A bond trader I know sent me this at the end of the week. He is obviously in the bull camp:
I expect the 10yr UST to be closer to 1.50% than to 2.50% by this time next year. Deflation, deleveraging, and risk-aversion will likely continue for closer to a decade than a few years. Add in QE and the Fed’s desire to keep rates low, and we should see a yield curve with even lower yields than today in the coming years.
A significant argument in favour of this outcome is Japan. We are following their path in so many ways. From the bond guy:
The US situation in 2010 is not all too different from Japan’s in 1990 – yes there are differences, but many similarities, and most importantly, our “solutions” are nearly identical to what Japan tried. Japan has wound up with 2 decades of deflation and a 10yr yield that hit 1% for the first time in 1998, and now sits at 0.95%.
This general view of the future is widely held. It’s hard to ignore the fact that in many ways we are mirroring Japan. I see the similarities, but I also see the differences. For me, there are enough of those differences to come to a different conclusion. A few to consider:
Store of Wealth
Looking at the long-term graph of USDJPY says it all on this key issue. The US has had policies that encouraged deficits; this results in a chronically weak currency. This dynamic is very supportive of bond prices in Japan. True, investors get little return, but they also get an FX gain. If a country that measured its financial reserves as a store of future purchasing power the dollar loses hands down.
The US continues to follow a weak dollar strategy. Therefore by comparison we lose to Japan on the store of wealth issue. That does not support long term US yields at sub 2%.
Debt and who owns it
Japan has a GDP of~$5T and public sector debt of ~200% so they are swamped with debt. US public sector debt is ~$13.7T or 93% of GDP. This “favourable” comparison has been pointed to again and again as evidence that the US can handle a much higher PS debt. I’m not convinced. Consider the ownership of Japanese debt. 5% is foreign owned.
On the other end of the spectrum is the US. The following is a list of holders as of late. The US debt to public is $9.1T, of that 4.2T or 46% is in foreign hands. We have 9x’s as much debt in hands outside the country. This reality is not supportive of a long-term bull market in bonds. Hostile bondholders are going to be a factor against sustained low rates. Do you see anyone on this list that might get hostile?
The US functionally has none. The CIA puts the number at $140b. But when you have $4.2T of foreign creditors that much in reserves only covers about one year of interest. There is no margin for error. Japan has $1T+ in reserves. It has enough money outside the country to buy in all of the debt held by non-residents and still have a ½ trillion to spare. Again, if you were running the “Fund for Future Generations” you would be willing to accept a lesser return from a borrower that had the ability to pay you back 2Xs over versus the other who had not a foreign penny on the shelf.
The typical response to this is, “The US can print as much as they want”. True, but it is this “compelling” logic that makes the US a fundamentally bad credit. One that will be forced to pay more for borrowed money than Japan.
This issue has nothing to do with market rates in any short-term period. But it is a powerful long-term one. Japan has had stable/declining population while the US continues to grow. This factor will come to bear at some point. The increasing population in the US supports growth, with growth will come natural inflationary pressure. That is not an environment where interest rates can remain low for an extended period.
My friend the bond guy thinks there is a play in the 10-year area. He looks for the curve to flatten as deflation and POMO do their work. He provided this graph of what has happened so far:
Looking forward, there is all the reason in the world to think that THIS FLATTENING WILL CONTINUE, even if on QE alone, further pushing down rates in the 5-10yr part of the curve…
To me this is a crowded and dangerous assumption. I am not suggesting that one should short bonds. That is a risky bet that has a very significant negative carry to hold. I never recommend negative carry trades.
On the flip side I consider a buy/hold to maturity of the 10 year at the current yield to be one of the dumbest investments the market(s) have ever offered. The best way to play bonds is not to play them at all. Find another sandbox. The one filled with bonds is dirty; some big dogs took a crap in it.
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