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Treasury Market Acts Like the Economy is in a Death Spiral, But Wait…

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Via Wolf Street

This is a transcript of my podcast. You can listen to me on YouTube.

The US Treasury market acts like the economy is going into a death spiral, with the 10-year yield dropping to 2.14% on Friday. That’s below the one-month yield of 2.35%. So why would investors in the Treasury market accept a return on a 10-year investment that is almost guaranteed to remain below the rate of inflation over the 10 years, when they could buy shorter-term securities, such as one-month Treasury bills that offer a higher yield of around 2.35%?

In the past, the participants in the Treasury market have been terribly wrong about this. In these instances, the 10-year yield had no predictive quality. It was just a stupid move by the market, that then self-corrected brutally. The last such massive idiocy happened in 2016, and the good folks who made that move are still ruing the day.

Back in December 2015, when the Fed raised rates for the first time in the cycle, the 10-year Treasury yield was about 2.25%. But it was the time of the oil bust, and in the energy sector, junk rated credit was freezing up as some shale oil-and-gas drillers went bankrupt. So then in early 2016, the Fed indicated that it would pause further rate hikes. Sound familiar?

Starting in early January 2016, the 10-year yield began to drop. And on July 8, 2016, it fell to a historic all-time low of 1.37%. Even during QE, when the Fed was buying these securities, the 10-year yield had never dropped this low. It was just stupidly low. For the next 10 years, these buyers accepted to earn just 1.37% a year.

But then, yields started rising as bond prices fell. Four months later, by November, the 10-year yield had jumped by 100 basis points, from 1.37% in July to 2.37%. In December, it hit 2.6%. In five months, it had jumped 123 basis points. It had nearly doubled.

And then the Fed started raising rates in earnest. One rate hike in December 2016, three rate hikes in 2017, four rate hikes in 2018.

Investors who’d bought that 10-year yield in mid-2016, well, they’re still ruing the day. They can hold on to these things until they mature in 10 years with a return of 1.37% a year. Or they can sell them. If they sold these misbegotten 10-year maturities since then, they booked a sizable loss.

In other words, they’d bought at the historic top of the market. And that bet went bad in a hurry.

And this drop of the 10-year yield in early 2016 to a record low predicted that the economy would spiral down and that the Fed would start a negative interest rate policy. But there was no deflation, there was no economic collapse, there was not even a recession. The prediction by the Treasury market in early and mid-2016 was patently wrong.

This is just one glaring example. The predictions of the 10-year Treasury yield have a well-documented history of being wrong — and also of whipping its participants around and kicking them in the gut.

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So now the 10-year yield has dropped to 2.14%; it’s predicting that the economy will spiral down: and it’s setting buyers up for another round of gut-kicking.

The economy is not spiraling down. The most important factor in the economy that accounts for 70% of GDP is the American consumer; and consumer spending is growing nicely. We just got the last batch of data from the Commerce Department on Friday.

The amount that consumers spent on goods and services in April, the Personal Consumption Expenditures, rose 4.3% compared to April last year, to a seasonally adjusted annual rate of $14.4 trillion.

This 4.3% increase was right in the range since the end of the Great Recession, not the hottest growth rate in the history of mankind, but pretty good.

Adjusted for inflation, the amount that consumers spent on goods and services rose 2.7% from April last year – which was also right in the range since the Great Recession.

So how are consumers getting this dough to spend?

In the same data trove, we learned that personal income rose 3.9% from a year ago to a record $18.1 trillion seasonally adjusted annual rate in April. Adjusted for inflation, real personal income rose 2.4% from April last year, right in line with the past few years.

And where does this growth in personal income and spending come from? Several factors:

  • Population growth (around 0.8% a year)
  • Job growth (around 1.8% over the past 12 months)
  • Wage growth.

Half of personal income comes from “wages and salaries”; the other half comes from other sources of income.

Income from “wages and salaries” rose 3.6% year-over-year to a record rate of $9.1 trillion.

The other half of personal income comes from diverse sources, including these biggies (dollar amounts are annual rates for April):

  • Interest income rose 1.6% year-over-year to $1.6 trillion
  • Dividend income rose 4.0% to $1.2 trillion.
  • Employer contributions to employee pension and insurance funds grew to a new record of $1.4 trillion.
  • Proprietors income of non-farm properties reached $1.6 trillion
  • Rental income grew to a record of $793 billion
  • Social Security benefits that were paid out exceeded $1 trillion.

And this is a lot of moolah going to consumers. Yes, it’s distributed very unequally. And this unequal income distribution, the gigantic and growing divide, is one of the biggest problems the American economy has. But consumers as one lump-sum figure are raking in the money.

So governments take their bite out of this income. What’s left over after the government gets its pound of flesh is so-called disposable income. This disposable income rose 3.8% in April compared to April last year, to a record $16 trillion annual rate.

