending as he has said during the campaign, according to the nonpartisan Committee for a Responsible Federal Budget.

Even after stimulus projects are completed, their impact on inflation isn’t necessarily positive. Improving roads and rails to make transportation more efficient can actually cut per-unit costs, Mr. Rosenberg said. He cited the New Deal package in the 1930s and the highway-construction spending of the 1950s as big stimulus measures that didn’t in their own right boost prices.

Still, many investors think inflation is headed higher as part of a broader economic reckoning. Prices had been rising in the months before the election, and a policy pivot could boost that, some say.

Market factors like higher interest rates and a stronger dollar also may have a damping effect on inflation because they can restrain the economy.

“There is a good chance that we are at one of those major reversals that last a decade,” Ray Dalio, chairman and chief investment officer at Bridgewater Associates, said in a LinkedIn post Tuesday. He suggested inflation was set to climb.

Even those who don’t see inflation in the cards suggest that some elements of Mr. Trump’s policy proposals may work toward that purpose, such as his vow to cut the corporate tax rate to 15% from 35%.

Yet the experience of tax cuts during President Ronald Reagan’s administration suggests this took a long time to filter through to the economy, Mr. Hunt said.

The most important macro theme I routinely cover on this blog is global deflation. You can view my past comments on deflation here. An equally important and closely related macro theme I love to cover is the so-called bond bubble. You can view my past comments on that topic here.

What do I keep warning all of you of? You need to get the macro right in order to get the micro right. If you don't understand the cyclical and structural forces driving the US and global economy, you will fall prey to the noise and get caught up in the price action and risk losing serious money.

More importantly, bond yields are rocketing higher and when it comes to pension deficits, it's the direction of interest rates that ultimately counts a lot more than any gains in asset values because as I keep reminding everyone, the duration of pension liabilities is a lot bigger than the duration of pension assets, so for any given move in rates, liabilities will rise or decline much faster than assets.

Will the rise in rates and gains in stocks continue indefinitely? A lot of underfunded (and some fully funded) global pensions sure hope so but I have my doubts and think we need to prepare for a long, tough slug ahead.

Trump also needs to carefully consider bolstering Social Security for all Americans and modeling it after the (now enhanced) Canada Pension Plan where money is managed by the Canada Pension Plan Investment Board. One thing he should not do is follow lousy advice from Wall Street gurus and academics peddling a revolutionary retirement plan which only benefits Wall Street, not Main Street.

You should read my comment on the global pension storm to understand why I continue to worry about global deflation, the rising US dollar and why bond yields are likely to revisit new secular lows, placing even more pressure on global pensions in the years ahead.

This is why I respectfully disagree with Bob Prince and Ray Dalio at Bridgewater who called an end to the 30-year bond bull market after Trump's victory. I have serious concerns on Trump and emerging markets and I wouldn't be so quick to rush out of bonds (in fact, I see the big backup in bond yields as an opportunity to buy more long dated bonds (TLT) and will cover this in a separate comment).

Let me flat out state that I believe the recent backup in bond yields is another huge bond buying opportunity and smart global asset allocators and pensions are buying long dated US nominal government bonds at these levels (click on image):

The chart above shows price action of the iShares 20+ Year Treasury Bond ETF (TLT) and it's important to remember that bond yields and prices are inversely related (so when yields go up, bond prices fall). What this chart shows is that every time this ETF fell below its 50-week moving average and stayed above the 200-week moving average, it was time to load up on bonds.

I use weekly charts to determine long-term trends and to see if price action is breaking down and so far, despite all the noise of the "30-year bond bull market being dead," I'm not convinced and think smart investors are loading up on bonds here.

That is my technical argument. On a fundamental level, and I've written plenty of comments on this, I just don't see fading risks of global deflation and I'm worried if the greenback keeps surging higher, which I correctly predicted back in early August, then we will see deflationary headwinds in the US as earnings get hit, unemployment rises and we'll see lower inflation expectations because a rising US dollar lowers import prices.

Of course, deflation is most prevalent in Europe and Japan which is why the ECB and Bank of Japan are still buying government bonds, desperately trying to reflate inflation expectations which are moribund in these regions.

