1% on 10-year Note?
David R. Kotok
Cumberland Advisors, January 13, 2015
“What if the Fed doesn’t raise rates at all this year? There’s certainly a good amount of volatility possible with the ECB meeting Jan 22, the Greek election Jan 25, and the FOMC announcement Jan 28.” – Don Rissmiller, Strategas, Jan. 11.
Don’s question is a valid one, notwithstanding the recent headline numbers from the employment report. My colleague Bob Eisenbeis has examined the composition of the Fed’s policymaking body, the Federal Open Market Committee (FOMC). He thinks a slight move up in rates will come before yearend. There is no need for me to repeat any of that here. For Bob’s discussion see his recent commentary at www.cumber.com.
My view is similar to Bob’s and it is the consensus within our firm. I would add that I believe the markets suffer from dysfunction when the interest rate is zero or very close to zero. As we see it, getting the policy rate up to 0.50% is a way for the Fed to restore market function. At one-half of one percent, cash earns something instead of nothing. Above zero, choices may be made in the very front end of the money market curve. Zero does the financial markets and the economy a disservice. Our friends in other jurisdictions such as the Eurozone are learning that the hard way.
But what happens to the longer rates once the Fed moves from zero to something else? Will benchmark long-term rates rise or fall? Some argue for higher rates. They have been doing so for years, and they have been consistently wrong. Maybe the move to lower longer rates is already anticipating the Fed will move away from zero?
Friend and fishing buddy Gary Shilling has been on the correct side of the bond yield outlook for years. He says the bond rally that started on 1981 is not over. In his January Insight Gary reaffirmed his position:
We expect a further rally in Treasury prices with the 30-year yield dropping … to 2%, perhaps by the end of 2015. If the 10-year note drops to 1%, as we forecast, the total return would be 12.4%. These may seem like big gains…. But that’s what happens when yields are low. We believe that “the bond rally of a lifetime” marches on.
Could we see a 1% 10-year Treasury note yield? Maybe. And the sooner the Fed moves away from zero, the sooner we will know where the market clears and at what yield. It is quite possible that we’ll see a short-term rate of 0.50%, an intermediate-term rate between 1% and 2% (it is already there), and a long-term Treasury rate close to 2.0% and between 2% and 3% (it, too, is already there).
Look around the world at 10-year yields in various countries on December 31. In the Eurozone, benchmark Germany was at 0.54%. Netherlands was 0.68%, Austria was 0.71%, France was 0.84%, Italy was 1.88%, and Spain was 1.61%. In Switzerland (which pegs its currency to the euro) the yield was 0.37%.
Elsewhere in Europe but not in the Eurozone, Sweden was at 0.94%, Norway was 1.55%, and the United Kingdom was 1.76%. And in the country with the highest amount of QE and the largest debt-to-GDP ratio, Japan, the 10-year yield was 0.33%.
Compare these yields with the yield of the 10-year US Treasury benchmark note on December 31. It was 2.17%. That’s right, the world’s reserve currency, denominated in the strengthening US dollar, in a country that has ceased QE and is shrinking its federal deficit, was yielding more than the others. If you were sitting abroad and allocating bond monies globally, which bond would you select for your sovereign-debt global fund? Note that nearly all highest credit quality yields are lower today than they were at year end.
It seems to us that the US Treasury note is the world’s best government bond idea. Is it any wonder that the bond market rally in Treasury securities continues? And is there any near-term action that will change this? It seems the answer is no. Gary Shilling’s courageous and consistent forecast may be right.
So what is a bond investor to do?
At Cumberland, we elect to use spread product and not Treasuries. We do our own credit research and make our own individual bond selections. We include Munis (taxable and tax-free) as an option. After 40-plus years, we think we know a little bit about how to examine credit and how to read bond indentures and interpret covenants. And we do some tactical hedging because we do not know when this market forecast will change. We are glad that we did not abandon the bond market.
Translate this outlook to the stock market in the United States. Suddenly the stock market doesn’t look as expensive as many think. Sure the median p/e for an NYSE stock is the highest ever in the post-war period and has exceeded 1962, 1998 & 2005. (Hat tip to John Melloy @ CNBC who forwarded Jim Paulsen’s chart.) That reference is worrisome. And sure the ratio of total stock market value in the US compared to US GDP is higher than any other time except for the tech stock bubble peak 15 years ago. That, too, is worrisome. But those references were in times when the yields on riskless debt were much higher. What about now?
Let’s use a low earnings estimate of about $125 for 2015. At an S&P 500 price of 2250, the earnings yield would be close to 6%, the p/e would be 18. Using a 2% yield for the riskless 10-year Treasury note, the equity risk premium would be 4 percentage points; @ 1% the equity risk premium would be 5. Both are way above the historic equilibrium of about 3%. And S&P dividend yields would approximate the yield on the riskless 10-year note and exceed the yield on cash, even if the Fed raised rates before the end of this year.
Within the US stock market the numbers above reflect the markdown of the energy sector and its earnings. And they support the notion that the most compelling sector to own is the utility sector, which happens to be Cumberland’s largest overweight in its domestic US ETF portfolios.
In sum, we expect higher volatility in 2015. It has to be so when interest rates are this low and when there is a vast gap among various countries, their currencies and their central bank policies.
But higher volatility is bidirectional. It will terrify investors on the downside and exhilarate them on the upside. 2015 is likely to offer both.
It is going to be an interesting year.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors