Ten Year Treasury Note @ 2.5%

Ten Year Treasury Note @ 2.5%
May 17, 2014

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The 10-year benchmark US Treasury yield is now 2.5%. That’s right – one can loan money to the United States in a riskless transaction, earn 2.5% interest, and be paid back in 10 years. The movement in bonds has been driven by a combination of geopolitical fears from abroad and expectations of low inflation and slow growth in the US. That combination brought the yield down to levels unexpected by market agents.

My colleague, John Mousseau, will discuss this transition in the tax-free Muni market in a forthcoming commentary.  Let me focus on a broader macro view.

For the last few years we have been hearing, “The Fed is printing all this money. We will have high inflation. Interest rates will go shooting UP, and the markets and the economy will go in the tank.”

Guess what. The inflation rate in the US is somewhere between 1% and 2%. And with this low inflation, the 2.5% yield represents the interest rate on the benchmark US dollar government bond. It is reflecting a market-based price of the combined real yield and the inflation premium.

Look to countries abroad. In Europe and the Eurozone the inflation rate is somewhere between 0.0% and 1%. The interest rate on the benchmark euro-denominated German government bond is about 1.3%. Big inflation does not seem to be looming there. It does not look as if interest rates will go shooting up or as if a catastrophe in the bond market is happening, either. The real interest rate in the Eurozone, combined with the inflation premium, result in this yield. We conclude that the inflation premium in the US is about 1 percentage point higher than it is in the Eurozone. Intuitively, that makes sense, so intuition and data seem to agree. BTW, both are very low.

Consider other credits worldwide – in Japan, the UK, smaller mature European economies like Sweden, and weaker ones like Spain. What do we see? Interest rates on benchmark 10-year government debt and inflation rates are very low.  Low, low, low interest rates are a worldwide event.  Not just here in the US.

We get pushback from readers every time we write about this. They say, “What do you mean there is no inflation. Can’t you see that the price of gasoline is up to about $4 or more? Don’t you go to the store and buy food? What do you mean there is low inflation?”

Other readers accuse the government of a conspiracy to keep official inflation numbers artificially low. We completely disagree with the latter allegation. The methodology is very transparent. Any economist can walk through it easily. The folks who do this work in the government are skilled and they are individuals who do their work with integrity. We do not like many aspects of our government, but we do have confidence in the independent data-collecting agencies. We know many of them, work with them in professional bodies, and have decades of experience with their integrity.

Let’s address the former criticism noted above. Of course the price of gasoline is apparent to this writer since he buys gasoline every week. Of course the price of food is apparent since he eats food every week. Does that mean that interest rates and central bank policies around the world are driven by the price of food and gasoline? No.

The US central bank, also known as the Federal Reserve, has no power to grow food. It is unable to drill for oil, process natural gas, build a pipeline, or transport oil from one place to another. It does not know how to process corn or bake bread. There are no free-range chickens running around on the front lawn of the Eccles Building in Washington.

Central banks around the world know that the global rate of growth is low. The pressures for changes in the price level are low. Central banks also know that there is an employment gap worldwide. On one side of that gap are cohorts of people who want to work but who haven’t found as much work as they want. There are many who wish to earn more income so they can spend it. On the other side of the gap are the employment possibilities to which they might be matched, in order that they might obtain that income. To the extent those matches do not occur, we have a lack of full participation in the global labor force.

When there is a large global overhang of labor that is not earning enough income to cover rising expenses and to make possible a rising quality of life, that labor force does not create an upward inflation pressure. And today we do not see upward inflation pressure coming from labor. It may come in the future, but it is not there now. At the same time, that labor pool has to eat and needs fuel. Rising food and fuel prices, in the absence of increasing labor income, result in economic slowing. One household at a time has to realign its budget in order to continue to cover the costs of its necessities.

In the US, every one-cent rise in the price of gasoline equates to about a $1.4 billion reduction in annual discretionary spending. This is our estimate. Other estimates range from $1.2 to $1.6 billion. People pay at the pump for the gasoline to commute to work whether the price of gas is up or down. Simple math!  Drop the price of gasoline in the United States from $4 to $3 a gallon, and the American consumer’s discretionary spending in the US will accelerate by $140 billion over the course of one year. Raise the price of gasoline to $5, and consumer’s discretionary spending in the US will fall by a similar amount. Food is more complex because of consumer substitutions of one food for another, but the concept is the same.

Currently, geopolitical risks in Nigeria, Europe (Ukraine), the Middle East, South America (Venezuela), the South China Sea, and other places around the world combine to maintain the oil price above $100 per barrel (and trending higher). And US politics are such that we cannot even approve a pipeline, a state of affairs which will inhibit the growth of the domestic energy sector. Additional failures in politics, along with weather-induced changes, are resulting in some pressures on food prices. Meanwhile, labor income for many people remains stagnant or is falling, even as necessities such as food and energy are becoming more expensive. In households subject to that predicament, real income (after adjustments for necessities like food and energy) is falling.

The takeaways from the bond market rally and low interest rates are that we’re experiencing slow growth and real incomes under pressure. Players in financial markets who do not understand this are on the wrong side of the trade. They bet that the bond markets would fall apart because of central banks. They either went on the short side of the bond trade or sat in cash. Now they do not know what to do. They cannot deploy the cash at the interest rates that were available a few months ago. They are bewildered.

Welcome to the middle of May, when financial markets are bewildering. Cumberland has had a terrific run in the bond markets. We thank Investment News for the recognition.  We have been on the longer side of duration. We have captured yields when they were available. We continue to capture the relatively attractive yields in places, sectors, and types of bonds that are spread to the Treasury market. We are not buying Treasury notes and bonds.

If we will not buy the 10-year US Treasury at 2.5% with our own money, we certainly will not buy it with a client’s money. We are approaching the time when portfolios need to be adjusted – step by step, nuance by nuance, bond by bond –for some shortening of what has been very long duration for a very long period of time.

One final note is offered for our clients and their consultants and co-professionals. Do not underestimate the power of the falling federal deficit. We peaked at a $1.4 trillion annual deficit run rate. We are heading to a $400 billion run rate, and the run rate continues to fall. Thus the federal government has a diminishing requirement to finance itself through borrowing. The Fed is tapering while the government deficit is shrinking. So even after the tapering, the Federal Reserve is still financing nearly all the deficit. Both of these trends should continue for the rest of this year. We do not expect any pressures on bond markets from the fiscal side of the United States government.

We send this from Sarasota on Saturday morning since we leave for New York tomorrow.  Dinner with some finance, economist and fishing buddy friends Sunday night is followed by the GIC conference on Monday morning at the New York Athletic Club (www.interdependence.org to register).  Registration is still open since a few spaces remain available.

As for fishing, the June and August trips to Leen’s Lodge are both filled and have waiting lists.  We usually open the Labor Day group since many folks ask “How do I get to visit this place?  Well, it’s easy.  Call Charles Driza, 207-796-2929 and come up on Labor Day weekend.

Tight lines.   See you Monday in NY.

David R. Kotok, Chairman and Chief Investment Officer