Corporate Finance: Why you Should pay Attention to 10Y Treasuries Going Up
Corporate finance columnist Les Nemethy looks at why investors need to take heed of rising treasury rates. Even if you do not own Treasuries, rising Treasury rates are arguably the most important event in financial markets this year so far: 10Y Treasuries bounced from a low of 0.52% on August 5, 2020 to 1.15% on January 15, 2021.
So, why is this so significant? First, it signals an increase in financing costs, not just of government debt, but for housing, corporations, mortgages, etc. When there are such massive amounts of government, corporate and individual debt, both in the United States and worldwide, any increase in financing costs sucks oxygen from the economy.
Just to put this into perspective, U.S. Government revenues are USD 3.3 trillion per annum, and the States has some USD 27 tln of debt and potentially USD 100 tln plus of off-balance sheet liabilities (pensions, etc.), as Luke Gromen discussed recently on the Erik Townsend podcast Macro Voices.
Global debt has been growing for a number of years, and has now surpassed USD 270 tln, some 370% of global GDP, as illustrated in this chart.
The second reason is that rising interest rates will affect asset valuations, which are exploding in the current market. Indeed, the S&P index is in record territory, by just about any metric.
Other stock exchanges, both in the United States and globally, are heading into similar record territory, as are various commodities, real estate in several markets.
The only possible justification for such valuations are the record low interest rates. As interest rates rise, valuations will become ever so more fragile. Markets may experience what I call a “road runner” moment: as the cartoon character runs over the cliff, he treads on thin air for a while; when he looks down, he crashes.
Third, one should look at the reason for the rise: an increase in inflation expectations driven by a massive double whammy of record monetary and fiscal stimulus. Last year’s surge in U.S. money supply was the largest in 150 years. Monetary stimulus will likely be even larger in 2021.
The Fed needs to refinance some USD 7 tln in maturing debt this year, and will need to fund the USD 2 tln stimulus program announced by new President Joe Biden, as well as many other new programs.
Many market watchers have discussed how this is likely to feed inflation in the mid- to long-term, once we have the deflationary forces of COVID behind us, (including myself in one of my former columns).
Should inflationary expectations, and hence Treasury rates, rise further, the U.S. Fed will have one of two choices: crush the economy, or crush the dollar (and hence ignite U.S. inflation). Let me explain.
Crush the Economy: If interest rates continue to climb, enormous pain will be felt throughout the economy, individuals, corporates and even government will strive to make interest payments, driving out other types of spending (or in the case of government, creating an even steeper debt spiral), thereby crushing the economy.
Crush the Dollar: To save the economy from tanking, the Fed may engage in yield curve suppression (in other words, keeping yields low by buying bonds, thereby driving bond prices up and yields down), which is likely to crash the U.S. dollar. This will have numerous knock-on effects, such as importing inflation into the United States.
The above choice puts the Fed between the proverbial rock and a hard place.
So, which of the two is the likelier option? Given that politicians have little tolerance for recession and want to be re-elected, probably crushing the dollar (although the Fed will probably want to defend the dollar while it can).
So, what might investors do? I would suggest four things. Firstly, avoid not only Treasuries, but also government bonds in all countries where national debt is high and spiraling higher. There is every likelihood that financial repression (real interest rates below interest rates) will reduce purchasing power of your investment). Unfortunately, eliminating or reducing government bond exposure in your portfolio also reduces your ability to mitigate risk.
Secondly, create or maintain an appropriate degree of liquidity (in cash, for example, or short-term bonds).
Thirdly, consider hedging up to 5% of your portfolio in physical gold. Gold is an excellent hedge, a form of insurance, in case the wheels come off, with thousands of years of history. (At the height of hyperinflation in the Weimar Republic, you could buy a large villa in suburban Berlin, for just five ounces of gold). The USD has lost 98% of its value since going off the gold standard in 1971.
Finally, for now, also invest a portion of your portfolio into stocks or other assets that produce yield. This is the most challenging part of the investment equation. How do you generate decent yields at acceptable risk levels? Markets today are in a relentless quest for yield. There are no easy answers here; the decision is very personal.
So, if you have not done so up to now, watch the Treasury yield curve, not only because it determines the cost of money, which financially fuels the world, but because trends in government bond yields provide a harbinger of things to come.
Note: Do your own due diligence and discuss any investment decisions with your financial advisor before making any investments.
Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. A former World Banker, he is author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.
This article was first published in the Budapest Business Journal print issue of January 29, 2021.
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