When the economy slows, tax receipts to the government, necessarily, will fall. At the exact time that we need, and expect, bond yields to move lower, they could do exactly the opposite.
As the economy slows, the government still needs to fund the budget, including paying interest on the national debt, defense expenditures, entitlements, federal employee pensions, etc. If tax receipts are not enough to fund these obligations, then the government will need to take on more debt by selling Treasury bonds to fund the obligations, which could cause yields to skyrocket, as investors demand more and more yield (and, perhaps, the term premium rises where capital is not being attracted), and as other investors discontinue viewing U.S. bonds as safe havens and move to other assets, including other select countries sovereigns that are unlikely to fall further, while offering good yields that justify the risk. The 10-yr. Treasury yield could completely disconnect from the economy (or from the needs of the economy at that time), and the yield curve could aggressively steepen- sending a slow economy into recession, or one that is already in recession- even deeper. Because of the government’s excessive and growing funding needs, even the floating 10-yr. yield would be out of the control of market dynamics and market demands. The President recently, strangely, is beginning to publicly excuse and accept “deficits”.
Why are yields suddenly rising?
The 10-yr. yield is rising as economic data points in the U.S. are declining. Even as the economy slows- as we’ve recently seen lower than expected PPI and CPI prints, lower consumer spending, a rising target Fed funds rate and 2-yr. yield, higher consumer and federal debts and deficits, consensus expectations of lower GDP prints ahead, EPS buttressed by tax cuts and stock buybacks with less of these impetuses ahead, an increasingly challenged housing market; corporate debt is growing; much Dow and S&P growth due to rising interest rates and bank stocks and rising energy prices and energy stocks (these are taxes on businesses and consumers); and reports on capex (how much and what on) are mixed and unclear- there still may be a floor on the 10-yr. yield due to the need to fund deficits- and the yield curve (or yield curves) may never invert- even as recession looms or arrives. The safe-haven nature of the U.S. 10-yr. Treasury bond may be compromised by the deficit.
Are we experiencing economic growth- or, rather, a rise in inflation expectations? Stocks have been rising while yields have been rising. Many analysts, portfolio managers and market participants and observers are pointing to bullishness on the U.S. and beliefs in bottoming in select EM markets as the reasons. As oil and gas prices and interest rates have been rising, taxes (tariffs) on consumer goods from China have been announced, labor markets are tightening- the U.S. dollar is weakening. This certainly sounds like inflation, or, at the least, inflation expectations. On the day President Trump announced his final decision on the most recent round of tariffs on China’s goods, yields spiked and the U.S. dollar sank.
The question is whether there is inflation- and growth. Growing economies with rising interest rates do not see their currencies weaken. Semiconductors can be leading indicators for the economy.
We will see what the next GDP print and upcoming earnings present. Remember that EPS growth is not net income or revenue growth- earnings can rise by decreasing stock floats. Even where there is revenue growth to exhibit true organic growth, consumer, corporate, and government debt-spending is what is helping create those revenues- and the cost of debt is rising. GDP and earnings show us levels of spending and revenue growth, but don’t explain the countervailing debt that was incurred to achieve these growth outcomes.
Regardless of why the 10-yr. is suddenly rising – anticipated earnings growth, China’s selling of U.S. Treasury bonds, inflation fears, quantitative tightening, expectation of growing U.S. Treasury bond offerings, re-allocations to EM assets, the tapering off of pension fund bond purchases, tariffs and product price inflation, or any mix thereof, the issue of the deficit (unless we grow out of it) remains, and will worsen as and when the economy slows. So any rises in yields will be in addition to the above reasons and will only be compounded if deficit concerns persist, and Treasury sales grow.
In any event, budgets and deficits can’t be funded by endless debt and bond offerings. The budget, by and large, has to be funded by income and tax revenues.
At the 1988 Republican National Convention, when accepting the Republican Party’s nomination as their candidate for U.S. President, George H.W. Bush famously made the statement, “Read my lips: No new taxes” to assure voters that his administration would not raise taxes on Americans. By 1990, rising budget deficits fueled by slowing growth and mandatory spending, greatly increased the federal deficits. As the result, on November 5, 1990, President Bush, grudgingly, signed The Omnibus Budget Reconciliation Act of 1990 that raised multiple taxes.
This decision was the equivalent of Present Bush signing his own political death certificate as Bill Clinton used this broken promise on taxes against Bush in the 1992 presidential campaign (yes- Bill Clinton actually used the issue of “truthfulness” against someone- and it worked; irony- and gall- in politics- and in life- never cease to amaze).
President Trump may face a George H.W. Bush “Read my lips: No new taxes.” moment where, despite prior promises and actions, he, nevertheless, has to agree to raise taxes to fund on-going budget deficits- regardless of which party controls Congress- or else allow longer term Treasury yields to soar, especially where rate cuts by the Fed would be difficult if the Fed funds rate and related shorter term Treasuries are still low- one of the reasons (one of the main reasons) that the Fed points to any scintilla of inflation to use as an excuse to keep raising rates- as insurance for the future. The Fed would not be able to rescue the economy with rates cuts designed to stimulate growth- at least not without cutting to zero.
Hopefully, in such case, U.S. bonds would become more appealing to investors as tax hikes (hopefully) bring deficits under control, allowing rates to decline, and a new economic cycle to begin. With higher taxes ad little room for the Fed to lower rates, it would be a challenge.
So, to the initial query:
What would be far worse than an inverted yield curve in a slowing economy?
A steep yield curve in a slow economy where lower tax receipts to the government mean bigger deficits, causing higher costs of capital to businesses and consumers, accompanied by a weak dollar from sluggish or negative growth, and with higher taxes to follow … all at the worst possible time.
