Despite the 10-year yield’s reluctance to hold above 3%, bond bears have been reluctant to throw in the towel completely, with Bill Gross recently changing his view to allow for a “hibernating” bear market in 2018 (he expects the 10-year with fluctuate between 2.80% and 3.25% for the remainder of the year). DoubleLine’s Jeffrey Gundlach has also backed away from his bearish outlook, recently declaring that the 10-year will remain “contained” if 3.22% isn’t broken by the 30-year.
Meanwhile, Hoisington Investment Management’s Dr. Lacy Hunt has been one of the few unabashed Treasury bulls operating in the market, refusing to cut back on duration as his peers warned that all hell would break loose as soon as the 10-year closed above 3%.
Of course, the aforementioned chaos hasn’t materialized, and Hunt’s view has been proven correct again and again. At the root of Hunt’s position is a bearish outlook for the US the economy as it begins to buckle under the weight of rapidly rising indebtedness and demographic headwinds like falling population growth.
While short-term fluctuations in interest rates are difficult to predict, Hunt points to the work of Milton Friedman, which shows that reductions in monetary stimulus lead to lower long-term interest rates as growth and inflation fall.
What Friedman had in mind is that, when the Fed engages in a tightening of monetary policy – what he called a liquidity effect – this tends to raise the short-term rates, but it begins to restrict the flow of money and credit. If this liquidity effect is repeated several times, it will eventually produce a countervailing income effect in which the rate of increase in interest will be slowed as the economy begins to moderate its rate of expansion.
And if the monetary deceleration extends for a protracted period of time, ultimately the inflation rate will fall. Hence Friedman’s conclusion: Monetary decelerations ultimately lead to lower interest rates, not to higher interest rates.
The problem with increasing debt, Hunt explains, is that it leads to diminishing returns. In the beginning, debt can be a boon to growth, but as the debt burden expands, and a rising share of national income is dedicated to servicing it, the benefits quickly begin to diminish. Economic activity begins to weaken, causing growth to slow, inflation to recede, and long-term interest rates to fall.
And so, while massive increases in debt can lead to a transitory boost in economic activity, this effect is relatively short-lived. And, ultimately, higher debt undermines economic growth. So over the longer term, extreme indebtedness leads to weaker economic activity, which, of course, is consistent with lower inflation and lower long-term bond yields.
Hoisington is a strict duration manager. Despite Hunt’s bullish view, the fund isn’t presently positioned for maximum duration, though Hunt says they’re already in excess of 20 years. However, his view has its limits. If the fund wanted to, it could go out and buy all the no-coupon 30-year government paper in the market. But it hasn’t, because, as Hunt explained earlier, secular trends often take years to unfold.
The problem with the US economy is that forgiving debt, as some on the far left have suggested, would destabilize the financial system. Meanwhile, allowing the Federal Reserve to print money without restrictions – an attempt to inflate away the debt (as well as the hard-earned savings of middle-class Americans) – would stoke inflation, but do little to benefit growth, making life harder for most people.
Well, there are people who have called for a so-called debt jubilee. The problem is that you bankrupt your financial institutions because they hold so much of it. There’s really no way to write it off. That’s the bottom line. There is no way to do a reset. You could go down the false road of changing the Federal Reserve Act allowing the Federal Reserve to print money. But the only way money printing works is if you increase the use of debt capital, which further triggers the law of diminishing returns. You will get a side effect of inflation, but you won’t boost real growth. And so, in essence, you’re just going to make people more miserable than they already are.
The only tenable solution to the debt problem, in Hunt’s view, would be a prolonged period of “living within our means.” Of course, austerity measures have helped mitigate debt crises in the European Union. But after so many years of deficit spending, it’s unlikely that the US would accept it.
In search of an answer, Hunt looked back on similar periods in US history: The US government took on a massive amount of debt in the 1820s and 1830s while building the railways and canals. Back then, it was the California Gold Rush that helped the US economy dig itself out of debt by bolstering growth to such a dramatic degree.
And today, the federal government is busy slashing revenues – as the Trump tax cuts did – while also increasing spending on the military and infrastructure. While these measures might bolster growth in the short term, over the coming years the growing debt burden will strangle the US economy, Hunt says.
And unless the US economy is lucky enough to experience another “gold rush,” it will likely continue to struggle with this intractable debt problem – that is, until something breaks.
Listen to the full interview below:
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