Summary:

• The 10-Yr UST yield has fallen from a high of 3.05% in January to a low of 2.52%
• Low bond yields and stocks near highs are sending conflicting messages
• Although many think this is bearish for stocks, I show why this probably isn’t the case

The 10-yr UST yield hit a low of 2.52% today, the lowest level since October of last year and continuing a trend of lower US long-term interest rates that began since the start of the year. Historically, falling bond yields have coincided with falling stock prices and vice versa; so, with the S&P 500 and the Dow Jones Industrial Average sitting near all-time highs, the biggest question right now is why are US Treasury rates still falling? The explanations crossing trade desks and media outlets are usually one or more of the following:

• Geopolitical concerns
• Worsening US growth forecasts
• Arbitrage between U.S. and European debt on ECB stimulus plans
• Rising credibility of the Fed’s ZIRP pledge

Since this has important implications for the stock market, let’s now examine each of the four explanations above and see which one holds water.

1. Geopolitical Concerns

One argument for lower bond yields making the rounds is that stock markets have largely ignored the unrest between Ukraine and Russia and are just now beginning to price in the growing geopolitical risk. There are hundreds of commentaries about the unrest between the two countries that argue things will spiral out of control while others are sanguine and think it is a non-event. What does the market tell us? If markets are truly just now pricing in geopolitical risk and beginning to weaken, then would it not be rational to conclude that Russian markets would also be deteriorating? Instead, we see the ruble and Russian stock market showing signs of stabilization. Shown below we see the MSCI Russia Index is up more than 20% from its March lows with the Russian ruble rallying nearly 7% relative to the USD. If tensions were unraveling we would expect to see the Russian stock market and ruble decline as it had in January and February.

2. Worsening U.S. Growth Forecasts

It is completely rational to think that lower bond yields are occurring as the economy is set to slip as typically bond yields decline when economic prospects worsen and rise when economic growth picks up. Thus, many investors are taking the decline in interest rates as a sign that the economy is set to roll over. However, rather than mirror bond yields, economic activity is supporting the message of the markets. For example, the ISM Manufacturing PMI shows strong directional similarity with the 10-yr UST yield and since January has been heading higher while rates have been falling.

It’s not just U.S. manufacturing that is diverging with bond yields but so has employment data. Since December U.S. payroll growth has been accelerating at the same time, 10-Yr UST yields have been falling.

If the U.S. economy was truly set to enter a soft patch ahead we would not expect developments like initial jobless claims dropping to a new best for this cycle. We learned today that Initial jobless claims dropped 24,000 to 297,000 during the week ending May 10, the lowest reported of the expansion so far.

While the argument that yields are falling as economic prospects are worsening may have been a good explanation during the first part of the year, the argument is weakening by the day. The Citigroup Economic Surprise Index for both the U.S. and major economies bottomed in April and has been heading higher as more economic reports have been surprising to the upside.

A case in point is the Empire Manufacturing PMI for May, which was estimated to be 6.00 and the actual was 19.01. The 19.01 reading beat ALL 51 estimates and was a big positive surprise. I think we can lay to rest the argument weakening economic growth is pushing down rates.

3. Investors Playing the Arbitrage Between U.S. and European Debt on ECB Stimulus Plans

Yields in Europe have been declining sharply for the last few years I believe for two reasons. The first is that Europe faces a deflationary threat as many country CPI indexes in Europe have turned negative and most, if not all, are below 1% annual inflation rates. In addition to the low inflation rates, I argued in February that the Eurozone economy was set to cool (click for article link).  Since that time European economic releases have been surprising to the downside and missing estimates with the Citigroup Economic Surprise Index hitting nearly a 1-yr low.

The threat of disinflation and a weakening economy is why I made the argument in February and again in April (click for article) as to why the ECB was set to bring out the monetary bazookas, which is the second reason rates in Europe are falling. With weakening economic growth, waning inflation rates, and the prospect of ECB stimulus many investors have front-run the ECB by bidding up European debt. According to a recent Reuters article, the ECB may even start charging banks to hold excess reserves by having a negative deposit rate at the ECB, as highlighted below.