The divergence in US monetary and global monetary policy is driving the US dollar higher, as is the expectation of a massive US fiscal expansionary program. How long can this go on before it wreaks havoc on emerging markets and reinforces global deflation?

We will find out soon enough but my friend François Trahan of Cornerstone Macro did another great short video presentation this morning and he allowed me to share this chart with you which shows global PMIs relative to the 10-year US Treasury bond yield (click on image):

What the chart shows is global PMIs have peaked and that typically means lower global growth ahead, which is bullish for bonds, especially US bonds.

And if a crisis in emerging markets erupts under a President Trump or even before he takes office, global investors will be running into US bonds (flight to safety and liquidity).

[Note: François Trahan will be in Montreal on January 26 of the new year to present his outlook at a CFA Montreal luncheon. My former boss and colleague, Clément Gignac and Stéfane Marion will also be presenting their outlook as will professor Ari Van Assche of HEC Montréal. Details of this event can be found here.]

That is the global backdrop. As Lacy Hunt and Van Hoisington argue in their latest economic quarterly comment, 2015's surging debt levels will also weigh on domestic growth and constrain growth no matter what President Trump and Congress pass as a stimulus package (there are already grumblings from Republican lawmakers over deficits and Trump's agenda).

Remember my six structural factors as to why I am worried about global deflation ahead:

High structural unemployment in the developed world (too many people are chronically unemployed and we risk seeing a lost generation if trend continues)

These six structural factors are why I'm convinced why global deflation is gaining steam and why we have yet to see the secular lows in global and US bond yields.

The reflationistas and bond bubble clowns will argue otherwise but I'm sticking with my macro call on global deflation which is why I'm recommending you load up on US long dated bonds after the latest backup in yields.

[...] at one point a rising US dollar impedes growth and is deflationary and if you ask me, the rise of protectionism will cost America jobs and rising unemployment is deflationary, so even if Trump spends like crazy on infrastructure, the net effect on growth and deflation is far from clear.

All this to say I respectfully disagree with Ray Dalio, Bob Prince and the folks at Bridgewater which is why I recommended investors sell the Trump rally, buy bonds on the recent backup in yields and proceed cautiously on emerging markets as the US dollar strengthens and could wreak a deflationary tsunami in Asia which will find its way back on this side of the Atlantic.

Unlike Ray Dalio and others, I just don't see the end of the bond bull market and I'm convinced we have not seen the secular low in long bond yields as global deflation risks are not fading, they are gathering steam and if Trump's administration isn't careful, deflation will hit America too.

This is why I continue to be long the greenback and would take profits or even short emerging market (EEM), Chinese (FXI), Metal & Mining (XME) and Energy (XLE) shares on any strength. And despite huge volatility, I remain long biotech shares (IBB and equally weighted XBI) and keep finding gems in this sector by examining closely the holdings of top biotech funds.

And in a deflationary, ZIRP & NIRP world, I still maintain nominal bonds (TLT), not gold, will remain the ultimate diversifier and Financials (XLF) will struggle for a long time if a debt deflation cycle hits the world (ultra low or negative rates for years aren't good for financials).

As far as Ultilities (XLU), REITs (IYR), Consumer Staples (XLP), and other dividend plays (DVY), they have gotten hit lately partly because of a backup in yields but also because they ran up too much as everyone chased yield (might be a good buy now but be careful, high dividend doesn't mean less risk!). Interestingly, however, high yield credit (HYG) continues to perform well which bodes well for risk assets.

Below, Oksana Aronov, JPMorgan Asset Management alternative fixed income strategist, and Barbara Reinhard, Voya Investment Management head of asset allocation, discuss current moves in the markets and what investors should be considering.

And while stock investors have calmed down, bond investors have gotten jittery. So who’s right about what’s ahead for the economy? Matt Maley of Miller Tabak and Gina Sanchez of Chantico Global discuss with Brian Sullivan (Note: This interview took place last week).

Lastly, Carmignac Managing Director, Didier Saint-Georges, gives his thoughts on the outlook for the bond market, following the US decision to elect Donald Trump. Listen very carefully to his discussion on what's driving inflation and deflationary headwinds have not disappeared.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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