Central Banks Are Fleeing Treasurys
A huge turnout for the first debate... Central banks are fleeing Treasurys... Japan could be between 'a rock and a hard place'... Another 'nail in the coffin' for corporate bonds... Junk bonds hit an eight-year extreme... More on Porter's 'Big Trade'...
Almost 100 million Americans tuned in last night to watch the first presidential debate of the season...
That's nearly as many who watched the Super Bowl, TV's biggest draw at 112 million viewers last year. And it's far higher than the average of 66.4 million folks who watched the first two presidential debates between President Obama and Mitt Romney in 2012.
If you didn't watch – and frankly, we don't blame you – it seems to us that Trump wants to crush financial markets by cutting off trade... and Clinton wants to crush financial markets by raising taxes and increasing government spending on social services.
We'll let P.J. O'Rourke handle the specifics (watch for his essay tomorrow).
While the media largely agree Clinton "won" the debate, the latest Bloomberg Politics national poll still shows the Republican and Democratic nominees locked at 46% of likely voters in a head-to-head contest.
Whoever wins in November will become president of an America with a higher debt-to-GDP ratio than any since Harry Truman took office at the end of World War II.
Worse, about two-thirds of all spending today is considered "untouchable." This includes entitlement programs like Social Security and Medicare. Neither candidate is likely to do anything about these massive expenditures.
The only tailwind the next president will enjoy is that central-bank manipulation has pushed interest rates to near-record lows... meaning the relative interest payments required to service the national debt are at their lowest in nearly 50 years.
This gives government officials cover to issue more debt, as even longtime critics of deficit spending are no longer speaking out. From the Wall Street Journal...
Doug Elmendorf, who as head of the Congressional Budget Office from 2009 until 2015 warned frequently of the toll unchecked deficits could take on the economy, now says the next president should tolerate wider short-term deficits to boost public investment in high-quality infrastructure or education programs.
"My thinking has changed because interest rates have fallen so far," he said. Policy makers should now recognize the declines have created "a sea change" in the conditions they now face, he said.
Of course, this benefit requires interest rates to remain near all-time lows. The tailwind could quickly evaporate if rates begin to rise.
Regular readers know that the Federal Reserve is already threatening to raise short-term rates. But there's another reason to worry if the U.S. could soon have to pay more to borrow...
Foreign central banks have long been one of the biggest buyers of U.S. government debt. But they've become even more important in recent years.
Bloomberg data show foreign creditors – led by central-bank buying – more than doubled their investments in U.S. government debt since 2008. They now own an incredible $6.3 trillion in Treasurys.
But recently, this has changed. These same banks are now fleeing Treasurys like never before...
The Federal Reserve's official custodial-holdings record shows global central banks have sold their Treasury stakes for three consecutive quarters, the most on record. And this decline has only accelerated in the last three months. As Bloomberg reports...
The amount of U.S. government debt held in custody at the Fed has decreased by $78 billion this quarter, following a decline of almost $100 billion over the first six months of the year. The drop is the biggest on a year-to-date basis since at least 2002 and quadruple the amount of any full year on record, Fed data show.
Remember, bond yields (interest rates) trade inversely to bond prices. Yields fall as prices rise. Strong foreign demand for Treasurys has been an important driver of higher Treasury prices and lower interest rates, particularly in recent years.
A reversal of this trend wouldn't just be bad news for bond investors. It could also mean big trouble for the U.S. government. More from Bloomberg...
With the U.S. facing deficits that are poised to swell the public debt burden by $10 trillion over the next decade, foreign demand will be crucial in keeping a lid on borrowing costs, especially as the Fed continues to suggest higher interest rates are on the horizon.
The selling pressure from central banks is "something you have to bear in mind," said [Jim Leaviss of M&G Investments], whose firm oversees about $374 billion. "This, as well as the Fed, all means we are nearer to the end of the low-yield environment."
Bloomberg notes that the biggest Treasury holders – including China, Japan, and oil-producing nations like Saudi Arabia – are selling in response to growing troubles in their own economies.
Speaking of Japan, there are already signs its central bank's latest policy change is failing...
Last week, the Bank of Japan ("BoJ") announced a change to its quantitative-easing ("QE") program. As we wrote in the September 22 Digest...
According to the announcement, the bank will no longer buy a set amount in bonds each month. Instead, it will adjust the pace of bond-buying to keep long-term interest rates – as measured by the yield on 10-year Japanese government bonds ("JGBs") – at 0%.