ECB readies package of rate cuts and targeted measures

The European Central Bank is preparing a package of policy options for its June meeting, including cuts in all its interest rates and targeted measures aimed at boosting lending to small- and mid-sized firms (SMEs).

Five people familiar with the measures being prepared detailed plans involving a potential rate cut, including the ECB’s deposit rate going negative for the first time, along with the targeted SME measures…

A second source echoed that sentiment, and added: “This will be the first major central bank to move to a negative deposit rate. That would move the exchange rate.”

If you invested in European debt back in 2012, you received rates that were 5-6% higher than a comparable U.S. debt on 10-yr bonds when buying Spanish or Italian debt. Similarly, two years ago, German 10-yr bunds were at parity with the 10-yr UST, no longer. Now we’ve seen European peripheral debt yields collapse to near parity with US Treasuries and German bunds yield more than 1% less than US 10-yr bonds as shown below.

So if you are an aggressive debt investor buying European debt you are no longer being compensated for taking undue risk in buying peripheral European debt like Italy or Spain, and if you are a high-quality debt investor that buys the safe end of the government bond spectrum in Europe, yields are next to nothing in German debt. Thus, it makes sense for both aggressive and conservative debt investors buying European debt to invest in U.S. Treasuries. For the aggressive investor you can get comparable yields and for less risk and for the conservative investor you can get more yield in UST bonds. This, I believe is one of the large factors as to why U.S. Treasury rates are plunging and yet our economy is humming along and the stock market is near its highs.

4. Rising Credibility of the Fed’s ZIRP Pledge

At Janet Yellen’s first testimony as Fed Chairwoman, when asked how long after the Fed ends their purchase program could the Fed Funds be raised she said six months. Markets were unsettled by that but Janet later back peddled and confirmed the Fed’s commitment to keep rates low for a considerable time. Investors took Janet at her word as expectations for higher interest rates in 2015 came down. This can be seen when looking at Fed Futures probabilities for the January 2015 FOMC meeting. Four months ago roughly 25% of investors thought the Fed would have already hiked rates to 0.50% and that has fallen to less than 10%. Notice the big jump in the percentage of investors betting rates will be at 0%, which increased from just over 30% to more than 50%. With investors having a greater belief that the Fed will keep rates low into next year, there is less of a fear of rising interest rates that would hurt bond investors and so we are likely seeing more money come back into the bond market.

Other Reasons

There was an excellent article in Bloomberg earlier this month that highlighted a more simplistic view as to why U.S. Treasury rates were heading down: simply more demand than supply.

Can’t Find Enough 30-Year Treasuries to Buy? Here’s Why

In a world awash with U.S. government bonds, buyers of the longest-term Treasuries are facing a potential shortage of supply.

Excluding those held by the Federal Reserve, Treasuries due in 10 years or more account for just 5 percent of the $12.1 trillion market for U.S. debt. New rules designed to plug shortfalls at pension funds may now triple their purchases of longer-dated Treasuries, creating $300 billion in extra demand over the next two years that would equal almost half the $642 billion outstanding, Bank of Nova Scotia estimates…

Pensions that closed deficits are pouring into Treasuries and exiting stocks to reduce volatility after a provision in the Budget Act of 2013 raised the amount underfunded plans are required to pay in insurance premiums over the next two years. It also imposed stiffer fees on those with shortfalls.

In the next 12 months alone, buying from private pensions will create $150 billion in demand for longer-maturity Treasuries, based on Bank of Nova Scotia’s estimates…

Net issuance of interest-bearing Treasuries will fall to $545 billion next year, estimates from primary dealer Deutsche Bank AG show. That’s a 36 percent decrease from last year.

The scarcity will act as a counterbalance to the Fed as it tapers, according to Dominic Konstam, Deutsche Bank’s New York-based global head of interest-rate research.

