“What everyone knows is not worth knowing”, as the famous financier Bernard Baruch once said.
And that’s how I was reminded of a long speech in the New York Times last week about why bond yields remain low, despite rising inflation and large budget deficits. Central banks around the world have set rates at zero or below while buying billions of dollars worth of bonds to cut their yields. Aging populations and continued demand for safe and liquid investments, along with excess global savings, have further reduced yields on risk-free government bonds. Good to print, but hardly news.
But, as everyone also knows, the Federal Reserve is about to start raising its key short-term rates, with a quarter-percentage-point hike all but stalled and a half-point hike outside, but growing, possibility. Up to five quarter-point increases by December are priced in the fed funds futures market, according to CME website FedWatch.
So, to find out what not everyone already knows, I turned to two opposites that have defied consensus (and me) for many years. Spoiler alert: they think bond yields will fall, not rise, if not immediately then at least in the not too distant future.
“I was never afraid to go against the consensus or the Fed,” says Lacy Hunt, chief economist at Hoisington Management in Austin, Texas, which was bombarded by an ice storm while we were talking on the phone. Despite the most recent gross domestic product data showing 6.9% annualized growth in the fourth quarter, he sees the U.S. economy as fragile due to its debt load.
Gary Shilling, who runs the long-established economic advisory service that bears his name, also diverges from the crowd by looking for “an economy that is going to be soft” and “inflation that is going to fade”. A recession has followed 11 of the last 12 Fed policy tightenings, he points out, in a phone conversation from his perch in northern New Jersey, which was hit by near-freezing rains from the same storm.
Beyond the weather, what these two veteran market economists share is the belief that the rise in bond yields over the past year, to a recent high of 1.83% on the good of the benchmark 10-year Treasury, will be reversed.
While the common perception is that American consumers are being held back from buying what they want because of supply chain issues, Shilling thinks they’ve “got their fill.” Inventory building, the main reason for the strong fourth quarter GDP report, is likely to prove overdone. In particular, he notes an increase in inventory at major retailers Walmart (ticker: WMT) and
(TGT) in the quarter, while overall retail sales reported by the Commerce Department fell 1.9% in December.
As unwanted inventory continues to pile up, Shilling seeks reductions in orders and production. At the same time, he thinks the real estate price boom is about to burst. The supply of new homes will catch up with demand. “I feel like the rush to suburbs and rural areas is almost over,” he adds. He also doubts that people moving to lower-cost areas will continue to receive the same pay from big-city employers for remote work.
Hunt, meanwhile, sees the economy continuing to be beset by debt and demographics. Contrary to the common belief that higher debt drives up interest rates, he argues that the debt drag slows growth and, in turn, lowers long-term rates.
Looking at very long-term trends, he says real per capita growth has halved to 1.1% since the late 1990s, from 2.2% in 1870 until then, which he attributes to the accumulation of US debt. Regarding demographics, he sees the slowest population growth in the country since the 18th century, limiting investment, which will limit the output of the economy.
In the meantime, Hunt sees inflation hurting most households, especially those on lower incomes, as prices invariably outpace wages. As the cost of basic necessities, such as food and fuel, takes up a greater share of budgets, consumers actually benefit from higher taxes.
Shilling expects the tightening the Federal Reserve is about to embark on to have the same impact that tightening policy has had in almost every other previous instance. It wasn’t until the 1990s that the Fed was able to pull off the proverbial soft landing by tightening and then easing in time to avoid a recession. In 1994-95, the central bank roughly doubled the federal funds rate in a short period of time, leading to major financial repercussions in the mortgage-backed securities market, the Orange County bankruptcy, in California, and the Mexican peso crisis that led to a US bailout.
Once the Fed’s rate hikes hit a slowing economy, Shilling sees a resumption of the “bond rally of a lifetime,” which he called when it started four decades ago and now says that it is not finished. He thinks long-term Treasury yields have already priced more than a full percentage point into the Fed’s short-term rate target.
If monetary policy tightening leads to a recession, he expects the 10-year Treasury yield to return to its early-2020 pandemic low of 0.54%, from 1.8% last week, and that 30-year bonds fall back to 1% from 2.1%. Since bond prices rise as rates fall, this would produce a total return of 30.7% for a 30-year Treasury note and 38% for a 30-year zero-coupon bond.
Shilling points out that he has always recommended Treasury bonds for capital gains, not income. But he’s not buying yet. He is waiting for economic weakness from excess inventory to develop and the Fed to worry about overdoing it before pulling the trigger.
Hunt believes economic conditions in Western Europe and Japan led to even weaker returns there. Thus, global investors are likely to continue to be drawn to rising US Treasury yields, which it believes are also becoming increasingly attractive to domestic investors as the US economy disappoints and the inflation is falling.
Will these veteran bond bulls prevail? I have to admit that over the years, when I disagreed with them, they ended up being right more often than not. If nothing else, opposing views force you to re-examine your assumptions.
Write to Randall W. Forsyth at [email protected]