I expected a bond market bloodbath ever since the yield on the 10 year US Treasury note rose above 3.50%. Why? One, the neutral rate of interest, called R* in the vocabulary of the Federal Reserve monetary economists and the bond trading desk of Wall Street. This is the rate of interest where the economy is in neither growth or recession mode and R* neither stimulates nor restrains the economy. The smart money on the Street estimates that R* is now at least 1% as Bidenomics has bequeathed the $25 trillion US economy with a $1.7 trillion budget deficit or 6.8% of GDP. Fitch was right and Yellen is dead wrong, as is Papa Doc. Fiscal risk is a shocker, as is the accelerating economy/white hot labour market prices-out recession risk. The Atlanta Fed’s GDPNow real time estimate for Q3 is a horrific 5.8% annualized growth rate.
Two, the inflation risk premium should be at least 3% now as TIPS breakeven rates have risen and wage growth, strikes and the embedded price rises in cartelized services like healthcare and education mean that there is zero chance that the Powell Fed will attain its 2% dual mandate inflation target in the next 12 months. Bill Clinton’s Treasury Secretary Larry Summers estimates that the inflation risk premium for the next 10 years is at least 2.5%. So I will differ to his view as his analysis makes perfect sense to me at this precise moment in the interest rate, credit and economic cycle.
Three, the term premium compensates investors for lending money to Uncle Sam for 10 years. The top economist on Wall Street estimates this as 1.5% and I accept this consensus view. Add a 1% R* neutral rate, 2.5% inflation risk premium and 1.5% term premium and fair value US Treasury note equates to 5%. Can the financial markets and global economy remain unscathed as the planet’s cost of long term capital rises to at least 5% in the next six months? No way. Humpty Dumpty is going to have a great fall and contagion will freeze the credit markets, exactly as happened in the fateful autumn of 2008.
The breakdown in the US and European bank indices tells me that the countdown to credit Armageddon has begun at the precise 5.5% Fed Funds rate we saw at the apex of the credit bubble in July 2007, when I was frantically selling 0-6% LIBOR one year non callable range accrual swaps to position for a daisy chain of banking crisis and property market crashes that would force the Fed into an epic U-turn in its tight money stance. This moment has not come yet – but it will in the next 6 months.
Could China be the “Lehman moment” for the global economy once the yield on the 10 year Uncle Sam note surges to 5%? I think so. The numbers are scary. The Dragon Empire’s property sector is no less than 25% of the $18 trillion Chinese GDP, 80 million apartments lie empty in ghost cities, Evergrande just declared bankruptcy with its $300 billion debt and a depositor run on the shadow banking system has now begun. King Dollar and T-bills rock for me.
Also published on Medium.
