A Gutsy Call on Interest Rates

By Rob McCreary

I guess I am just a sucker for contrarian thinkers, but when I first read Stephanie Pomboy’s investment guidance in an article by Barron’s Leslie Norton on March 22, 2018, I was a little skeptical about her thesis. In the face of a new Fed Chairman’s committed interest rate increases for 2018, Stephanie was telling her clients to buy 10 year treasury bonds as her best investment idea???

This is a single direction trade with no place to hide. The only way you get any increase in bond value is dramatically lower interest rates than anyone could foresee at that point.

Stephanie Pomboy is the founder of MacroMavens and she is a frequent contributor to Barron’s. In February of 2018, when she was interviewed by Leslie Norton of Barron’s. She was then a lone voice on the subject of interest rates:

I know everyone thinks the 10 year is going to 4% or 3.5% or whatever, but we are more leveraged today than ever; our threshold for pain is lower than the market recognizes, so I would be overweight long dated treasuries and underweight the dollar. Those four rate hikes will be chopped to three and then two, and people will actually start to talk about maybe they have to pause quantitative tightening.”

Ms. Pomboy’s call has proved to be prescient. She had the correct view of the consumer being “tapped out” and more likely to save the Trump tax cuts than spend them. She also showed a keen appreciation of the costs associated with debt-based prosperity.

The Fed blinked in November 2018, when the 10 Year Treasury rate touched 3.2% and since then the yield on the 10yr treasury has fallen to 2.3% in March 2019, and now stands at 2.58%. The S&P 500 has rallied from a low on December 24, of 2,351 to 2,905 on April 15, for a YTD gain of 23% and all is well again.

The elephant in the room, however, is still the consumer as well as underfunded public and private pension promises. The Wall Street Journal highlights the extent of the pension problem in its April 10, 2019 edition in an article by Heather Gillers.

Ms. Gillers looked at state and city underfunding and concludes that even though there has been a phenomenal recovery in the stock market since 2008, the investment returns did not keep pace with the increase in liabilities; “Liabilities of major U.S. public pensions are up 64% since 2007 while assets are up 30%, according to recent data from Boston College’s Center For Retirement Research.” For example, in 2010 the assets were valued at $1.78 Trillion and the liabilities were $2.75 Trillion – about a $1 Trillion underfunding. Today the assets are $2.91 Trillion and the liabilities are $3.82 Trillion- about the same $1 Trillion underfunding. These charts show the math problem and why the Fed must continue to provide liquidity induced stock market returns:

A logical question to ask is how we can ever close the $ 1 Trillion gap?  We have had perfect conditions for a decade and now most of the variables are turning against any further reduction.

  • Return assumptions for the future are dramatically lower.
  •  Fewer workers support more retirees who are living longer.
  •  Future stock market returns cannot replicate the last 10 years without consumer spending
  • Cutting pension promises is political suicide.
  • Yields on risk free assets are miniscule.
  • Many states cannot afford their current promises.
  • Infrastructure everywhere needs attention.
  •  Millennials are sitting on their wallets

Pomboy was prescient to see a strong relationship between the economic welfare of the U.S. consumer and the growth of GDP. Just by looking at unfunded public retiree pensions you can predict they are likely to get about 1/4 less in promised pensions than they expect and that may fall even more if the stock market starts to trade on future growth prospects, not momentary liquidity. When it is clear that spenders must become savers to survive retirement what will sustain a 25x PE multiple?

Rob McCrearyA Gutsy Call on Interest Rates

Comments

  1. Bill Ross

    Rob, very helpful. Agree with last comment money eventually having to leave and curious about any projections on impact. Would also be great if you could to me exactly when that starts to happen. 🙃. On a separate note, the other elephant still in the room is the budget deficit. Thanks

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