After inflation, real disposable income rose 2.2%, and this is also in the middle of the range since the end of the Great Recession.

And consumers were even able to save 6.2% of disposable income. Spread out over the year, the increase in savings amounts to nearly $1 trillion.

So, there are more consumers, and they’re making more money, and they’re spending most of it, and this produces economic growth.

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This has also shown up in consumer confidence surveys. For example, the University of Michigan consumer sentiment index for May rose to 100, which is near the very top of the range over the past two decades. It’s only during the years of the Dotcom Bubble that consumers were consistently more excited.

So that’s 70% of the economy. That part is showing decent growth.

Now on the government side: Spending by the federal government is soaring. In the first quarter, spending jumped nearly 6% from a year ago, to an annual rate of $4.6 trillion. This is a huge amount of money, and a huge growth rate. Most of what the government spends ends up in GDP directly or indirectly, sooner or later.

We can argue until our brains fall out whether or not this is what a government should do, and how it should fund this spending binge, but the mathematical result is that this federal spending binge boosts GDP.

So consumer spending is rising and federal government spending is surging.

Now on the business side:

Manufacturing is still growing in the US, but at a much slower growth rate. So there is a slowdown, and that slowdown is likely to get worse. The auto sector is particularly affected.

But manufacturing is a small part of the US economy. Its employment in the US is only 8.5% of private sector employment, down from 30% in 1955.

A big factor of what causes recessions is that people lose their jobs and then spend less. So consumer spending declines when unemployment surges. A decline in manufacturing employment is going to hurt, but these days, it is a relatively small factor.

The by far biggest employer is the service sector.

The two biggest segments in the US economy, each by multiples larger than manufacturing, are finance & insurance, and healthcare. Then there is the whole “information services” segment, such as telecom, data processing, etc. And then there are “professional services,” such as computer programmers, engineers, architects, etc. Those are the top four services segments.

Employment in these segments overall has been strong. And those workers are making a good amount of money, and they’re going to contribute to economic growth until they get laid off, and there are no signs of this happening yet.

So if manufacturing slows down hard, as it did in 2015 and 2016, and services slow down some, we might get one quarter of flat or slightly negative GDP growth. That’s still not a recession. Official recessions include are variety of factors, that last at least two quarters – two quarters of GDP decline, plus surging unemployment rates, a hit to consumer spending, and the like.

I’m convinced that someday, the US economy is going into a recession. Recessions are part of the business cycle. There is nothing abnormal about recessions. They’re a cleansing process that weeds out overindebted companies and gives the economy a fresh start.

But there are just no major signs of a recession yet. And the Fed has been pointing this out for months. It has been pointing this out in its meeting minutes. And a slew of Fed governors, including Fed chair Jerome Powell, have pointed this out in their speeches.

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Even the biggest Fed “doves” have come out to say the economy is in a “good place,” and it would have to deteriorate and inflation would have to drop before it’s time to consider cutting rates.

Minneapolis Fed President Neel Kashkari did so on Friday. He is a super-dove. He said it’s too early to think about cutting rates. Low inflation and the escalating trade war “could be cause for changing the path of monetary policy,” he said. But he wasn’t “quite there yet,” he said. And he added, “I take a lot of comfort from the fact that the job market continues to be strong.”

And on Thursday, Trump’s man at the Fed, Vice Chair Richard Clarida said that the economy is, quote, “in a very good place,” and he said that the economic data would have to reveal a significant risk of a sharper slowdown than the slowdown the Fed already expects, before the Fed would consider cutting rates.

OK, this is not the fastest-growing economy in the history of mankind. Economic growth ebbs and flows. So there will be a period when growth slows from the hot pace last year. But this is not a rate-cut economy either.

And yet, Wall Street is clamoring for rate cuts – now it’s wanting three rate cuts this year. And it is betting on rate cuts – just like it did in early and mid-2016.

There is a reason why bond investors that hold bonds now want a rate cut: Bonds gain in value when yields fall. Big banks and other financial enterprises hold large amounts of Treasuries, and those Treasuries have dished out large amounts of paper losses in late 2017 and 2018 as longer-term yields were rising. So Wall Street is just talking its book when it’s clamoring for rate cuts.

This clamoring has zero predictive quality. It says nothing about what the economy will do next. It’s just a trick Wall Street performs to make more money at the moment. And in a world where nearly everything is overvalued, it’s hard to make money, and for Wall Street anything is fair game.

But there is a good chance that the 10-year Treasury yield will snap back, just like it did in 2016, and jump by a 100 basis points over the span of a few months. And then the wailing and gnashing of teeth by those who’d bought the rate-cut hype at the peak will be deafening. This is a transcript of my podcast on Sunday. You can listen to it on YouTube.

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