Common Cents & Falling Interest Rates on August 16, 2019

August 16, 2019, by John Norris

What an awful week, I mean really. It is too hot to much of anything outside other than sweat. However, if you stay inside, you are probably going to watch the markets flummox about and the rest of the world try to tear itself apart at the seams.

For some reason, as I was reading yet another depressing story on some news service this week, a song came into my head and become something of an earworm. It is an old one, which most people probably wouldn’t remember today, let alone the artists The Kingston Trio. However, my father played Kingston Trio records over and over again when I was a child, and particularly liked this one which I found funny. It is called the “Merry Minuet,” and I will simply paste the lyrics below. Trust me, the recoding industry probably wouldn’t release something like this today, even if it swamps listeners with prurient drivel. Here goes:

 

“They’re rioting in Africa

They’re starving in Spain

There’s hurricanes in Florida

And Texas needs rain

The whole world is festering with unhappy souls

The French hate the Germans, the Germans hate the Poles

Italians hate Yugoslavs, South Africans hate the Dutch

And I don’t like anybody very much!!

 

But we can be tranquil and thankful and proud

For man’s been endowed with a mushroom-shaped cloud

And we know for certain that some lovely day

Someone will set the spark off

And we will all be blown away!!

 

They’re rioting in Africa

There’s strife in Iran

What nature doesn’t so to us

Will be done by our fellow man”

Even when I was a kid, I got the joke. As an aside, during the summer of 1990, after some courage of a sort, I sang this song at a marina in Hilton Head to a group of 50 unfortunate souls, and about half of them sang along. This was just after the early bird happy hour had ended. Two types of folks go to those, and I was one of them at the time.

With this little ditty in my ear on Thursday, I watched the Bloomberg screens in astonishment, yet again, as the yield to maturity on the 30-Year US Treasury Bond fell below 2.00%. This was an all-time first, and the thing ended up hitting 1.915% before eventually closing the day at 1.97%. Heck, it was 2.26% last Friday. That type of move is almost mind-boggling to bond nerds.

So, let’s all say in unison: “how now brown cow?” The US Treasury, the US Federal government, the same folks that have run up a $22-23 trillion tab, can borrow money for 30-years, three decades, at 2.00%? That is a full percent lower than the generally accepted historical rate of inflation, 3.00%. And that is the US! In Europe and Japan, the central governments get to borrow at negative rates of interest. That is right: the lender/investor pays them to hold onto their money!

What ever happened to coffee cans, home safes, gold & silver coins, and safe deposit boxes? Only The Shadow knows.

IF you go back to your Econ 101 class, you might remember supply/demand curve graphs. If you remember anything from that intro course, it is probably the price of anything goes down when the supply of it goes up faster than demand, and the inverse holds true. This makes sense. Since interest rates and bond prices move in opposite directions, lower interest rates can only mean the demand for debt is going up fast than supply.

How can this be with the world awash in debt as it is? The US Treasury alone has all those IOUs outstanding! Other countries are even worse on a debt to GDP basis. How can the global demand for debt be greater than the supply? Has everyone lost their minds? Probably not.

You see, the global economy generates a lot of money each and every year. According to the World Bank, global GDP (Gross Domestic Product) was $80.886 trillion (USD) in 2017. Also, according to the World Bank, gross savings as a percent of global GDP was 25.23%. Doing some quick math, that works out to be $20.408 trillion each and every year that needs to find a home in some form of savings and/or investment vehicle or heaven knows what else.

Throw in how the world’s central banks have maintained their bloated balance sheets since the last financial crisis, and, whew, that is a lot of money sloshing about the global economy looking to find a home. For kicks, if you are old enough to remember the man, imagine Carl Sagan saying: “trillions upon trillions of dollars.” Admittedly, it doesn’t take much to tickle me.

Since supply/demand curve graphs are incapable of lying, that has to be the only possible answer: too much money and too few investment opportunities, as incredible as that may seem. Interestingly enough, emerging economies have dumped a lot of money into the US Treasury market, which hasn’t been the case for very long.

