After years of central banks’ monetary stimulus, investors got conditioned into believing that zero-bound interest rates were here to stay. Then, Europe and Japan introduced negative interest rates for the first time in 4000 years of recorded human history. Zero was no longer the limit which rates could ever approach but never quite reach – instead, rates broke right through that previously-untouchable floor. What a brave new world! In this wonderful alternative universe, rates could go lower, and bond prices higher, infinitely. The math “works”: -0.4% can become -4%, then -40%, if needed. -100% presented the next conceptual challenge – but nothing that our talented central bank economists could not solve.

On a serious note, we have amassed $46 trillion in total non-financial debt, according to the Federal Reserve. Government debt doubled in the past decade to $19 trillion, and business debt increased by 30% in that period. Interest on Debt already makes up 6% of federal government expenses, the fourth-largest budget category, as I described earlier this year. We needed not worry about paying interest, we were told, because rates were so low. But I digress from the main topic – please stay tuned for more on debt in another article.

My main topic today is an update on the “market forces” that drove interest rates higher (bond prices lower) since mid-year. The Fed is fully expected to raise its short-term policy rate in December, but it’s no longer just about the Fed. In my previous articles here and here, I described the trifecta of market forces that increasingly drive interest rates: inflation, currency markets, and the Chinese yuan as reserve currency.

Below are updated numbers and charts.

Market Force #1: Inflation

Consumer price inflation (CPI) (the yellow line above) rose from 1.46% to 1.64% in October. As I have been writing this year, total inflation has, and will continue to rise toward core inflation (2.1%). Producer price inflation also rose, while core inflation, excluding food and energy, fell somewhat, from 2.2% to 2.1%.

Market Force #2: FX Market

Large depreciation in the Chinese yuan (rising blue line means weaker yuan) and the British pound after Brexit, required central banks to intervene to defend their currencies from free-fall. In addition, emerging market currencies plunged across the board after the U.S. election, lead by the Mexican peso. Central banks had to buy their currencies and sell dollars (i.e., U.S. Treasuries). This put downward pressure on Treasury prices (upward pressure on yields).

Market Force #3: Yuan As Reserve Currency

After years of talks, China’s yuan was admitted to the IMF’s list of reserve currencies on September 30, 2016. This may be the biggest shift in global financial infrastructure since the early 1970’s when the current, floating currency system was adopted.

Source: U.S. Treasury

Due to wider acceptance of the yuan, there may be less demand for U.S. dollars/Treasuries. China may have begun diversifying its holdings into the yuan from dollars. The decline in China’s Treasury holdings accelerated since July, as is evident on this chart. China reduced its Treasury holdings by $83 billion in three months. To put it in perspective, this reduction exceeds the entire Treasury holdings of France ($70 billion), and is equal to Canada’s.

Because China is (still) the largest lender to the United States government, its selling, or not buying as much, is likely to put upward pressure on U.S. Treasury borrowing costs going forward. Whether this in itself is a bigger concern remains to be seen, but for now, I consider it one of my three “market forces” driving Treasury prices.

Back To The Real World

Investors are being thrust back into the real world where rates are not zero and bonds can lose value. Here’s performance of several popular bond index ETFs since mid-year:

• U.S. Aggregate Bond index (AGG, BND): -3.1%
• iShares iBoxx Investment-Grade Corporate Bond (LQD): -3.9%
• iShares 7-10 Year Treasury index (IEF): -6%
• Long-Term Treasury bonds (TLT, TLO): -13%

The 10-year Treasury yield rose 0.8% so far this quarter. Most interest rates, including mortgages, car loans, etc., move in tandem with respective Treasury yields. The average 30-year mortgage rate, at 4.1% already jumped to the high end of its 2-year range:

The effect of higher borrowing costs on our finance-based economy remains to be seen, but will likely be significant. I will update you as data becomes available – stay tuned.

What does it mean to active fixed-income investors (that is, those not satisfied with the buy-and-hold approach)? My earlier recommendation to avoid long-term bonds and to shift to floating-rate notes still stands. This tactic is “paying off” by remaining stable among broad declines in most bonds. This is a “tactical” position focusing on reducing risk, with yield just above 1%. There will be a time to look for yield – but not yet.

If you are a regular reader of MCM’s Tactical Strategies reports, you had an advantage of our timely recommendation earlier this year to stay away from longer-term bonds, along with recommendations for high-quality income ETFs with no exposure to interest rates. Learn more about our fundamentals-based, forward-looking approach to tactical investment management. If you are an advisor and are interested in adding a tactical component to your practice, please contact us to begin receiving the report.