There truly is an emerging scarcity of long-term U.S. Treasuries as a narrowing in the deficit from tighter spending and higher taxes along with an expanding economy leads to a lower net issuance of Treasuries. The budget surplus of $106.9B seen in April was the third largest monthly surplus seen in this recovery and now the 12-month moving average of the monthly deficit/surplus is at -$41.6B, much improved from the -$123B average seen in early 2010.

So What Is Driving U.S. Rates Lower?

It’s important to understand what is driving U.S. Treasury rates down as the reason will shape your outlook for the market. If you believe that yields are lower as investors price in greater geopolitical risk and/or a worsening US economic growth forecast, then you would expect the stock market has it wrong and shouldn’t be near its highs and will recouple with bond yields and sell off. However, if you feel it is more of a U.S. and European bond arbitrage and/or more credibility being given to the Fed that they will keep rates low for a long time, then the stock market does not have it wrong and one should not be fearful of falling US interest rates. In addition to the factors making the rounds on trading desks there is also the issue of supply as the U.S. government issues less UST’s to finance its budget.

So, while many look at lower rates as a reason to become defensive, they may want to think again since the likely causes for lower rates do not have bearish implications. Moreover, lower rates are helping the market by bringing down overly bullish sentiment. Markets perform best when sentiment is bearish and with AAII % bullish readings near levels that have marked short-term lows in interest rates, we may be near a low in rates and the stock market, with both standing a good chance of rallying in the weeks ahead.

Summary

In summary, the likely reasons for U.S. Treasury yields selling off do not carry bearish implications for the stock market. As such, the belief that the bond market is signaling a bearish message for the stock market is likely to be proven unfounded. Rather, the bearish sentiment that has coincided with falling bond yields has actually helped provide a bullish support for the market and may now start to act as a tailwind.

About Chris Puplava

One of the biggest questions at the end of 2013 was how the Treasury market would react to the reduction of bond buying that would result from the Federal Reserve’s tapering campaign. If the Fed were to hold course to its stated intentions, its $45 billion monthly purchases of Treasury bonds would be completely wound down by the fourth quarter of 2014. Given that those purchases represented a very large portion of Treasury bond issuance at that time, it was widely assumed by many, me in particular, that the sidelining of such huge demand would push down the price of Treasury bonds. Without the Fed’s bid, interest rates would have to rise.

But almost five months later, yields on the 10-year Treasury bond are 50 basis points lower than they were at the end of 2013, despite the fact that the Fed has officially trimmed its monthly purchases in half. Apparently, plenty of other buyers were prepared to fill the void. Many have concluded that Uncle Sam doesn’t need the Fed after all.  But a close look at international activity in the Treasury market reveals some odd patterns that should be explained.

Over the last six months Belgium has started to behave eccentrically, even by Belgian standards. No, the small country of 11 million has not decided to stop making chocolate or waffles. It has decided to increase its buying of U.S. Treasury bonds…in a very big way. According to latest U.S. Treasury Department data, since August of 2013 entities in Belgium have purchased and held a stunning $215 billion of U.S. Treasuries. This figure is equivalent to about half the country’s annual GDP, and equates to almost $20,000 for every living Belgian. Prior to that time, Belgium had held its cache fairly steady at around $170-$190 billion. But by March, that total had increased by almost 130% (to $381 billion) in just seven months. The purchases represented 61% of the total increase in foreign holdings of U.S. Treasuries over that time frame. Given the fact that Belgium, as of last September, had less than 3% of the Treasury bonds held by foreign sources, this is strange behavior indeed.

Of course exactly who is buying those bonds remains a mystery. It’s only known for sure that a Belgium-based clearing house called Euroclear is “likely responsible” for holding the $200 plus billion in Treasuries. It’s amazing in this day and age when every e-mail and phone call is scrubbed for security content that hundreds of billions of dollars could move across borders without anyone really knowing what is going on. Of course this is likely only possible if official sources themselves are the transacting parties.

What is clear is that this is not likely the government of Belgium, or private Belgian capital, that is doing the buying. The numbers are just too large. This is particularly true in the First Quarter of 2014 when the buying averaged a stunning $41.5 billion per month (January was the biggest month with $54 billion). In all likelihood, the only European buyer with a wallet that big would be the European Central Bank (ECB) itself. But why would the ECB buy when the Federal Reserve was supposed to be tapering?