The move is intended to target the "yield curve," or the difference between short- and long-term interest rates.
One of the worst consequences of central banks' QE programs has been a "flattening" of sovereign yield curves... Long-term bonds yield less relative to short-term notes than at virtually any time in history. This has punished savers – setting off the global "reach for yield" we've discussed in these pages – and made it more and more difficult for banks to earn a profit.
As we noted at the time, this move was intended to "steepen" the yield curve by increasing the difference between short- and long-term rates. But that hasn't happened...
Since last week's announcement, the yield on 10-year JGBs has plunged back below zero, and the yield curve has flattened even more. And the Japanese yen – which the BoJ has been trying desperately to weaken – has continued to rise. It now sits just shy of its highest level of the year...
We can't say for certain what the BoJ will try next...
In theory, according to its new plan, it will now dramatically reduce its purchases of 10-year debt – or even begin to sell – to push yields back up to 0%.
The market could see this as de facto "tightening" – the opposite of what its QE program was meant to do – leading to a stronger yen and further flattening as longer-maturity bonds sell off in response.
In short, it's looking more and more like the BoJ is running out of options.
Meanwhile, despite the obvious failures of QE in both Japan and the eurozone, the U.K. continues to follow the same playbook...
Today, the Bank of England joined the BoJ and the European Central Bank in adding corporate bonds to its QE program. It intends to buy $13 billion worth of U.K. corporate bonds over the next 18 months.
The plan has already had a dramatic effect on the relatively small U.K. corporate debt market...
Bloomberg notes that yields on investment-grade corporate pound bonds have dropped to a record low of 2.06% today, down from 2.48% when the plan was announced.
Of course, while the Fed's QE program officially ended in 2014, regular readers know that U.S. corporate debt hasn't escaped the global "reach for yield."
Despite deteriorating credit conditions, income-hungry investors have been piling into corporate bonds – particularly high-yield (or "junk") corporate bonds – like never before.
According to Marty Fridson – the world's leading expert on the corporate credit cycle – this has pushed the high-yield market to its most extreme valuation in nearly a decade.
Earlier this month, Fridson noted that the "spread" on high-yield bonds – which is simply how much more they yield than comparable U.S. Treasurys – had fallen more than two standard deviations below fair value.
Now, if you don't recall your high-school math, don't worry... all you need to know is this is an extreme move that doesn't occur very often. (In fact, just one standard is considered "extreme.") Fridson says junk bonds haven't been this expensive since May 2008, just before the worst of the financial crisis.
In other words, folks loading up on high-yield debt today are certain to regret it.
On the other hand, folks who short the riskiest high-yield debt could make a fortune over the next few years. There's just one problem...
Shorting bonds is virtually impossible for anyone but the biggest institutional investors. It's simply not a strategy most folks can take advantage of.
But that doesn't mean you're out of luck. As Porter explained in the September 9 Digest...
What about regular investors? What about folks without the capital or the sophistication or the patience to deal in the bond market, where getting a position filled can take months and dozens of phone calls?
That's a great question. And I've spent a year thinking about the right and safe way to make gains that are big enough to cover the risks involved. The answer isn't trying to short individual bonds. Or even bond exchange-traded funds. The right way is a wholly different kind of strategy.
Regular readers know that Porter and his team have been working for the past several months to perfect this strategy – what they're calling their new "Big Trade." And we're happy to report it's just about ready.
Stay tuned... More details are headed your way soon.
New 52-week highs (as of 9/26/16): Anheuser-Busch InBev (BUD).
In today's mailbag, another great note about this year's Stansberry Conference. Send your questions, comments, and concerns to feedback@stansberryresearch.com.
"Hi Porter and gang, thanks for the nice event in Las Vegas. I'm actually starting to lose track of how many I've been to, must be getting close to ten of them. It appears as if these events run as smooth as silk and without a glitch. Whoever it is that puts this all together should be commended, it has to be a huge undertaking, they did a superb job! I thought the speed painter broke up the event nicely and the dinner party at the pool was really a nice touch. Although I have to say, based on how I felt the next day, the open bar is a little bit dangerous. This year I ordered the OneBlade, I look forward to its arrival in October. Take care and see you next year. Thanks again!" – Paid-up Stansberry Alliance subscriber Bob G.
Regards,
Justin Brill
Baltimore, Maryland
September 27, 2016
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