We’ve all seen charts similar to the chart below, showing US bond yields, and the extraordinarily orderly decline in yields over the last 30 years or so. On the chart, we have marked the trend channel that has contained all price action for at least 25 years, and the red horizontal line illustrates some chart resistance at current levels. At the risk of stating the obvious, within the confines of a multi-decade trend that has shaped the performance of all financial markets globally, we are near a tipping point that should be resolved within the next 9 months.
Chart 1 – Weekly chart of US 10 year bond yield
We have made the case recently that higher interest rates could easily impact global financial markets, and although equity markets are seemingly ignoring this as they melt up, there is a potential coming together of macro factors that really could change the world as we know it.
Since the end of WWII and the signing of the Bretton Woods agreement, there has been one major change to the global financial system. Between 1944 and 1971, most currencies were fixed against the US Dollar, and with the Dollar convertible to gold at a fixed price of $35, there was a backstop against US profligacy. So long as the world had faith in the Dollar, and decided against converting Dollars to gold, everything would be fine.
However, the fiscal strains for the US began to show in the 1960s, and in August 1971 the US ended the convertibility of Dollars into gold, and the world order shifted from an effective Gold Standard to a US Dollar Standard.
For decades, the Dollar standard has worked incredibly well. Credit creation, untethered from gold and controlled by commercial and central banks, has led to strong global growth and rising asset prices. The dark side of the Dollar Standard is that it has also led to an unparalleled growth in debt in virtually every country and every sector. The economic outcome is that rather than the economic cycle being mostly about inventory cycles, it is now much more sensitive to boom and bust cycles in the financial markets.
But so long as everyone played to the rules of the Dollar Standard, things would generally be ok. What we don’t know is what would be the impact on the global economy and global financial markets if the global system shifts away from the Dollar Standard.
In just the last few weeks, we have the following dynamics to consider;
1. Trump slapping tariffs on selected items with more to come
2. China hinting that they would hold fewer reserves in US Dollars
3. Other central banks admitting that they are already holding more reserves in Yuan, and that they expect the amount to be higher in the future
4. US Treasury secretary publicly saying a weak Dollar is good because it will help the US trade position
5. The passing of US tax legislation that is likely to lead to a much larger budget deficit
6. The beginning of quantitative tightening that will see the Fed’s balance sheet reduced by $450 billion in 2018 and likely more in 2019
These dynamics, together with Trump’s more isolationist agenda, are threatening the Dollar standard. So the big picture questions are 1) will the Dollar standard remain in the years ahead and 2) if it changes, how and what will the new system look like and 3) what will happen to the global economy and markets during any transition?
These are such big issues that we won’t be able to answer them in one commentary. What we can see is that if global investors begin to lose confidence in the Dollar at a time when US inflation is rising, bond yields are rising, the Dollar is weakening, the budget deficit is set to increase dramatically and the US central bank is draining Dollars from the system, there is a case to be made that the future may not be quite as bright as many pundits are currently claiming.
But these dynamics change relatively slowly, and financial markets are currently in no mood to think negative thoughts.
We would like to add just a couple more thoughts in the big picture. First, the US consumer may be running on fumes. The household savings rate has collapsed, and as a result growth remains reasonable. At the same time, consumer debt is increasingly dramatically just at the point when interest rates are rising. There is a strong case to make that unless households can find a new source of income, rising interest rates and inflation will impact both consumer spending and therefore the economy.
The second thought is on oil. At $65 on US WTI, this represents an increased burden for the US consumer compared to a year or two ago, and a potential boom for US shale. If the US consumer begins to retrench at a time when US policy is becoming more isolationist and the US continues its shift towards energy self sufficiency, this will reduce the US current account deficit, adding a further strain to the Dollar standard that has been in place since 1971.
All of these thoughts need to be fleshed out, and we will attempt to do so in the weeks ahead. However, as we sit here watching equity markets melt up, retail investors piling in at record levels and reliable valuation measures at levels comparable to 2000 and 1929, we begin to worry that a collapse or large shift to the Dollar standard would come as a huge shock to the global system. We are watching the rise in US bond yields, the decline in the US Dollar and the policy shifts occurring on the global stage, and wonder whether these are indeed major warning signs that investors are ignoring simply because the equity market party feels like a great place to be and there is a huge inertia and fear of missing out.
We are also acutely aware that either our concerns may be mis-placed, and that it could take a long time for them to matter even if we are correct to be concerned. So, for the moment, our concerns remain focused on bonds and the US Dollar, and even in the short term, we wonder whether the Dollar in particular is oversold and due some sort of relief rally. However, with market valuations so stretched, we do think that equity investors need to have their exit plans at the ready. So far in 2018, we have seen volatility inch up across the major assets, and with everything else noted above, we wonder aloud whether an increase in market volatility could be the harbinger of greater change in the months ahead.
Stewart Richardson
RMG Wealth Management