It is widely recognized that as the flow of capital increases exponentially across borders, and financial systems become more globally integrated, international central bank cooperation has increased. This is especially true between the Federal Reserve and the European Central Bank (ECB) which have closely coordinated policy to deal with the Great Recession of 2008 and the European Sovereign Debt Crisis of 2011. Exactly how, where, and why these banks have worked together is a little harder to imagine.  

Back in late 2011, when the sovereign debt crisis of Greece, Spain, Italy and Portugal threatened to fracture the European Union and take down the euro currency, the Wall Street Journal

reported the Federal Reserve was engaging at that time in a “covert bailout” of European banks. Using what was known as a “temporary U.S. dollar liquidity swap arrangement,” the Fed provided billions in funds that its European counterpart used to bail out its banks. The Journal

speculated that the roundabout arrangement was followed in order to get around legal restrictions that prevented the ECB from lending to banks directly. The Journal called the arrangement “Byzantine” and questioned whether its design was simply meant to confuse the press and investors as to who was funding whom. In any event, the program seems to have achieved its end of keeping European banks solvent until the debt crisis had abated.

The Belgian head-scratcher may therefore be a simple case of central bankquid pro quo. In fact, on my radio program today, former Congressman Ron Paul shared my suspicions that there was indeed some type of “quid pro quo” coordination. While there is no smoking gun, the timing and scope of the buying is certainly suggestive of a coordinated effort. Confidence that the financial markets would stay stable during the tapering campaign was a critical element of the program’s success. Any panic in the bond market would cause yields to spike, which would have a strong negative effect on stock prices and economic confidence. If the fear persisted for more than a few weeks, the Fed would have been forced to an embarrassingly early backtrack. The lost credibility would have greatly limited the Fed’s latitude for further maneuver.

But what if the ECB started buying just as the Fed stopped? Better yet, what if the ECB purchases were larger than the taper? It would then appear that the Fed buying was simply a footnote in the current environment of ultra-low interest rates, not the driving force. It may not be coincidental that the Belgian buying began in earnest just as the tapering got underway. Something may in fact be rotten, and it’s not in Denmark…but several hundred kilometers to the southwest.

Rather than looking to explain the unusual spike in Belgian coffers, most market watchers are fixated by recent comments by Mario Draghi that the ECB is poised to launch a quantitative easing-style bond buying campaign in order to weaken the euro and to push up inflation in Europe. If that is the case, how long could the ECB be expected to fight a two-front monetary war…carrying water for the Fed while buying European bonds simultaneously?   We must expect that any clandestine campaign by the Europeans to support Treasuries will have a brief shelf life, which could get even briefer if the ECB initiates their own QE. 

It is a testament to the bovine nature of our financial media that this story is not being pursued strongly by all the power the fifth estate can muster. But who cares when rates are low and stock prices high? Have another chocolate. The Belgian ones are the best.

Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show. 

Catch Peter’s latest thoughts on the U.S. and International markets in the Euro Pacific Capital Spring 2014 Global Investor Newsletter!

How important is housing to the American economy?

If a 2011 SMU paper entitled “Housing’s Contribution to Gross Domestic Product (GDP) quot; is right, nothing moves the economic needle like housing. It accounts for 17% to 18% of GDP.

And don’t forget that home buyers fill their homes with all manner of stuff—and that homeowners have more skin in insurance on what’s likely to be their family’s most important asset.

All claims to the contrary, the disappointing first-quarter housing numbers expose the Federal Reserve as impotent at influencing GDP’s most important component.

The Fed: Housing’s Best Friend

No wonder every modern Fed chairman has lowered rates to try to crank up housing activity, rationalizing that low rates make mortgage payments more affordable. Back when he was chair, Ben Bernanke wrote in the Washington Post, “Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance.”

In her first public speech, new Fed Chair Janet Yellen said one of the benefits to keeping interest rates low is to “make homes more affordable and revive the housing market.”

