I believe that the yield on the 10-year U.S. note, currently at 2.63% (down by three basis points from Monday's close), is about sixty basis points underpriced -- and that bonds should be shorted.
I base this view on inflation breakevens (now over 2.00%), projected 2018-19 domestic Real GDP growth (of +2.75%) and an anticipated relationship of 0.7x (well below the historical range of the multiplier of 0.8x to 1.0x) between the 10-year yield and nominal GDP.
Importantly, it is necessary to cite the vulnerability of European bonds as the European Central Bank gets closer to ending quantitative easing and the potential negative impact on U.S. Treasuries -- as well as the projected tightening in domestic monetary policy.
I now believe a bond selloff and yield overshoot (to over a 3.5% yield on the 10-year U.S. note) is possible in 2018.
Back in July 2016 I posited in my Diary and in a Barron's interview that we were likely at a Generational Low in U.S. and Global bond yields.
It is always important to look at both sides of the bearish bond argument, however.
I recognize that there are several important anchors to U.S. bond yields (and that is why I am conservatively applying only a 0.7x multiplier (compared to 0.8x to 1.0x historically) to nominal GDP in determining the fair market value or intrinsic value of the 10-year note yield).
Perhaps the most important factor is the low/negative yields available in non-U.S. fixed income, which naturally compete, to some extent, with U.S. yields. (In the past I have minimized the influence of this much talked about factor given the high cost of hedging currency -- and I continue to do so!)
Of even more consequence, with the domestic economy heavily levered, a rapid rise in bond yields (and borrowing costs) will likely serve to slow growth below consensus expectations as rising interest rates will likely divert capital from consumption. Yesterday I highlighted the rise in LIBOR. (Note that I have only used +2.75% Real GDP (E) in my calculation of intrinsic bond values.)
My friend Lance Roberts outlined 10 other factors that could restrain a decline in bond prices and a rise in bond yields on his site, "Real Investment Advice" Monday:
1) The Federal Reserve has been buying bonds for the last 9 years in an attempt to push interest rates lower to support the economy. The recovery in economic growth is still dependent on massive levels of domestic and global interventions. Sharply rising rates will immediately curtail that growth as rising borrowing costs slows consumption.
2) The Federal Reserve currently runs the world's largest hedge fund with over $4 Trillion in assets. Long Term Capital Mgmt. which managed only $100 billion at the time nearly brought the economy to its knees when rising interest rates caused it to collapse. The Fed is 45x that size.
3) Rising interest rates will immediately kill the housing market, not to mention the loss of the mortgage interest deduction if the GOP tax bill passes, taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.
4) An increase in interest rates means higher borrowing costs which lead to lower profit margins for corporations. This will negatively impact the stock market given that a bulk of the "share buybacks" have been completed through the issuance of debt.
5) One of the main arguments of stock bulls over the last 9-years has been the stocks are cheap based on low interest rates. When rates rise the market becomes overvalued very quickly.
6) The massive derivatives market will be negatively impacted leading to another potential credit crisis as interest rate spread derivatives go bust.
7) As rates increase so does the variable rate interest payments on credit cards. With the consumer being impacted by stagnant wages, higher credit card payments will lead to a rapid contraction in income and rising defaults. (Which are already happening as we speak.)
8) Rising defaults on debt service will negatively impact banks which are still not adequately capitalized and still burdened by large levels of bad debts.
9) Commodities, which are very sensitive to the direction and strength of the global economy, will plunge in price as recession sets in.
10) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.
As to the dynamic between bonds and stocks, according to Lance, "with "expectations" currently "off the charts," literally, it will ultimately be the level of interest rates which triggers some "credit event" that starts the "great unwinding. It has happened every time in history... Given the current demographics, debt, pension and valuation headwinds,ten-year rates much above 2.6% are going to start to trigger an economic decoupling. Defaults and delinquencies are already on the rise and higher rates will only lead to an acceleration."
Food for thought to start a Tuesday morning!
(This commentary originally appeared on Real Money Pro at 8:45 a.m. ET on Jan. 23. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)
