Sell your bonds?

RYAN  By Guest Blogger Ryan Lewenza

With our expectations for a Fed rate hike of 25 bps in December, and two more 25 bps hikes in 2017, should clients/investors be selling their bonds? The answer is an emphatic no!

In my last blog post I highlighted the significant back-up in US government bond yields on expectations that Trump’s policies will lead to higher inflation down the road. For example, the US 10-year Treasury yield has surged 60 bps to 2.40% since the November 8 election day.

With the back-up in bond yields (and declines in bond prices) we’re once again hearing from the financial media and so-called “experts” that the 35- year bull market in bonds is about to end and that investors should rush out and sell their bond positions before it’s too late.

If I had a dollar for every time I’ve heard this in recent years I would have about $25 or just enough to buy a Trump “Make America Great Again” hat.

So Ryan, which is it? You see further Fed rate hikes but continue to recommend exposure to bonds?

Essentially, we believe interest rates have bottomed and will grind higher over the next few years but believe the Fed will be glacially slow in raising interest rates and see rates remaining low from a historical context. Here’s why.

First, we see interest rates remaining lower than normal because the US government simply cannot afford significantly higher interest rates given their ballooning US debt load. While the Republicans like to blame the Democrats for the out of control deficits and debt load, the reality is both parties have contributed to the massive US debt load. Under President Bush II, US federal government debt doubled from roughly $5 trillion to $10 trillion, and under President Obama, it doubled again from $10 trillion to the current $19.9 trillion level. Incredible! A couple of wars and a major economic meltdown can add up pretty quickly.

Now what’s interesting is that the interest expense on this debt as a percentage of the overall US budget has actually declined from roughly 20% in the 1990s to just 10% today. How can this be? The answer is that as government bond yields have declined to historic lows, this has more than offset the impact from the dramatic rise in debt over this time.

With the US government owing nearly $20 trillion, if interest rates were to jump materially from their current low levels this would dramatically increase interest servicing costs, putting serious stress on the US budget and spending programs. The Congressional Budget Office (CBO) projects interest costs to rise 250% from current levels if the 10-year yield rises to 4% by 2026. By 2030 they see interest costs representing over 14% of the federal budget versus 10% today, and rising further in future years. Given this, and the fact that the US population is aging, which will only add to increased costs in the coming years, the US government can simply not afford significantly higher interest rates, which we believe will help to keep them well anchored at historically low levels.

US Gov’t Interest Expenses Have Declined With Low Rates


Source: Bloomberg, Turner Investments

The second reason we see US (and Canadian) interest rates remaining relatively low is that they are approaching “fair value” based on our model for forecasting interest rates. I’m going to get a bit geeky here but I built a financial model using different inputs (e.g., inflation, economic activity), that has helped explain/predict the level of the US 10-year government bond yield. My model, which has a high level of predictability (high R-squared for you quant geeks), currently suggests “fair value” for the US 10-year yield of 3% compared to current levels of 2.4%. So, we see interest rates rising a bit further from current levels but for the US 10-year to be capped around 3% over the next year.

Turner Bond Model Suggests 3% 'Fair Value' US 10-Yr Yield


Source: Bloomberg, Turner Investments

Finally, another important reason why we see interest rates remaining low is due to the aging demographics in the US and across the developed nations. Economic growth over the long-run is driven by two key factors – population growth and productivity gains. Both of these factors are in decline, in large part due to our aging population. Below I illustrate this with US population growth declining from 1.7% annually in 1960s, to 1.4% in mid-1990s, to just 0.7% today, according to The World Bank.

The simple fact is that while Garth Turner can continue to pump out six meaty blog posts a week, many of his contemporaries are just not as productive as us 40-year olds, or those pesky millennials. A millennial these days can order a low fat mocha Frappuccino from Starbucks, pay a bill on their mobile phone, upload pictures from the previous night’s dinner at some trendy restaurant on Instagram, and try to save the world all at the same time! I can barely write this blog and drink my Earl Grey tea without spilling it all over myself.

So millennials, the next time you want to blame your parents and grandparents for leaving this world and the future in worse shape than their parents, remember to thank them for being old and them greatly contributing to the current record low interest rates that are allowing you to lever up and buy that million dollar home.

