22 Feb IS THIS A VALID FEAR?
Data posted yesterday was contradictory, perhaps the result of the shutdown. Weekly jobless claims unexpectedly fell to a four week low. Factory orders however declined more than expected. And then there were existing home sales which also missed their mark, the result of higher prices and low inventories. Commenting on inventories, at current pace it would take 3.9 months to sell all homes on the market, up from 3.7 months in December. Anything below five months is considered “tight.”
Headlines indicated there was “uneven progress” in trade negotiations.
Equites traded lower.
I believe a major risk for the markets are interest rates. I will continue to argue economic growth will be stronger than expected which will in turn generate greater than expected inflationary pressures, pressures that may be amplified by the massive demand for money by both the government and corporations.
Commenting about growth, job creation and home values are the primary determinate of society’s economic health. Most people gauge their net worth by their home value not stock account.
The largest component of inflationary models is owner equivalent rent (OER) or what someone thinks they can rent their home if it was indeed rental. Historically OER tracks home values and apartment rentals. Rental rates have increased at near double digit rate for at least five years. Home values are now rising in secondary and secondary cities.
All know the relationship between employment and wage growth.
I rhetorically ask what happens to inflationary expectations if OER accelerates in the face of rising wages, wages that are already rising at the fastest pace in ten years?
And then there is the demand for monies. The federal deficit is over $22 trillion and the largest buyer of Treasuries—the Federal Reserve—is/was a net seller. [Note: The Fed bought almost 50% of all Treasury issuances for about a decade]. The Treasury must rollover existing debt and originate new debt in an environment when the largest buyer is no longer in the market. Who will pick up the slack?
On the corporate level, according to Dow Jones a record 48% of all current outstanding rated debt—about $3.3 trillion—comes due by 2023. Will demand for monies by the federal government crowd out demand for monies on the corporate level?
Currently there is $9 trillion of negative real yielding sovereign debt, up from about $6 trillion a year ago but down from about $13 trillion three years ago. Historically negative real yields correlate to inflationary growth.
Based upon current conditions, the 10-year Treasury should be yielding around 4.25-4.5% or 175 to 200 basis points higher than today’s prevailing rates.
Based upon Bloomberg’s mono variable interest rate sensitivity model, if the 10-year increases in yield by 175 bps, a generic current coupon 10 year AA corporate bond would decline in value by approximately 33% in a year.
I have experienced two major fixed income bear markets caused by greater than expected growth…1987 and 1994. They were really ugly. A major issue at hand is the complacency and the lack of experience of those who remain in the fixed income market. Many have only experienced a sub three percent yield on the 10-year, the prevailing yield of the last 10-11 years.
As discussed many times there is a lack of liquidity in the bond market, the result of regulatory fiat that emphasizes speed and cost of execution over liquidity and capitalization.
Can a bear market occur in the intermediate future, a bear market that was greater than the 1994 implosion?
I am a firm believer it is not what one does but rather why ones does it. A mono variable risk monitoring system that only emphasizes rating does not accurately capture risk. Historically less than 4% of bonds default.
If rates spike any investment grade rated bond that was originated in the last 10 years will get crushed the result of present valuing the future value of that cashflow.
I believe this risk is not discussed or remotely discounted, a view validated by the collapse of term premium which is now at the lowest level since Brexit in 2016.
Any increase in longer dated yields will negatively impact equites; a risk that I believe has not yet been remotely discussed.
Enough of these cheery sounding comments, equities were moderately lower on thin trading, the result of conflicting data and trade uncertainty.
Last night the foreign markets were up. London was up 0.61%, Paris up 0.42% and Frankfurt up 0.59%. China 1.891%, was Japan down 0.18% and Hang Sang up 0.65%.
The Dow should open nominally higher on trade optimism. Oil is also up about 1% to the highest level in over three months. The 10-year is up 1/32 to yield 2.69%.