FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
September 10, 2019

IN THIS ISSUE:

1. Fed Expected to Cut Rates Again on September 18

2. Yield Curve Flattens Significantly Due to Low Inflation

3. Negative Interest Rates Top $17 Trillion Globally

4. How Can Government Bonds Have a Negative Yield?

Fed Expected to Cut Rates Again on September 18

The next meeting of the Fed Open Market Committee (FOMC) will be next week, September 17-18, when it is widely expected they will cut the Fed Funds rate from the current range of 2.00-2.25% to 1.75-2.00%. According to the CME FedWatch guide, the odds of this happening are over 90%. A third rate cut is widely expected at the December 10-11 FOMC meeting.

Regular readers know that I questioned the Fed’s decision to cut its key interest rate at the end of July. The economy remained solid even though GDP growth cooled from 3.2% in the 1Q to 2.0% in the 2Q. The unemployment rate remains near a 50-year low at 3.7%, and there are a million more unfilled jobs than there are unemployed working-age people to fill them.

The question remains: Why does the Fed feel the need to cut rates repeatedly with the economy this strong? The answer is, as I first stated in my Blog on April 11, the Fed is very worried about the inverted yield curve. The 3-month Treasury bill yield has been higher than the 10-year Treasury note since April. The 2-year Treasury note yield is about the same as the 10-year yield, but this commonly watched spread has also inverted marginally a few times in the last couple of months. Here’s how it looked when it briefly inverted in the first half of August:

The yield on the 2-year Treasury note at one point reached 1.634% versus 1.623% on the 10-year Treasury at the same time. That’s not a big short-term premium, mind you, but it was an inversion nonetheless. Even though the inversion was only temporary, the two rates have remained very close since then.

This worries the Fed a great deal, especially with the 3-month/10-year yield spread still inverted. The Fed knows all too well that inverted yield curves have preceded every recession in the last 50 years. The average time a recession occurred was apprx. 16 months after the yield curve inversion happened.

The minutes from the last FOMC meeting on July 30-31 show that the Committee discussed the 3-month/10-year yield curve inversion and its implications for the economy should it worsen. If the FOMC lowers the Fed Funds rate, this has the effect of reducing the yield curve inversion by lowering the yield on 3-month Treasuries.

This is why, in my opinion, the Fed abruptly reversed course in late July and began cutting interest rates – not because President Trump demanded it – but because Fed Chairman Powell and a majority of the FOMC members are scared of the inverted yield curve.

Yield Curve Flattens Significantly Due to Low Inflation

Many economists and financial analysts are puzzled over why the US yield curve has flattened so significantly over the last few years. As noted above, the 2-year Treasury note yield and the 10-year yield were both around 1.6% recently versus the 20-year bond yield of only 1.77% and the 30-year bond yield of only 1.95% as of the end of last week. That is really flat.

Normally, these yield spreads are significantly wider. But “normally” doesn’t apply to today’s yield curve environment. While numerous things affect the yield curve slope, one influence many analysts fail to take into effect is the fact that inflation is very low.

For years, long-term bonds had to offer much higher yields to attract investors to compensate for the fact that they were a poor hedge against the biggest worry of the day, namely an unexpected spike in inflation. These days, though, the biggest worry is not inflation but deflation. Bonds happen to be an excellent hedge against deflation because they gain in value when interest rates fall.

This is a roundabout way of explaining why the slightly inverted yield curve – so widely followed that even President Trump tweets about it – may not be as worrisome as it once was. Long-term bonds have become more useful in reducing the risk in investors’ portfolios than they were 20-30 years ago, so they don’t have to offer such high yields to attract buyers.

As a result, the historical upward slope of the yield curve has largely disappeared, and a modest inversion on the short end of the curve, such as we have now, is less likely to be a predictor of a recession than it used to be.

The Fed’s preferred gauge of inflation is the Personal Consumption Expenditures Price Index (PCE) minus food and energy, the “core” PCE Index. The Fed’s target for this Index is 2%, but as we see below, core PCE has been running well below 2%, with a couple of brief exceptions, for over a decade now. The PCE Index rose at an annualized rate of only 1.38% (red line) and core PCE climbed only 1.58% in July.

This explains in large part why people are less worried about a spike in inflation than they used to be. And that means lower interest rates which we all know are good for the economy.

Surge in Negative Interest Rates Tops $17 Trillion Globally

There’s another big reason why US interest rates are near historic low levels and the yield curve is flatter than it’s been in decades. The global amount of negative-yielding debt is now in excess of $17 trillion as rising market volatility lends extra force to this year’s unprecedented bond market rally.

Some 30% of all investment-grade securities now bear sub-zero yields, meaning that investors who acquire the debt and hold it to maturity are guaranteed to take a loss. As a result, foreign money is rushing into the US from the negative yield countries, driving our interest rates lower and lower.

The negative yield phenomenon is turning financial markets on their heads – raising the specter of a bond bubble, draining pension funds of a valuable source of income and incentivizing riskier companies to mortgage their assets. At the same time, banks are having to reassure citizens that they won’t suddenly start charging customers to store their money.

With recession signals flashing around the globe – such as the inverted Treasury yield curve – and with a trade war between the US and China heating up, there are arguments for the stock of negative-yielding debt to keep expanding.

Monetary policy may also play a role, with the European Central Bank set to decide this month whether to cut interest rates further below zero. It could also end up expanding its 2.6 trillion-euro package of quantitative easing to as much as €2.9 trillion.

The following graphic tracks the spread of negative-yielding bonds around the world, broken down by country and by sector:

How Can Government Bonds Have a Negative Yield?

It starts when an investor buys a bond for more than its face value. If the total amount of interest the bond pays over its remaining lifetime is less than the premium the investor paid for the bond, the investor loses money and the bond is considered to have a negative yield.

Investors are willing to pay a premium – and ultimately take a loss – because they need the reliability and liquidity that government and high-quality corporate bonds provide. Large investors such as pension funds, insurers and financial institutions may have few other safe places to store their wealth.

Here’s an example of how it works. In July, investors paid €102.64 for a German bond with a face value of €100. The bond pays zero interest. If they hold it to maturity in 10 years, they will get €100 back. Factoring in the price paid, the smaller amount received back and the absence of interest payments, the yield is -0.26%, and it continues to get worse.

Negative interest rates are terrible for banks. They destroy the banking business model. They make future bank collapses more likely because banks cannot build capital to absorb losses. But banks are a crucial factor in a modern economy.

European banks, for example, are really sick. With negative yields, they’re getting the exact opposite of what they need, and lending in the region is down accordingly. The point is, negative yields are a sign of economic weakness.

At the end of the day, the question is whether the US is headed for negative interest rates. This is why the FOMC wanted to continue raising the Fed Funds rate earlier this year so they would have more room to lower rates in the next recession. Yet they decided to reverse course at the end of July out of fear over the inverted yield curve. Now they have less room to cut rates in the next recession before hitting zero.

With that said, however, I believe the Fed will do everything in its power to avoid negative rates in this country. In Europe, negative rates were initially tried as a short-term emergency experiment. Now it’s the new normal. Let’s hope it doesn’t happen here!

Best regards,

Gary D. Halbert

SPECIAL ARTICLES

Fed Not On Red Alert Over Yield Inversion (Yes, they are.)

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Gary's Between the Lines Blog: CBO: US Budget Deficit To Top $1 Trillion In 2020

 

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