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Echoes from Africa

Bill Gross  |  12 Jan 2017Text size  Decrease  Increase  |  

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The yield on the benchmark 10-year US Treasury note will be the key to interest rate levels and perhaps stock price levels in 2017, says Janus Capital's Bill Gross.

 

"If I sang a song about Africa/Of the spotted giraffe, the hyena's laugh/Of the fiery sun rising to meet the day/With a stillness belying the lion's evening meal/Would Africa sing a song about me?"

"If I remembered a time once in Africa/Bride at my shoulder, chasing a leopard's shadow/With human eyes and Nikon shutters wide apart/Invading the solitude of blackened ancestors/Would Africa remember a time once with me?

"If I knew a story of Africa/Capturing a disappearing continent for a moment in time/Fleeting--far briefer than the earth's reign/At least until its dusty death/Would Africa know a story of me?"

Bill Gross, with appreciation for Isak Dinesen

I travelled once to Africa, as you might have guessed by now, and it's been a part of me ever since. Being perhaps the cradle of civilization, if not life itself, Africa casts an eerie glow over the entire history and, indeed, meaning of existence.

There's a strange beauty to it--this eat and be eaten land--brutal, yet fair and loving underneath its violent surface. I think it's how I view my own life. I saw myself in Africa and, of course, through my own eyes I saw you there, too.

The question however, that ends every stanza of my poem is whether Africa saw and will remember me. Are we just passing through without a trace following our dusty deaths? Will anyone, or anything, at the end of the line be the better for our time on earth?

I, myself, know nothing of a grand scheme of existence, but I wish there to be one--if only to give meaning to our precious moments of happiness and frequent hours of despair.

Happiness has dominated risk markets since early November and despair has characterised global bond markets. Hope for stronger growth via Republican fiscal progress/reduced regulation/and tax reform have encouraged risk.

The potential for higher inflation and a more hawkish Federal Reserve lie behind the 100-basis-point move in the 10-year Treasury from 1.40 per cent to 2.40 per cent over the same period. Are risk markets overpriced and Treasuries over-yielded? That is a critical question for 2017.

The assessment of future growth and associated risk spreads is still uncertain of course. President-elect Trump tweets and markets listen for now, but ultimately their value is dependent on a jump step move from the 2 per cent real GDP growth rate of the past 10 years to a 3 per cent-plus annual advance.

Three per cent growth rates historically have propelled corporate profits to a somewhat higher clip because of financial and operating leverage dependent on higher growth. Two per cent or less typically has smothered corporate profits. The 1 per cent difference between 2 and 3 is therefore critical.

We shall see whether Republican/Trumpian orthodoxy can stimulate an economy that in some ways is at full capacity already. To do so would require a significant advance in investment spending, which up until now has taken a backseat to corporate stock buybacks and merger/acquisition-related uses of cash flow.

I, for one, am sceptical of the 3 and more confident of the 2. The longer-term negatives of my "New Normal" and Larry Summer's "Secular Stagnation" may have disappeared from the business front pages of the FT and the NYT, but they have never really gone away--Trump or no Trump.

Demographic negatives associated with an ageing population, high debt/GDP now more at risk due to rising interest rates, technology displacement of human labour, and finally the deceleration/retreat of globalisation pose negative ongoing threats to productivity and therefore GDP growth.

Trump's policies may grant a temporary acceleration over the next few years, but a 2 per cent longer-term standard is likely in place that will stunt corporate profit growth and slow down risk asset appreciation.

The critical question of interest rates and the future level of the 10-year Treasury is equally challenging. While the Fed has begun to tighten policy after abandoning quantitative easing several years ago, other major central banks continue to stoke the fire with as much as $150 billion of monthly buybacks.

With the pinning of Japanese JGB 10-year yields at near 0 per cent and the ongoing dovishness of Draghi's ECB, global arbitrage effectively caps the 10-year at 2.4 per cent to 2.6 per cent levels.

Currency-adjusted yield pickups of 70 basis points by selling 10-year JGBs or German bunds and buying US Treasuries, outline the artificial pricing of our 10-year, even as inflation moves higher and short-term yields are raised by the Fed once, twice, or three times in the next 12 months.

So, for 10-year Treasuries, a multitude of influences obscure a rational conclusion that yields must inevitably move higher during Trump's first year in office.

When the fundamentals are confusing, however, technical indicators may come to the rescue and it's there where a super three-decade downward sloping trend line for 10-year yields could be critical.

Shown in the chart below, it's obvious to most observers that 10-year yields have been moving downward since their secular peak in the early 1980s, and at a rather linear rate. Thirty-basis-point declines on average for the past 30 years have lowered the 10-year from 10 per cent in 1987 to the current 2.40 per cent.

 

USGG10YR Index


chart


Source: Bloomberg

 

Now, however, this super strong, frequently tested downward trend line is at risk of being broken. 2.55 per cent to 2.60 per cent is the current "top" of this trend line, and over the past few weeks it has held and reversed lower by 15 basis points or so. But ...

And this is my only forecast for the 10-year in 2017. If 2.60 per cent is broken on the upside--if yields move higher than 2.60 per cent--a secular bear bond market has begun.

Watch the 2.6 per cent level. Much more important than Dow 20,000. Much more important than $60-a-barrel oil. Much more important that the dollar/euro parity at 1.00. It is the key to interest rate levels and perhaps stock price levels in 2017.

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Bill Gross is the lead portfolio manager of the Janus Global Unconstrained Bond Fund. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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