Recently Federal Reserve Chairman Jerome Powell suggested that the Federal Funds rate, or overnight bank lending rate, will return to the Effective Lower Bound (ELB). In central banker speak, the ELB is zero percent. Powell indicated the return to the ELB is not an if event, but only a matter of when. This has spurred professional money managers and the financial media to suggest that long-term interest rates are about to skyrocket. They could not be more wrong.
The two “bond gurus,” as proclaimed by the financial services industry, proclaimed that ten-year Treasury yields were headed north of five percent after President Trump was elected. Both gurus suggested that massive fiscal deficits would lead to higher Treasury bond yields as investors would demand a higher coupon rate to fund the Federal government. While believable to most investors, this assumption is wrong.
Adding to their belief that Treasury yields were headed higher, both “bond gurus” also showed a similar chart where ten-year Treasury yields were going to break out of a predefined range going back to 1981. Ten-year Treasury yields can be charted in a declining channel that shows yields follow a declining path since 1981 while oscillating between an upper and lower bound.
For the first time since 1981, the upper end of this channel was broken in 2018, which caused chartists, analysts and professional money managers to proclaim that yields had broken out of their declining range and were headed higher. The breaking of the channel spurred global investors to proclaim that inflation was about to rear its ugly head and that ten-year Treasury yields were headed to five percent and higher. This assumption is also wrong.
Interest rates are a function of supply and demand. When the amount of demand for loans exceeds the available pool of money to back those loans, interest rates rise. Interest rates will continue to rise until demand is reduced to meet the available supply of money to back those loans. When the demand for loans is less than the available pool of money to back those loans, interest rates fall until demand increases to meet the amount of money available to lend out.
The biggest borrowers are corporations, who borrow huge sums of money to build factories, to expand their businesses, to buy their stock back, to fund mergers and acquisitions, and to invest in research and development. The amount of money corporations borrow eclipses the amount of money borrowed by consumers. As it turns out, ten-year Treasury yields are correlated to the amount of money demanded by corporations.
The St. Louis Federal Reserve tracks the outstanding loan balance of all commercial and industrial loans in the country, which is freely available on their website. In the past, I have charted Commercial and Industrial loans against 10-year Treasury yields on a year-over-year basis, which showed a strong correlation. When lending demand rose, so did the rate of increase in yields, and when lending demand slowed or contracted, yields followed suit.
Recently I went back to the chart and made one small change. Instead of comparing the annualized rate of change of 10-year Treasury yields to the annualized rate of change in Commercial and Industrial loans, I changed 10-year Treasury yields to be expressed as a percentage. The correlation was obvious, and it supported my view.
Every time the year-over-year growth rate of Commercial and Industrial loans grew, 10-year Treasury yields rose. Every time the year-over-year growth rate of Commercial and Industrial loans slowed or contracted, 10-year Treasury yields fell. Commercial and Industrial lending growth on a three-, six-, and twelve-month basis is slowing, with the three-month rate of growth now in contraction. When Commercial and Industrial lending starts to contract, stock prices and the economy are soon to follow.
In a debt-based economy, such as ours, where economic growth is a function of how much new debt is created, it makes perfect sense that slowing or contracting lending leads to an economic slowdown or a recession. For bond investors, monitoring the annualized change in Commercial and Industrial lending is a useful tool to know when it is a more opportune time to buy bonds and when it is wise to sell bonds.
Crude oil prices also rise and fall based on the growth rate of Commercial and Industrial lending. Oil companies borrow large amounts of money for exploration and production of crude oil, so a change in lending should be reflected in the price of crude oil. When oil prices are rising, oil companies increase their demand for new loans, and when oil prices are falling, oil companies decrease their demand for new loans. Just like with Treasury yields, crude oil prices rise and fall as the growth rate of Commercial and Industrial lending rises and falls.
With Commercial and Industrial lending beginning to contract, it makes sense why the “Smart Money” is buying U.S. Treasury bonds and selling or shorting crude oil. They know bond prices are going to rise and crude oil prices are going to fall, all based on the demand for large loans. The reason five-year Treasury yields are so closely tied to the price of crude oil is that oil companies tend to borrow money over five-year periods for their projects.
Many investors erroneously believe that the more money a government borrows, that investors need to be compensated with higher interest rates, yet there is no evidence this is true. Japan’s and most of Europe’s governments have borrowed large amounts of money relative to the size of their economies, and interest rates on their ten-year government bonds are slightly above or below zero percent. Interest rates fall as governments borrow more money, which is why interest rates in the United States have steadily fallen since 1981.
U.S. Treasury bonds work differently than most investors realize since they are considered reserve assets that can be borrowed against. For example, the United States did not have thirty-year mortgages until thirty-year Treasury bonds came into existence. Once thirty-year Treasury bonds were issued, banks were able to lend money out to thirty years. This is the reason why there are not government insured fixed-rate mortgages longer than thirty years available in the United States.
The reason Treasury yields fall during recessions is due to a decline in lending demand and due to a substantial increase in government borrowing. As the government borrows more money, there are more Treasury bonds in the marketplace looking for loans to back them. When there are more Treasury bonds issued than loans to back them, Treasury yields fall until demand is met.
During the next recession, lending demand is likely to crash, and government borrowing is likely to skyrocket. Lending demand has been slowing as 85 million Baby Boomers enter retirement, where they are more focused on reducing their debts than accumulating more debt. The Congressional Budget Office (CBO) is already projecting a $100+ trillion shortfall to cover promised entitlement benefits, which means the government is going to be running large multi-trillion-dollar deficits in the future.
There is unlikely to be enough lending demand from Gen X, the Millennials, and Gen Z to drive enough lending demand to soak up all the debt being issued by the government. Due to a lack of lending demand and heavy government borrowing, U.S. Treasury bonds will be at zero percent and possibly lower during the next recession and for many years following.
With the U.S. economy teetering on the edge of a recession as evident by Commercial and Industrial lending starting to contract, those who own long-term U.S. Treasury bonds are likely to make a larger return than stock investors have over the past few years as Treasury yields head towards zero percent.
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