Normalize to What?

Despite a disconcerting, growing consensus among investors, the likelihood of a sudden increase in U.S. interest rates is fairly remote for now.

July 29, 2014    |    By Scott Minerd

Global CIO Commentary by Scott Minerd

Recently, as I listen to the growing chorus of investors claiming that U.S. Treasury yields are poised to rise and return to their historical norm, I am reminded of a Keynesian sentiment about the problem with long-term thinking. Last week, for example, I was at a meeting of prominent investors where nearly everyone held the view that rates must normalize. I sat there listening, and thought, "Normalize to what?" As my fellow investors shared forecasts for forward rates and everything else, at one point I remarked that people are flattering the Federal Reserve, giving it too much credit for why long-term interest rates are where they are today.

#Fed says it will keep rates low even after employment & inflation meet targets. That says it all!


What I mean by this is that when I look around the world and consider what is going on, it is hard to argue that U.S. 10-year Treasuries with yields hovering near 2.5 percent are unattractive compared to 10-year Japanese government bonds yielding close to 50 basis points. German 10-year bunds are yielding a historic low of just over 1 percent with the Treasury/bund spread as wide as ever. Even in troubled Spain, benchmark borrowing costs in recent days have at times dipped below 2.5 percent -- their lowest yield since 1789. Add to that the perception that both the yen and euro are seemingly a one-way bet toward depreciation and it is reasonable to expect that international capital will continue flowing toward the United States, pressuring U.S. Treasury yields down as quantitative easing draws to an end.

Most investors can agree that loose monetary policy and quantitative easing have caused overvaluation in some spheres of U.S. credit. Even Federal Reserve Chair Janet Yellen has said that some leveraged credit is showing signs of frothiness. But the palpable fear that the Fed’s eventual hiking of short-term interest rates will prompt a general upward shock in interest rates and an abrupt repricing of credit risk and U.S. Treasuries is getting overplayed and too much attention. The reality is that with international demand for U.S. Treasuries likely to increase and the size of incremental U.S. government borrowing expected to decline because of shrinking federal budget deficits, U.S. Treasury yields could move lower.

The likelihood that we are going to have a sudden, ugly increase in interest rates seems fairly remote for now. As for the long-run, well, the consensus view of interest rates normalizing will eventually come true. The problem with that thinking may lie in the definition of "long-run." As John Maynard Keynes wrote in "A Tract on Monetary Reform" in 1923, "In the long-run we are all dead."

History Suggests U.S. Treasury-Bund Spread May Tighten

It is hard to argue that U.S. Treasuries are overvalued with yields around 2.5 percent compared to German 10-year bunds yielding near historic lows just above 1 percent. The spread between Treasuries and German bund yields, at 138 basis points, is rapidly approaching record levels. The last two times the spread was so wide it soon reversed course. Unless bund yields head higher, unlikely given accommodative ECB monetary policy, Treasury yields could fall in the near term.



Source: Bloomberg, Guggenheim Investments. Data as of 7/30/2014.

Economic Data Releases

U.S. GDP Bounces Back in Second Quarter

  • Second-quarter GDP rebounded 4.0 percent at an annualized rate, following the first quarter’s revised 2.1 percent fall. Consumer spending on durable goods was strong and business investment rose 5.9 percent.
  • New home sales fell more than expected in June, down to 406,000 from a sharply revised 442,000 in May.
  • Pending home sales unexpectedly declined in June, falling 1.1 percent after three months of increases.
  • The S&P/Case-Shiller 20-city home price index continued to show slower growth in May, decreasing to 9.3 percent year over year from 10.8 percent, the slowest since February 2013.
  • Durable goods orders were better than expected in June, up 0.7 percent after falling by 1.0 percent in May. Non-defense capital goods orders rose a strong 1.4 percent.
  • The Conference Board’s consumer confidence index rose for a third straight month in July, increasing to 90.9, the highest level since 2007.
  • Initial jobless claims dropped to 284,000 for the week ended July 19, the lowest level since the current expansion began.

Euro Zone and China PMIs Expand

  • The euro zone manufacturing PMI ticked up in July to 51.9 from 51.8, with the services PMI reaching the highest level since May 2011.
  • Euro zone economic confidence inched up in July to 102.2 from 102.1.
  • The manufacturing PMI in Germany was stronger than expected in July at 52.9. The services PMI reached a three-year high.
  • Germany’s IFO Business Climate index dropped for the third month in a row, falling to 108.0 from 109.7, with both the current assessment and expectations down.
  • France’s manufacturing PMI fell for a fourth straight month in July to 47.6. The services PMI returned to expansionary territory after contracting for two months.
  • U.K. second-quarter GDP expanded at 0.8 percent, meeting expectations.
  • China’s HSBC manufacturing PMI showed the fastest pace of expansion in July since January 2013, rising to 52.0.
  • Japan’s CPI slowed slightly in June, decreasing year over year to 3.6 percent from 3.7 percent. Prices excluding food and energy ticked up to 2.3 percent.
  • Industrial production in Japan dropped 3.3 percent in June, the most since the 2011 earthquake.


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