What A Flattening Yield Curve Means – Fasted Yield Curve Flattening Since 2008

The anticipation of Fed rate hikes has gradually raised short-term rates this year, with the demand for longer-term bond maturities increasing. The result has been a flatter yield curve, where short-term rates have risen and long-term yields have dropped. A flattening yield curve implies that longer-term economic growth may be subdued or not expected to be very extensive.

At the end of November, short-term rates such as the 2-year Treasury yield had risen to 1.75% from 1.22% at the beginning of the year. The longer-term 30-year Treasury bond yield fell to 2.77% on November 30th from 3.04% in January.

As promised, the Fed has started to curtail its buying of Mortgage Backed Securities (MBS). Through September, the Fed was buying an estimated 20-25% of the roughly $110 billion of MBS sold each month. In October, the Fed scaled back its purchases by $4 billion and is scheduled to reduce purchases by another $4 billion every quarter. As the Fed buys less and less MBS, the market will need to slowly absorb the additional paper made available by the Fed’s lack of buying. As this occurs, it is expected that MBS prices will gradually fall and yields will gradually rise. (Sources: Federal Reserve, Bloomberg, Treasury Department).

A significant rise in long-term rates and a tightening in credit could spell real trouble for bondholders and the credit markets.  Due to the now massive size of global debt (approaching $240 trillion) it is estimated that a 1% move in long-term rates equates to approximately $1.2 trillion in losses for bondholders (many estimates have that number much higher).  As we have discussed in our previous newsletters since the bond market is comparatively illiquid,  losses tend to accelerate as the buyers step away and bids for bonds tend to dry up.  However, the bond market is telling the central banks that it does not believe that the current growth levels are sustainable and while it is not quite yet projecting a recession it is certainly spelling trouble down the road.  Only time will tell if the bond gods are right this time but there are certainly enough warning signs that investors should exercise extreme caution in the coming months.

Credit Markets

As we previously discussed, from mid October to mid November credit spreads rose dramatically from a low of around 338 basis points to nearly 400 basis points.  While we have continually called for credit spreads to widen, we noted last month that the move had been extremely rapid and we could see buyers stepping back in especially if volatility began to calm. Buyers stepped back in and credit spreads have once again tightened giving up about half the previous widening and now sit at 363 basis points. For new readers, we are referring to the option adjusted spread on high yield bonds expressed in basis points (meaning that investors in high-yield bonds are receiving a 363 basis point risk premium or 3.63% over the corresponding treasury considered the risk free rate), This is still an extreme historically low risk premium for investing in bonds that are rated BB or lower.

Credit Markets (continued) 

Our favorite whipping dog has been the Tesla 5.3% maturing in 8/15/2025. We have been tracking this bond in our newsletters since they were issued and believe its issuance in August could mark the bottom in credit spreads (and investors blind greed and willingness to lend money to almost anyone regardless of creditworthiness). After declining every month since they were issued the have temporarily leveled off and are trading at about the same level as November with a $94 handle price.  For more information on the Tesla issue or credit markets please visit our website and view our archived newsletters and our FI Learning Center.

The quandary facing bond holders is that if this economy continues to “boom” then yields will ultimately have to rise which will drive bond prices lower (there is an inverse relationship between yields and prices).  While some of the losses from rising rates will be offset by  spread tightening (due to investors belief that the booming economy will increase the likelihood that these junk rated companies will survive and be able to pay off their obligations) it is important to note that rising rates could make it more difficult for many of these companies to refinance their current debt at favorable rates (if at all).  But the real whammy for investors comes if the economy begins to stagnate (or worse) in which case one would expect a significant amount of spread widening (investors demanding more risk premium).  In this case interest rates would likely fall (good for bond prices) but with 10 year U.S. Treasury rates sitting in the 2.37% range how far can they really go and will it be enough to offset the widening in credit spreads?  Considering credit spreads hit 864 basis points in 2016 and now sit at 363 basis points there just isn’t enough room for bond prices to rally to offset a possible 3-500 basis point widening in credit spreads.

And remember folks, the bond market is facing a record mountain of high yield debt coming due with over $1 trillion in debt maturing between 2018 and 2021.  This debt will have to be refinanced or these companies will be in default.  A rise in interest rates or even a relatively minor widening (2-300 basis points) could make refinancing this debt a tenuous proposition and if the dominos start to fall it could get ugly.  For the last 5+ years the credit markets and lenders have been willing to give money to any company with a pulse.  Recently we saw one of the best known retail names in the world, Toys-R-Us unable to obtain reasonable financing and was forced to file for reorganization.  It won’t take many more big names going bust to see a significant tightening in lending and a real crisis in the high-yield bond market.