We have all read about how much US Treasury debt the Chinese, Japanese, and US Federal Reserve own, but consider this: India has increased its holdings by over $120 billion over the last 10 years. Brazil has added over $160 billion. Thailand’s holdings have grown over $50 billion, and Singapore’s are about $100 billion higher…as are Saudi Arabia’s. Then there is the great Celtic Tiger, Ireland, which has gobbled up an additional $210 billion of the things over the last decade. Finally, as this is getting kind of repetitive, and I suppose fears over Brexit might play a part, the British have tacked on an additional $250+ billion worth of US Treasury securities since June 2009.

Obviously, the US is a big importer of capital from around the world. Why? Well, the simple answer is: the money has to go somewhere, and the US has the largest, most dynamic, most liquid, and most transparent financial system in the world (even if our friends in London might argue the point). The US $100 Note is the preferred store of value in many emerging economies and black markets. The USD is the world’s primary reserve currency, with no real immediate threat due to the size, depth, and breadth of our banking system.

The kneejerk question to this information is: if the US financial system is so great, why don’t US Treasury securities have a negative yield like they do in, say, Japan and Europe? Great question, and I would answer it thus: 1) more confidence and better demographics in the US economy over the long-term; 2) the Federal Reserve has opted (to date) NOT to go into ‘negative interest rates’ with the overnight lending target rate, as have the Japanese and Europeans (Eurozone) with theirs; 3) fewer ‘domestic’ options for the others to soak up the higher savings rates in both Japan and Europe, both relative to the US.

An academic might be able to come up with a few more reasons, but these answer the question more than sufficiently enough for the vast majority of the curious.

But why this week? What happened to cause the 30-year Treasury to fall below 2.00% and for you to have that old song stuck in your head?

Well, atop the general concern about a global economic slowdown, two things: 1) a primary election in Argentina, and; 2) civil unrest in Hong Kong. First things first, Argentina is somewhat major economy in South America which occasionally finds it difficult to pay its bills. The previous regime, led by the Peronist Kirchner family, pretty much spent the country to the brink of disaster, piling up bills the country could neither pay or wanted to pay. The solution was a supposedly pro-business, no nonsense sort named Mauricio Macri who embarked upon some prescribed austerity measures which haven’t much helped the Argentine economy or made a lot of friends. As a result, it seems the crowd wants a return to Peronist profligacy, which will likely lead to another default and economic dislocation, as the leftist ticker (including previous President Kirchner) won a resounding victor in the primaries. More to come on this as we lead up to the final vote in a couple of months.

Then, there was the continued protesting in Hong Kong against an extradition law which the government had postponed. It seems the law was the tipping point, the proverbial straw that broke the camel’s back, as it unleashed a torrent of overall grievance against the local government, and Beijing by association. Of course, the remainder of the world has been anxiously waiting to see whether President Xi will call in the PLA to quell the protests and restore general order. If it does so, it would suggest the 1 country / 2 systems form of government would be at an end in Hong Kong. Since a lot of money flows through Hong Kong and it has an outsized economy for a territory its geographic size, what would this mean to the flow of funds through the global economy? What would this mean for trade throughout Asia? For transportation? All of it.

While far apart, the common thread between the two situations was discontent with the status quo. This seems to be the norm throughout the world these days. I mean, Venezuela has collapsed. There are severe riots in Harare, Zimbabwe over the mismanagement of that country and the threat of starvation for up to one-third of that country. The Iranians are threatening shipping in the Gulf. North Korea started back up with its old tricks this week. Extreme heat from Texas to the Atlantic Ocean is taxing our already taxed energy grid, with temperatures over 100 degrees across much of the area…putting everyone in a bad mood. What is next, a hurricane in the Gulf? Yep, Things really stunk this week.

When things stink what do people do with their money? That’s right, they opt for some measure of safety. What are the presumed safest investments in the world’s largest, most dynamic economy with the greatest prospects for growth? That is right: US Treasury securities.

But Is the rally in Treasuries a little overdone? Personally, I think it is. While the bond market rarely lies, it isn’t always accurate either. After all, we saw yields plummet a couple of years ago for no apparent reason, and I have seen short-term freak outs on more than one occasion in my career. That doesn’t mean we are in the clear, or what have you. It simply means the bond market is ‘flashing’ a much worse future than what the rest of the readily available information suggests is possible.

In the end, let me leave you with this one: when there is rioting in Africa, when there is strife in Iran, and when Texas needs rain, buy the 30-Year and make a few bucks.

Have a great weekend.

 

John Norris