As quick as they are to lower rates and increase prices, Fed chairs are notoriously slow at spotting their own bubble creation. In 2002, Alan Greenspan viewed the comparison of rising home prices to a stock market bubble as “imperfect.” The Maestro concluded, “Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole.”

Three years later—in 2005—Ben Bernanke was asked about housing prices being out of control. “Well, I guess I don’t buy your premise,” he said. “It’s a pretty unlikely possibility. We’ve never had a decline in home prices on a nationwide basis.”

With never a bubble in sight, the Fed constantly supports housing while analysts and economists count on the housing stimulus trick to work.

2014 GDP Depends on Housing

“There’s more expansion ahead for the housing market in 2014, with starts and new-home sales continuing to rise at double-digit rates, thanks to tight inventory,” writes Gillian B. White for Kiplinger. The “Timely, Trusted Personal Finance Advice and Business Forecast(er)” says GDP will bounce back.

Fannie Mae Chief Economist Doug Duncan says, “Our full-year 2014 economic forecast accounts for three key growth drivers: an acceleration in spending activity from private-sector forces, waning fiscal drag from the federal government, and continued improvement in the housing market.“

We’ll see about that last one.

Greatest Housing Subsidy of All Time Running Out of Gas

With the central bank flooding the markets with liquidity, holding short rates low, and buying long-term debt, mortgage rates have been consistently below 5% since the start of 2009. For all of 2012, the 30-year fixed mortgage rate stayed below 4%. In the post-gold-standard era (after 1971), rates have never been this low for this long.

The Fed’s unprecedented mortgage subsidy has helped the market make a dead-cat bounce since the crash of 2008. After peaking in July 2006 at 206.52, the Case-Shiller 20-City composite index bottomed in February 2012 at 134.06. It had recovered to 165.50 as of January.

However, while low rates have propped up prices, sales of existing homes have fallen in seven of the last eight months. In March re-sales were down 7.5% from a year earlier. That’s the fifth month in a row in which sales fell below the year-earlier level.

David Stockman writes, “March sales volume remained the slowest since July 2012.” He listed 13 major metro areas whose sales declined from a year ago, led by San Jose, down 18%. The three worst performers and 6 of the bottom 11 were California cities. Las Vegas and Phoenix were also in the bottom 10, with sales down double-digits from a year ago.

This after housing guru Ivy Zelman told CNBC in February, “California is back to where it was in nirvana.” Considering the entire nation, she said, “I think nirvana is not far around the corner… I think that I have to tell you, I’m probably the most bullish I’ve ever been fundamentally, and I’m dating myself, been around for over 20 years, so I’ve seen a lot of ups and downs.”

Housing Headwinds

Housing is contributing less to overall growth than during both the days of 20% mortgage rates in the 1980s and the S&L crisis of the early 1990s.

In Phoenix, where home prices have bounced back and Wall Street money has vacuumed up thousands of distressed properties, the market has gone flat.

In Belfiore Real Estates’ April market report, Jim Belfiore wrote, “The bad news for home builders is they have created a glut of supply in previously hot market areas… Potential buyers, as might be expected, feel no sense of urgency to buy because they believe this glut is going to exist indefinitely.”

Nick Timiraos points out in the Wall Street Journal that with a 4.5% mortgage rate and prices 20% below their peak, “… homes are still more affordable than in most periods between 1990 and 2008.” So why is demand for new homes so tepid? And why have refinancings fallen 58% year-over-year in the first quarter?

“Housing’s rocky recovery could signal weakness more broadly in the economy,” writes Timiraos, “reflecting the lingering damage from the bust that has left millions of households unable to participate in any housing recovery. Many still have properties worth less than the amount borrowers owe on their mortgages, while others have high levels of debt, low levels of savings, and patchy incomes.”

More specifically, “So far we have experienced 7 million foreclosures,” David Stockman, former director of the Office of Management and Budget, writes. “Beyond that there are still nine million homeowners seriously underwater on their mortgages, and there are millions more who are stranded in place because they don’t have enough positive equity to cover transactions costs and more stringent down payment requirements.”