In an article in this weeks Barron’s titled The Best Bond Sectors for 2018 the head of Nuveen’s taxable fixed income said:

“There isn’t much room for spreads to tighten further, but there is little risk that spreads will widen, unless there is a global recession”

However almost all the analyst quoted in the article felt that we would see long-term rates rise to at least 3%.  Considering spreads are at or near historical lows and the fact that the bond market can quickly become illiquid during times of volatility (such as a 60+ basis point sell-off) we strongly disagree.  We believe there could easily be a situation where yields rise AND spreads widen as investors back away.  Think about it this way, if bonds prices are steadily falling and you are a money manager placing a bid on a bond you are clearly going to try and compensate for the fact that what you buy today will be worth less tomorrow.  And since you cannot control the treasury rate which the bond is being priced to you compensate by backing up the spread you are willing to pay.  I have seen this happen several times in my 27 year career.  Of course, their thesis makes sense – If the economy is performing well spreads should hold tight but experience says this does not always happen.

In the same article they suggest the best fixed income investments for 2018 will be emerging market debt and asset-backed securities (ABS) with 2-5 years.  We have been huge proponents of the ABS sector and for the exact reasons they give in the article, the shorter maturities and faster paydowns mean these securities have less duration risk (price sensitivity)  as rates rise.  They fail to mention the fact that these securities offer superior yields compared to comparable maturity corporate debt (and even emerging market debt if you know how to cherry pick the right sectors/bonds).  It should also be noted that these securities have very little default risk because they are backed by a pool containing hundreds (or thousands) of individual loans or assets (mortgages, rail cars, auto loans, etc.).  Investors buying the front-end and higher rated bonds have almost zero chance of defaults as it would take a large portion of the individual loans to default all at once.  Even in that case the high rated front-end bonds have a tremendous amount of credit support and are designed to withstand such an event.

It wasn’t long ago entire elections centered on the national debt debate.  Obama called it “unpatriotic” that Bush had raised the debt by over $3 trillion and then went on to accumulate more debt in his tenure than had been accumulated in the entire history of the United States (over $7 trillion – much more if unfunded liabilities are counted).  The debt used to be a major debate among politicians yet it wasn’t even a factor in the 2016 election and is almost never discussed in the news or even among most conservative politicians.  We now sit with over $20 trillion in federal government debt not counting the unfunded liabilities (social security, medicare, etc.).  This is an astounding $62.000 for every living person in the U.S. or nearly $250,000 for a family of four!  The CBO estimates that over the next few years interest payments on the national debt will go from 6% of the federal budget to 11%.   Economics 101 would dictate that as government debt rises (especially this significantly) that the borrowing cost should rise (printing funny money should cause inflation) but this hasn’t happened as central banks have kept rates artificially low for over 10 years.  Now, for the real kicker:

Household Debt On The Rise – Consumer Behavior

As the economy has grown, so has household debt. Data tracked by the Federal Reserve shows that debt held by U.S. households rose to over $12.9 trillion in the third quarter, the highest level ever. A favorite form of consumer debt, credit cards, rose by 3.1% for the quarter. The Fed report did note that delinquencies among credit cards and auto loans were rising, an indication that some households might be overstretched.

According to data from the Federal Reserve Bank of New York, total household debt climbed to $12.96 trillion at the end of the third quarter. The current amounts now surpass the debt levels Americans had in 2008, when total consumer debt reached a record high of $12.68 trillion.

The Fed tracks household debt by categories, such as mortgage, student, credit cards, home equity loans, and auto loans. Over the decades, the most consistent and significant amount of household debt has been mortgages.

The recent increase in total overall debt is primarily attributable to a steady rise in both student and auto loans. Recent Federal Reserve data shows that these two loan types are primarily held by younger consumers. The concern is that the difficulty of obtaining mortgage loans has led younger consumers to take out student and auto loans instead.  An upturn in delinquent credit card debt is a concern to the Fed, since it has occurred during a period of job market strength. The culprit might be that workers may not be earning more, but just working more.  Sources: Federal Reserve Bank of New York.  It should be obvious to anyone paying attention that this combination of record government and consumer debt is the black swan bubble hiding in plain sight.

Bitcoin Hysteria – Digital Currency Overview

Euphoria has sweep Bitcoin to unreal levels over the past few weeks. Bitcoin, one of many digital currencies, shot past 11,000 in the final week of November after eclipsing 10,000 just hours prior. The cumulative value of all cryptocurrencies throughout the world are estimated to be more than $300 billion, an enormous increase from the $18 billion at the beginning of the year.