Sorry I went on a rant there, but to conclude, we see interest rates slowly grinding higher over the next 1-2 years, but see them remaining low from a historical perspective, and why we believe investors should not rush out and sell all their bond holdings. They continue to be important in portfolios as they help to provide balance and stability, while also providing a little insurance just in case the millennials are correct that the world is going down the tubes.

Declining Population Growth Should Help Anchor Rates


Source: Bloomberg, Turner Investments
Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.



Another day. More reasons to fret about the future value of your home. They’re coming faster and furiouser than Vin Diesel flicks.

And then there were but two…
National Bank has just pulled out of the mortgage brokerage business, leaving only two major banks (Scotia and TD, for now) willing to fund home loans through the broker channel. The move seems a direct result of Wild Bill Morneau’s draconian moves to tighten up on lending, reduce loans to certain borrowers (kids, the self-employed, amateur landlords) and try to wrestle the gasping, bloated real estate gasbag softly back to earth before it blows up the entire deplorables class.

It’s “a stinging blow” says the leading mortgage brokerage site, and although National will continue for the time being to offer money through a third-party provider (Paradigm Quest), but this is no vote of confidence in the entire residential real estate scene.

“Anything but normal.” Ya think?….
Blood continues to seep out of Vancouver houses and rivulet down the gutters. The latest sales numbers are just as bad as the ones published last month. On Friday the Van board announced a 37.2% plop in deals during November, coming after a 38.8% rout in October. Ouch.

“While 2016 has been anything but a normal year for the Metro Vancouver housing market,” said cartel boss Dan Morrison, practicing for his gig at Yuk Yuk’s, “supply and demand totals have returned to more historically normal levels over the last few months.”

The average detached house price has dropped in price by just over $200,000 now. Last month the benchmark was down 2.2% from the previous month (26% annualized), and sales have collapsed 52% from this time one year ago. In the entire region, only 638 changed hands. Still working on his routine, Mr. Morrison put on his clown shoes and said, “detached homes are seeing modest month-over-month declines.”

“Wait and see” time in the Big Smoke…
Despite rising prices and a paucity of listings, some Toronto realtors are trying to frame news of the inevitable declines to come. “The urgency seems to be seeping out of Toronto’s real estate market as the year comes to a close,” reported Canada’s national house porn journal, the Globe and Mail, as the week ended.

“I think people have frankly gone into a ‘wait and see’ mode,” agent Janet Lindsay says. The reasons are simple, obvious. Trump. The bond market. Mortgage crackdown. And unsustainable prices in the GTA, where the average suburban house is now almost a million. There’s something in the air. Not snow.

Well, so much for that bronco…
Poor Cowtown. Things were looking so frisky for a month or two as house sales popped higher, breaking a year-long string of losses. But, alas, we are gelded once again. “The gains in last month’s sales were temporary,” says CREB chief economist Ann-Marie Laurie. “Stringent conditions for borrowers are converging with the current economic climate and weighing on demand.”

She means Wild Bill’s new rules, combined with 21,000 lost jobs, apoplectic landlords and tumbleweeds rivalling cars in downtown Calgary. Property sales last month were 17% below long-term averages with prices running about 4% less than year-ago levels. For the first time in almost three years the typical detached house is changing hands for less than $500,000.

Just eleven more sleeps…
After the latest US job stats, there’s no doubt American interest rates will be heading higher on December 14th. Close to 180,000 new hires came on stream, with the unemployment rate falling to 4.6%. Given American (and Canadian) demographics and a huge wave of retiring Boomers, this is now considered full employment.

Combine that with the bond market massacre since that goofy billionaire was elected, a stock market surge, looming tax cuts, inflationary government stimulus spending, raging greenback and an outbreak of trade protectionism, and you have the perfect storm for the rising cost of money. The Fed will move next month and (markets believe) twice more in 2017. Given Canada’s better job numbers and GDP growth, plus steamy bond yields, the next Bank of Canada move will be up, not down.

Well, that’s today’s news. Join me for a scotch? Or three?