Why Boring Bonds Hold All the Clues

The Aussie market is set for a slow start to the week. US stocks pulled back slightly in Friday trading, largely thanks to weaker than expected US GDP growth.

Growth for the first quarter of 2017 came in at just 0.7%, well below forecasts of a 1.2% pick up. The culprit was weak consumer spending, which grew by just 0.3%, well down on the 3.5% growth achieved in the final quarter of 2016.

On the plus side, investment growth was strong. As Fox Business reports:

‘…residential investment posted a 13.7% gain, business structures grew 22.1%, the fastest clip since early 2014 before the collapse in oil prices, Barclays economists point out.

“The rise in equipment investment indicates that firms are expanding capacity in anticipation of rising demand. Likewise, a strong showing of residential investment, along with other positive signals from the housing sector, indicates that the household sector remains confident in the economic outlook,” the Barclays economics research team led by Michael Gapen said.

Because consumer spending accounts for around 70% of the economy, the slowdown had a big effect on the overall growth number. But the fact that investment spending is growing strongly is a positive sign.

The market always looks ahead. GDP numbers for the first three months of the year are old news. The fact that the market remains near all-time highs suggests the slowdown in consumer spending experienced in the first quarter isn’t the start of a major trend. That’s why US stocks didn’t fall too much on the news.

While the stock market may not have responded to the slower than expected growth, it does explain the recent rally in the bond market.

The yield on the benchmark US 10-year Treasury bond peaked at over 2.6% at the end of December, 2016. A few weeks ago it hit a low at just under 2.2%. Falling bond yields often indicate slowing economic growth.

The yield is now around 2.3%, and its direction from here will give you a good insight into the health or otherwise of the US economy. If yields fall below 2.2%, then it tells you that the US economy hasn’t regained strength and that the Federal Reserve might hold off on more interest rate rises. After all, it makes no sense to raise rates in a slowing economy.

But if yields start to move higher again, you’ll know that the first quarter slowdown in consumer spending was a one-off, and growth is likely to have picked up again.

I don’t know which way things will go. I’ll be keeping a close eye on US bond yields.

This also has implications for the gold price. Gold and bond yields have moved in tandem lately. That is, as bond yields fall, the gold price rises. And when bond yields rise, gold moves lower.

As bond yields topped 2.6% in December, gold bottomed at US$1,130 an ounce. Then, as bond yields fell to a low of around 2.2% in mid-April, gold peaked at just below US$1,300 an ounce.

The relationship is easy to explain. The bond yield represents a cost to borrow money. Gold, being a monetary asset, moves in price to reflect these changing costs.

Gold benefits from monetary extremes, like deflation or high inflation. It also benefits from monetary disorder and the fear that this brings.

Stronger growth bringing about higher inflation would be bad for gold. The stock market likes a bit of inflation. That would attract more capital to stocks, and reduce the need to hold gold. It’s only when inflation becomes too strong (which could bring about a faster pace of interest rate rises than expected…and an unexpected economic slowdown) that gold would benefit.

Right now, the chances of inflation becoming too strong look remote. And before inflation becomes too strong, it is just right. So unless we’re heading back to a general global slowdown and deflation again, I can’t see gold taking off to the upside.

But who knows? As I said, your best bet is to watch bond yields closely to see how the US economy is tracking.

Closer to home, the focus will be on the banking sector this week, with ANZ and NAB set to release their first half results. From The Australian:

The big four banks are expected to unveil profits in excess of $13 billion over the next two weeks, with recent independent interest rate hikes, aimed largely at property investors, expected to boost earnings into the future.

The sector has been hit by rising costs as competition for term deposit customers sparked a price war between the lenders towards the end of last year. But with the Australian Prudential Regulation Authority forcing the banks to tighten access to riskier investor and interest-only loans, a wave of mortgage interest rate hikes across the sector will add about $2.5 billion to the bottom line of the four major banks this year alone.

That last sentence tells you why the Reserve Bank of Australia won’t be raising interest rates anytime soon. The banks’ recent interest rate hikes will suck around $2.5 billion out of the economy.

That money won’t disappear though. It will flow into the banks and capitalise into higher share prices (actually, that’s already happened), and then come back into the economy via dividends. In effect, it’s a redistribution of wealth from borrowers to savers.

That’s not such a bad thing. It’s about time savers in Australia got something. For years now, the old adage ‘saving is a virtue’ has been turned on its head.

In saying that, things aren’t about to change. The Reserve Bank can’t raise interest rates with household debt levels as high as they are. That’s why they’ll be happy to see these pseudo rate rises work through the system.

The question is, how much will the recent bank rate rises actually bite? Will they stop the housing market in its tracks? And will that in turn reduce the demand for borrowing, and therefore weaken bank profits over the longer term?

More on that tomorrow…

Greg Canavan,
For Markets & Money


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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