If the 10 Year Treasury were 4.0% at the end of 2019, would you expect US equities to be higher or lower then? It is easy enough to tell a story either way:
- Bullish for stocks. Rising inflation caused by economic growth lifts both bond yields and corporate earnings. Companies push for greater efficiency to offset labor/materials costs, limiting margin erosion and (finally) increasing workforce productivity.
PE multiples contract, but earnings growth more than offsets the decline and stocks rise.
- Bearish for stocks. Rising inflation caused by escalating trade frictions lifts interest rates, but has a chilling effect on the economy and corporate earnings. The Federal Reserve likely avoids going full Volcker, and simply keeps rates constant in 2019 knowing an inflation-induced recession will take inflation lower without their having to become a political pariah.
Multiples contract due to higher rates, but earnings are down 10% rather than the current forecast of +10%. The combination pushes US stocks lower.
Capital markets currently see the bull case as much more likely, and the other end of the yield curve – 2 Year Treasuries – supports that interpretation. It sits at 2.68% today, just 1 basis point off its post-Financial Crisis high, and has been moving upward all year. This is entirely consistent with the view that the Federal Reserve will respond to a strengthening US economy with higher rates through 2019. A trade war recession isn’t priced in at all.
The Fed Funds Futures market tells a similar story:
- The odds of 2 more rate hikes in 2018 is up to 67% versus just 44% a month ago.
- Futures also price in an all-but certain 50 basis point increase in 2019 (2 hikes), and a growing chance of 3 rate increases.
So far we’ve tread familiar ground, but we also want to point out one risk factor for Treasury yields that doesn’t get enough attention: rising levels of new issuance. This was one less-reported factor in today’s move over 3.0% in 10-Year bonds. The US Treasury surprised debt markets by announcing a new 2-month bill, an increase in the size of this quarter’s note auctions by $1 billion/month, and an August increase in bond auctions of a similar amount. More paper coming, in other words, and higher yields needed to clear them.
This announcement sent us to the Daily Treasury Statement (essentially the nation’s checkbook) to assess YTD tax/withholding receipts. These have been harder to predict in 2018, given tax reform and changes to withholding tables. The data:
- 2018 Calendar YTD Tax/Withholding (Individual and Corporate): $1,752 billion
- 2017 Calendar YTD: $1,769 billion
- Difference: $17 billion, or 1% lower this year
- This decline, while small, compares to a modest expected increase (0.2%) in 2018FY receipts as published by the Office of Management and Budget in their Mid-Session review last month.
The bottom line is that Treasury’s announcement today likely stems from a revenue shortfall in 2018. Again, this is understandable. Tax reform happened at the very end of last year, and many companies were slow to change withholding tables or have their employees complete new tax forms.
This unexpected revenue miss is important, because it ties to how poorly the US balance sheet is set up for the next recession. Small shortfalls are OK, but the 2000-2003 recessionary experience (a pretty normal recession) saw a 12% decline in receipts over 3 years. Part of that was fiscal stimulus, and part was lower receipts. In total these swung the US deficit by $614 billion into the red.
The US faces a larger challenge now, because the OMB is looking for +$1 trillion deficits from 2019FY to 2021FY and there are no recessions baked into their numbers. Debt held by the public – the sort that markets actually have to absorb – rises by $3.4 trillion over that 3-year period. And remember that government fiscal years start in October, so we are 2 months away from a $1 trillion deficit run rate sitting here in August.
Pulling this discussion back to US equity prices, we have one question from all this: are markets ready for higher US Treasury rates if they are caused by incremental issuance and (perhaps) overly optimistic revenue estimates?Long-term rates are important mechanisms that allow the economy to self-correct in a recession. And whenever that comes, deficits will be larger than during any other non-recessionary period in history.