Why the US 10 year yield cant move above 3%

Here is an article I publish for my firm this weekend, hope you enjoy reading it.

Don’t look for higher long term interest rates in the US anytime soon.

Going back to February of last year your humble author has written that the US 10 year would have a difficult time yielding in excess of 3% assuming monetary policy elsewhere in the world remained unchanged. Well global policy does indeed remain the same and promises to continue for the foreseeable future. Despite a 2 month period from Oct thru the end of November, the 10 year has indeed yielded less than 3% and during that period the highest yield was 3.2%. Here is a good reason why the 10 year continues to yield so little:

] Regulatory official says China won't slash US treasury holdings - Bloomberg

• Bloomberg cites Fang Xinghai, vice chairman of the China Securities Regulatory Commission (CSRC), who said at a World Economic Forum panel in Davos that he doesn’t think his country “will in any way significantly reduce its investment into the US government bond market.” Adds that China must invest abroad given its surplus savings and the US government bond market is a good place to invest.

What choice does China have, where else can it go and achieve the same return and security as our 10 year offers? Here is a list of sovereign 10 year bonds that out yield the US 10 year, Brazil (5.45%), Argentina (9.28%), Mexico (4.5%), Greece (4.0%) and Italy…oops Italy actually yields less than the US at 2.6%. There is Japan and Switzerland that offer significantly more security than the previous mentioned countries but perhaps the issue there is they actually have negative yields, an investor would be paying them for the privileged of owning their bonds. France, Germany, Sweden and the Netherlands all yield less than 1%. So at 2.7% the US 10 year is probably the only place that China can go. As long as Japan, the ECB and others continue to pour liquidity in the global marketplace the yield on the US 10 year will be repressed. And it doesn’t appear that anything is really going to change, let’s take a look at Japan:

BOJ leaves policy unchanged, matching expectations

• The BOJ voted 7-2 to leaving short term rates at minus 0.1% and long term rates at around 0%. Also preserved flexibility on yields and JGB purchases. Yutaka Harada and Goshi Kataoka dissented again. Board members voted unanimously to maintain other asset purchases, also maintaining allowance for fluctuations in ETF/J-REIT purchases. They also extended various lending programs for one year.
• According to the outlook report, the BOJ revised down its inflation forecasts: FY18 +0.8% from +0.9%, FY19 +0.9% vs +1.4%, FY20 +1.4% vs +1.5%. GDP estimates for FY18 were revised down to +0.9% from +1.4%, while FY19 was revised up to +0.9% from +0.8% and FY20 was also upgraded to +1.0% vs prior +0.8%.
• The report attributed marginal downward revision to the FY18 GDP forecast to last year's natural disasters, while inflation estimates were driven mainly by falling crude oil prices. The report also reiterated that risks to both economic activity and prices are skewed to the downside.

Inflation forecasts downgraded: According to the outlook report, the BOJ revised down its inflation forecasts driven by falling oil prices, consistent with prior press leaks. GDP estimates for FY18 were revised down significantly, mainly due to last year's natural disasters, while FY19/20 were revised slightly higher. The report also reiterated that risks to both economic activity and prices are skewed to the downside.

Japan exports post biggest drop in two years

Trade growth was weaker than expected in December. Exports posted the biggest since October 2016. Imports slowed sharply compared to the previous month. China weakness stood out. Asia shipments was the main drag on exports, while US/EU demand remained lackluster. Import weakness was broadly based. By product, exports were weighed by tech: semiconductor making/IT equipment, and semiconductor components. IT equipment (from China) was also the biggest drag on imports. Aggregate volumes were also lower on the year. BOJ's real trade indices showed imports outpaced exports in Q4, pointing to a net drag on GDP.

By all appearances Japan will continue to deploy negative interest rates and dump buckets of liquidity into the marketplace, how about Europe?

• ECB to deliver cautious message: The ECB is widely expected to leave its key policy settings on hold today. With no economic updates due and steady policy expected, market participants will scrutinize language in the ECB policy statement and President Draghi's comments related to the policy debate on the Governing Council. Today's update comes against a backdrop of weakening industry and survey data, leaving focus on the assessment of growth risks. In December, Draghi said risks are broadly balanced and slowly tilting to the downside. The other area of attention is whether there has been further discussion on the provision of cheap long-term loans.
• ECB to acknowledge weak growth but keep policy unchanged: Reuters reported that the ECB is all but certain to keep policy unchanged on Thursday but may acknowledge a sharp slowdown in economic growth, raising the prospect of any further policy normalization being delayed. It highlighted that the ECB ended QE last month and maintained its guidance that an interest rate hike is likely late this year. However, growth appears weaker than thought just a few weeks ago, suggesting that its next move could even be an easing of policy rather than a tightening. The article said that the ECB could downgrade its economic assessment on growth risks and might provide clues about new loans to banks, likely to come in the spring.
• ECB faces delicate balancing act in face of weakening growth: The FT discussed today's ECB policy decision and its path to normalize policy, which is being complicated by slowing exports and weakening business investment. It highlighted that President Draghi faces a delicate balance — signaling that it is heeding markets’ concerns over the weak outlook for growth while not sounding so alarmist that investors panic. It said the way to do that would be for Draghi and his colleagues to downgrade the bank’s outlook, saying that risks to growth are now “tilted to downside”, replacing the official “broadly balanced” view.

Europe’s economy continues to sputter, there certainly is a desire (especially among the Germans) to normalize policy and raise rates but extreme weakness in the Euro economy is preventing any changes to its aggressive monetary policy, look for Europe to continue to dump a lot of liquidity into the marketplace. What about elsewhere in the world?

Norges Bank leaves it key policy rate at 0.75%

Bank of Korea leaves repo rate unchanged at 1.75%, matching expectations

One might ask what if the Fed continues to aggressively raise short term rates despite what is happening elsewhere in the world? Looks as if chairman Powell has had a change of heart. After following a path of continued tightening on January 4th in Atlanta he appeared to change course. He said that the Fed would be “patient in tightening policy”, perhaps Global pressures are starting to garner his attention.

If you are an international investor, sovereign or private, there is only one avenue that offers both security and at least some kind of return. As long as aggressive monetary policy is exercised by the rest of the developed world, the US 10 year will have a very difficult time yielding in excess of 3%, in our opinion.

Steve Massocca

Wedbush Inc.

2 Embarcadero Center 6th Floor

San Francisco, CA 94111