Last week, as the stock market experienced extreme fluctuations and oil prices plunged, we turned our attention to the 10-Year Treasury note. On Thursday and Friday, its yield fell to 1.75 percent—marking the lowest level since May 2013.
Moreover, the 10-Year Treasury yields are inching closer to their all-time low of 1.53 percent, which was reached briefly in July 2012. It’s essential to remember that when Treasury yields decrease, Treasury prices rise. This means that Treasuries are currently nearly as costly as they have ever been.
In a climate of global financial uncertainty, U.S. Treasuries are perceived as a reliable choice. Many investors believe they can expect not just the return of their principal investment, but also an additional 1.75 percent.
However, here at Economic Prism, we contend that 1.75 percent is merely a pitfall waiting to ensnare unwise investors. We’ve been forecasting a reversal in the debt market for at least six years—if not longer.
Our reasoning is robust. The government debt market tends to be uneventful for lengthy stretches. Yet, at times, it hits an inflection point that can cause rapid changes.
High Peaks and Wide Valleys
It seems we may be approaching such an inflection point now. Sadly, we won’t truly know until after the moment has passed. Here’s why:
Interest rate cycles can span extensive periods—often lasting between 25 and 35 years. For instance, U.S. Treasury yields peaked in 1920, then gradually declined to about 2 percent in the early 1940s.
Following that, yields began to rise, accompanied by inflation, for an extended duration. By 1980, it appeared that yields would continue to climb indefinitely. During this time, Franz Pick notably remarked that “bonds are certificates of guaranteed confiscation.”
What Mr. Pick failed to grasp at that moment was that an inflection point had been reached. In early 1982, yields began to ascend once more, ultimately reaching historic lows of 1.53 percent in July 2012. Since then, they have languished at the bottom, with the Federal Reserve intent on keeping them there.
The Zero Interest Rate Policy (ZIRP) is well into its sixth year, but this may be set to change later this year. Nevertheless, raising the federal funds rate from nearly zero to rates like 0.5 or even 1 percent remains exceedingly low by historical standards. Moreover, there are inherent limitations to what the Fed can truly control.
Treasury Bubble Redux
The idea that the Federal Reserve has control over mid- and long-term interest rates is a fallacy. While they may have had some influence in the past, the deep intertwining of global economies now means that government bond yields are more significantly affected by trade deficits and the dynamics of the petro dollar.
Currently, both trade deficits and the influence of the petro dollar are undergoing shifts distinct from their patterns over the past 30 years. If these changes continue, yields may finally be poised to embark on their long-anticipated climb up Mount Everest. But why is this happening now?
Over the last 40 years, fueled by extensive access to cheap credit from the Fed, both public and private debts surged. This surge manifested as massive trade deficits, with the U.S. importing more than it exported.
To finance these imports, the U.S. exported a vast amount of paper dollars to pay for oil and inexpensive consumer goods. Oil-rich nations like Saudi Arabia and low-cost producers like China accepted these excess dollars, converted them into local currencies, and subsequently reinvested them into U.S. government debt. This cycle distorted currency values, artificially suppressing foreign currencies while reinforcing the strength of the dollar, and continued to drive Treasury yields lower.
However, signs of change are emerging. In November 2014, the U.S. trade deficit decreased to $39 billion, an 11-month low, aided mainly by a reduction in oil imports—now at a 20-year low. Additionally, the November trade deficit with China dropped by 8 percent.
For the time being, U.S. Treasury yields are still being suppressed by investors seeking safety amidst heightened market volatility. However, as conditions stabilize, a declining trade deficit could become a pivotal factor, potentially reversing a 40-year trend of declining interest rates.
Should this occur, the enormous Treasury bubble could finally burst. Instead of experiencing increasingly cheaper credit, it may become pricier, forcing asset prices to readjust downward. This adjustment would also have far-reaching repercussions for economies worldwide, many of which have become reliant on the influx of inexpensive credit. Removing this lifeline would likely lead to widespread consequences.
In conclusion, the financial landscape is experiencing notable shifts, and careful observation will be necessary to navigate these changes. Understanding the implications of rising or falling yields and trade dynamics will be crucial for making informed investment decisions in the future.
Sincerely,
MN Gordon
for Economic Prism