The commodity futures trading commission granted the Chicago Board Options Exchange (CBOE) to issue Bitcoin futures which will allow traders to bet on the price of the digital currency via a trusted exchange. Traders will be allowed to bet on the appreciation of the cryptocurrency or the demise of it by buying and selling the futures.

What took the equity markets decades to establish, the cryptocurrencies market is trying to build in mere months. Bitcoins emerged in 2008 designed by a programmer or group of programmers under the name of Nakamoto, whose real identity remains unknown. New Bitcoins can only be created by solving complex math problems embedded in the currency keeping total growth limited.

Many believe that the development of digital currency it is just beginning of a globally accepted process sometime available in the near future. Bitcoin could merely be a stepping stone to an eventual acceptance of digital currency. Bitcoin currently accounts for roughly 55% the total digital currency market, down from 87% of the total market at the beginning of year. Hence, Bitcoin has incredibly fast growing competition. Bitcoin is currently one of over 1000 other digital currencies in the marketplace. Other popular cryptocurrencies include Ethereum, Ripple, Litecoin, NEM, Dash, and IOTA, to name just a few.

Digital currencies are being examined as a store of value and a method of making monetary payments. Gold, an accepted store of value, and currencies issued by countries have been established internationally for centuries and are and now challenged by the cyptocurrency concept.

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One factor driving Bitcoin’s growth has been the emergence of a broader cryptocurrency ecosystem. Bitcoin serves as the reserve currency for the cryptocurrency economy in much the same way that the dollar serves as the main anchor currency for international trade. Bitcoin has been recognized as the first truly decentralized electronic payment network.

A looming regulatory crackdown is affecting the digital currency as well. Bitcoin has already been hit by a crackdown from Chinese officials who have been severely restricting the use of cryptocurrencies. In the United States, there’s little risk of a direct crackdown on Bitcoin, but there’s a real risk that the Securities and Exchange Commission will crack down on the ICOs (Initial Coin Offerings) that have pushed Bitcoin’s price upward. An unregulated means by which funds are raised for new crypto currency bench ICOs are used by startups to bypass the rigorous and highly regulated capital raising environment.

Bitcoins exist as software, not physical currency, and are not regulated by any country or banking authority. Even though U.S. Senate hearings disclosed that Bitcoin could be a means of exchange, it gave no assurance that it would actually become an accepted medium of exchange. Government regulations would need to be created and then enforced in order for Bitcoin to become accepted by other government entities. The currency can be traded without being tracked, thus raising the potential for illicit activity, such as involving weapons, drugs, and prostitution. Even though Bitcoins are not illegal, it is not legally recognized by governments as a currency.

Some believe that the price appreciation of Bitcoin has been solely a result of speculation and hasn’t yet been used as a store of value or as a medium of exchange to any extent. Some compare Bitcoin to the tulip craze in Holland of 1637, when speculators pushed the price of tulip bulbs to incredible levels, followed then by a collapse in the tulip bulb market. Bitcoin has also surged on speculation that perhaps one day digital money will eventually become a legitimate global currency and even replacing currencies from certain countries.

Bitcoins are mined by powerful computers that calculate complex, mathematical functions. Total Bitcoin quantity is capped at 21 million and currently there are about 12.4 million that exist worldwide.

The growing mobile payment industry could be a big benefactor to the acceptance of Bitcoin as new and creative applications are being devised to accept digital currency. Bitcoin transactions are very popular among mobile users, where rather than using a credit card or cash to make a purchase, all you need is your phone.

In 2014, the value of Bitcoins fell by over fifty percent following remarks by China and Norway to not recognize the digital currency as legal tender. The government of Norway ruled that Bitcoin does not qualify as real currency but rather qualifies as an asset, producing taxable capital gains. Norway said that Bitcoins don’t fall under the normal definition of money or currency.

More and more nations have been taking an official stance as the popularity of Bitcoins has evolved. The European Banking Authority has warned about the risks of trading digital money and subject to losses where consumers are not protected by any government entity or authority.

As digital currency evolves, some believe that it will eventually be accepted as a legitimate currency. But for the time being, others believe that its time hasn’t arrived yet. Various studies have recently emerged with different opinions, such as
a Stern School of Business study conducted by David Yermack, which concluded that Bitcoin behaves more like a speculative investment than a currency and has no currency attributes at all.

Sources: Bloomberg, Reuters, cointelegraph.com