Everyone assumes that if we see a weak economy we will get low interest rates and low yields. But, just look around the world; if fiscal discipline is absent, it may not go that way. Everyone assumes that higher interest rates and high yields mean a strong currency- but, just look at what is happening in the United States today.
- The U.S. dollar would be weak, even as yields climb, due to deficits and due to the expectation of low internal rates of return due to an economic slowdown.
- At this stage of the cycle, wage inflation may be more of an expense (rather than a demand side stimulus), and, anyway, is offset by the rising commodities costs (namely, energy) and higher interest rates (both of which, along with tight labor markets, appear late in business cycles). It’s unknown, and unknowable, how wage inflation earlier on in the cycle would have helped or hindered growth.
- It was, actually, the overall sluggish economy, probably combined with many American’s “Republican-fatigue” after twelve years of a Republican White House (all of which included Bush) that contributed to President Bush’s defeat- plus the possibility that many Ross Perot votes would, otherwise, have gone to Bush.
- Certain dynamics could offset rising yields, such as, at a certain point, high yields attracting yield-seeking capital that helps push yields lower.
- A few things to note about people on “Wall Street” (analysts, CEOs, portfolio managers) to keep in mind as you evaluate markets and the economy:
- They either didn’t see or didn’t warn about the 2007 housing crisis (as some investment banks were selling housing securities short).
- They touted a “global coordinated” growth story for months in 2017 and 2018, that never panned out- quite the opposite.
- They spent the latter parts of 2017 and early 2018 recommending emerging market stocks and bonds to everyone – Great call!
- You never see calls from investment banks about shadow banking risks (even China had enough sense … and transparency… to try to step-in on and reel-in theirs. It’s only when asked – such as on Bloomberg TV- that Wall Street concedes to a possible problem. This whole shadow banking issue is addressed when brought up, but glossed over … and percolates below the surface, along with other non-regulated high return debt investments.
In light of the above, when “Wall Street” over and over, stresses a 2020 slowdown in the economy and stocks – you can be sure that they will not be waiting until 2020 to do something about it. In 2019- not in 2020- they will be getting their clients out of the market long before “you” are out. So, don’t wait until “they” call the slowdown and alert you. It will be too late. Look at CPI, PPI, expected GDP, consumer spending, interest rate trajectories, housing permit applications … the slowdown is here.
Neil S. Siskind, Esq., President
The Siskind Law Firm
Neil Siskind is the Founder & Chairman of The Fatherhood Assignment
Learn more at: http://www.neil-siskind-the-fatherhood-assignment.org/
Neil Siskind is the Conservator of the Neil S. Siskind Nature Preserve
The Neil S. Siskind Nature Preserve is over 7 acres of environmentally-pristine waterfront land in a magnificent setting along New York’s majestic Hudson River. The Preserve includes a variety of species of animal and plant life, and is a precious example of the thoughtful maintenance of New York’s priceless open spaces. The land’s uses are limited to outdoor recreation such as hiking and climbing, and the study of ecology, nature and land use. The Neil S. Siskind Nature Preserve allows for the intelligent contemplation of our valuable natural resources and the most effective ways to maximize them and keep them protected.
Neil Siskind, Founder, “National Fatherhood Day” – March 29th
Read about the non-profits and charities whose missions Neil Siskind supports and promotes: www.neilsiskindsupports.com
Caring is Free®
You can read what clients and associates say about Neil Siskind at: http://siskindlawfirm.com/neil-siskind-bio/.
Neil Siskind’s Volunteer Work:
– Memorial Sloan Kettering Cancer Center, Volunteer
– Memorial Sloan Kettering Cancer Center, My Fundraiser- Help Neil Siskindhelp children with cancer to be more comfortable: http://mskcc.convio.net/site/TR?px=3182108&fr_id=2632&pg=personal
– Make-A Wish Foundation- Help Neil Siskind make sick children’s wishes come true by creating your own fundraiser: Neil-Siskind/Help-Make-A-Child-Smile.htm
– DonorsChoose.org- Donate to one of my needy public classrooms: http://www.donorschoose.org/NeilSiskindGiving
– Champion Children– We seek to inspire people through stories of children who have overcome challenges: http://siskindlawfirm.com/neil-siskind-champion-children/
Neil Siskind’s Pro Bono Work:
– Saving Senior Citizens- Protecting New York’s senior citizens from fraud and financial abuse www.savingseniorcitizens.com
– Senior FreeStart Business– Pro Bono: We seek to help put senior citizens in the right direction so that they can face the challenges of the modern economy: http://siskindlawfirm.com/free-start-business/
– Veteran FreeStart Business– Pro Bono: We seek to help put Iraq and Afghanistan war veterans in the right direction so that they can face the challenges of the modern economy: http://siskindlawfirm.com/free-start-business/
– In development: The Neil S. Siskind School of Hope: A free school to teach inner-city youths the skills of entrepreneurship and importance of economic self-sufficiency.
Neil Siskind’s Government Work:
– Suffolk County District Attorney’s Office, Boston, MA, 1994, Intern
– Office of Senator Christopher J. Dodd, Newington, CT, 1992, Intern
– Hartford County Department of Probation, Hartford, CT, 1991, Intern
Neil Siskind’s Community Assistance:
Financed & operated a legal clinic providing low-cost legal services to struggling Long Islanders during the recession to help clients resolve debt, organize finances, and launch new businesses.
Neil Siskind’s Professional Curriculum Vitae: http://neilsiskind.com/
Inventors, IP Owners, Manufacturers
Learn How To Bring Products To Market And To Expand Your Distribution Channels
The Complete Guide To The Ways To Manufacture & Sell Your Products