Young people used to drive real estate growth, but not anymore. The percentage of young home buyers has been declining for years. Between 1980 and 2000, the percentage of homeowners among people in their late twenties fell from 43% to 38%. And after the crash, the downtrend continued. The percentage of young people who obtained mortgages between 2009 and 2011 was just half what it was ten years ago.

Young people don’t seem to view owning a home as the American dream, as was the case a generation ago. Plus, who has room to take on more debt when 7 in 10 students graduate college with an average $30k in student loan debt?

“First-time home buyers are typically an important source of incremental housing demand, so their smaller presence in the market affects house prices and construction quite broadly,” Fed Chairman Ben Bernanke told homebuilders two years ago.

There’s not much good news for housing these days. For a little while, the Fed’s suppression of interest rates juiced housing enough to distract Americans from weak job creation and stagnant real wages. Don’t have a job? No problem! Just borrow against the appreciation of your house to feed your family.

But Yellen’s interest rate wand looks to be out of magic. The government had a pipe dream of white picket fences for everyone. But Americans can’t refinance their way to wealth. Especially in the Greater Depression.

Read more about the Fed’s back-breaking economic shenanigans and the ways to protect your assets in the Casey Daily Dispatch—your daily go-to guide for gold, silver, energy, technology, and crisis investing. Click here to sign up—it’s free.

For the next six months maybe cash is the most attractive asset, predicts Marc Faber, The Gloom, Boom & Doom Report, citing Yellen as a “money printer,” which Faber says depreciates the U.S. dollar.

the most underappreciated asset is cash. nobody likes cash. cash for the next 10 years you earn precisely zero. ms. yellen is a money printer like all the others. and she will make sure that the dollar continues to depreciate in real terms. for the next six months is the most attractive. i don’t want to be in cash 

Marc Faber is an international investor known for his uncanny predictions of the stock market and futures markets around the world.Dr. Doom also trades currencies and commodity futures like Gold and Oil.

At a speech in Chicago in March, Janet Yellen waxed lyrical about the plight of America’s unemployed. 

In preparation for her speech, Yellen talked for more than an hour by phone to three Chicagoans struggling to find work. Then, like a presidential hopeful, she weaved their heartbreaking stories into her speech: 

I have described the experiences of Dorine, Jermaine and Vicki because they tell us important things that the unemployment rate alone cannot. They are a reminder that there are real people behind the statistics, struggling to get by and eager for the opportunity to build better lives.

What’s odd about the Fed’s focus on jobs is that the current unemployment rate of 6.3% isbelow the 6.4% average the US economy has experienced since 1970. Never before has the nation’s top central banker delivered such a tear-jerker. And never before has the nation’s top central banker gone to such lengths to personalize the plight of the unemployed to justify Fed policy. 

It’s also below the 6.5% target the Bernanke Fed set for keeping the federal funds rate (the rate at which banks lend to each other overnight and the key interest rate in the country) at the “zero bound.” 

Here’s what the Bernanke Fed had to say last year about its unemployment target: 

We wonder what the market reaction would be if the Fed had kept to its word and started moving the federal funds rate higher once the unemployment rate fell to under 6.5%. 

Would US stocks still be rallying? Would the yield on the 10-year Treasury note be just 2.6%… and the yield on the 2-year note be a mere 0.4%? 

Unlikely. 

The Fed talks a big game on unemployment… and why EZ credit is the key to getting Americans back to work. 

The truth is the Fed manipulates the price of credit as it sees fit. When certain objectives are met, it simply changes them to keep the credit economy booming. 

Dorine, Jermaine and Vicki are useful PR tools. But Janet Yellen’s “jobs crusade” is just a fig leaf to hide the real reason credit needs to stay ultra cheap: Without it, the whole economy is under threat. 

P.S. Don’t forget to check out the latest special report from Diary of a Rogue Economistpublisher Will Bonner. Will recently “spied” on a very elite – and extremely wealthy – group. And he got to see how the richest of the rich make their money… and how they keep it.