Tipping The Scale

The long end of the Treasury market has been overpriced with yields too low for years. There are two reasons for this.

First, bullish traders continued to anticipate an economic slump. It never happened, but that was the consensus, and the Fed supported that by keeping rates too low for too long.

Second, and more important, the Fed placed a heavy hand on the scales by buying almost $4 trillion in securities and distorting the pricing of bonds. That’s now going away. The Fed will be out of the buying business in 2018, just as the Treasury’s funding needs explode to the upside. The bullish bond crowd is living in the past and in denial of how much the supply/demand equation will shift and tip the scales toward higher rates.

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The Fed did not add to its portfolio in 2017, but it did re-invest the interest and maturing proceeds. That amounted to roughly $500 billion in a combination of treasuries and mortgages. Coincidentally, the net new issuance of Treasurys was approximately $500 billion an even trade in dollar terms.

The Fed started reducing the rollover in the fourth quarter of 2017 and will be out of the markets in the fourth quarter of 2018. At the same time, net new issuance of Treasurys this year will reach $1 trillion, according to the Treasury, and likely will hit $1.2 trillion next year. How will the bond market handle this massive swing?

If the economy takes a dive and drags down the stock market, no problem. Treasuries will be the hot ticket again. Otherwise, it will be up to the market to price bonds the old-fashioned way, by pricing them against inflation.

If inflation remains in the 2% range, that would imply a 10-year rate of 3.50-4.00%. There is nothing too scary about that. Things will only get scary if inflation hits 3%.

No natural forces such as wages or commodity prices would cause that much upward pressure on inflation. But, there is one thing that could tip the balance toward higher inflation a trade war.

One of Trump’s key talking points during his campaign was on what he saw as unfair trade agreements. He focused his rants on China but also targeted the trade practices of the United States’ closest allies and trade partners, Canada and Mexico.

It was more talk than action last year. That changed this year.

Trump’s surprise announcement in March of harsh tariffs on steel and aluminum ignited fears of a full-blown trade war. Those fears were quelled when the tariff proclamation excluded several key allies, but I don’t believe we’ve heard the last of this.

The elevation of vociferous, antitrade aide Peter Navarro to Trump’s key advisor on trade shortly before the tariff announcement is a bad omen. You can read Navarro’s books if you want to know just how much of zealot Navarro is on trade. Navarro will not be satisfied with these limited tariff actions. Navarro will agitate for more, and perhaps dangerous, action.

I won’t dive deep into all the ways the United States will lose much more than it gains in any trade war, but the bottom line is that inflation would rise. And it would not stop at 2.50-3.00%.

The costs of the imported goods we consume would rise sharply, and we cannot create overnight the facilities here to replace these goods. It took decades for manufacturing jobs to shift overseas, and it would take decades to bring them back. More importantly, the price of goods we produce here will rise as so many of the basic materials and components our manufacturers use are foreign-produced.

As another unintended consequence, demand for our exports both manufactured goods and intellectual products would shrink dramatically, putting far more jobs at risk than replacing foreign goods would create. The stock market would tumble. Business spending and hiring would, too.

This could be a very big deal. It will matter to interest rates and, more importantly, to credit union members. This should very much be on the radar of industry leaders. The best-case scenario is that only one of the scale-tippers, the supply/demand equation, comes to pass. If both are realized, the scale won’t tip, it will topple.

Dwight Johnston is the chief economist of the California and Nevada Credit Union Leagues and president of Dwight Johnston Economics. He is the author of a popular commentary site and is a frequent speaker at credit union board planning sessions and industry conferences.

Strategy & Performance 4Q 2017

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