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Trade Wars, Bonds and Rates

07/23/2018 5:00 am EST

Focus: MARKETS

Mary Anne & Pamela Aden

Co-Editors, The Aden Forecast

The direction of interest rates is most important because this will determine which way the global economy and the markets go. And currently, there are some concerns. One big concern has recently been about foreigners and bonds, explains Mary Anne and Pamela Aden, editors of The Aden Forecast.

Here’s the story. The U.S. debt is huge and it keeps growing. About half of the debt is financed by foreigners. They do this by buying  U.S. Treasury bonds, and that money is used to cover government spending.

As our friend Bill Bonner notes, over the past 20 years, foreigners have financed $8 trillion worth of deficit spending. And next year the government is expected to sell more than $1 trillion in new bonds just to cover the deficit. This all worked fine, but now we’re beginning to see a change.

Trump’s tariffs and trade war tensions are straining relations and many countries are dumping their U.S. bonds. The Russians, Chinese, Japanese and others are selling their bonds, and concerns are growing that if the trade war continues to escalate it could lead to a global boycott of U.S. Treasury bonds.

Already foreign ownership of U.S. debt has dropped from 50% to 43% in recent years. For now, Russia is leading the charge and it’s pretty significant. In just the month of April, Russia sold half  of all its Treasury bonds. It sold $47 billion out of $96 billion.

And by doing so, Russia dropped down to 22nd place on a list of major foreign holders of U.S. securities. Russia's bond selling was in response to new U.S. sanctions on their aluminum  exports. And other countries are
expected to follow suit.

But this is all happening at a bad time. Why? Because the Fed is also selling bonds! You’ll remember that following the 2008 financial crisis, the Fed had to  intervene to help rescue the economy. They did this by dropping interest rates to near zero. They also bought bonds for several years via their QE program.

In fact, when all was said and done, the Fed ended up buying about $4.4 trillion worth of mostly U.S. Treasury bonds. And all that money added fuel to the economic recovery and it helped drive asset prices higher.

But last year, the Fed started selling some of its bonds. It actually went from being the biggest buyer of bonds to the largest seller. It did this because they felt the economy was strong enough to stand on its own. The Fed also raised interest rates.

Both of these measures were ways to begin tightening credit. This was an attempt to offset the easy days when the money was flowing. Our colleague Chuck Butler points out that the Fed will have sold $80 billion in Treasury bonds by year end. And they’ll reach a total of $2.5 trillion by 2023. This would be equivalent to a 1.25% additional interest rate hike.

So what does all this mean for interest rates? With demand becoming more scarce, it strongly suggests that interest rates will have to keep rising to attract potential buyers. That is, bond prices will be under downward pressure.

Currently, bond prices have been benefitting as a safe  haven due to trade tensions. And if the trade war gets nasty, we could see a recession pressure develop on the economy, pushing up bond prices. And safe haven buys could continue.

We’ll soon see. In the meantime, interest rates remain at a critical juncture. The 30 year yield keeps trading near its 80-month moving average at 3%. This average identifies the mega trend; above this average, the mega interest rate trend is up and that’s generally been the case this year. But it’s resisting, and until we see a clear move either way, the next trend direction will remain elusive.

The 10 year yield is similar. It’s been holding near 3%, which is the line in the sand. That is, if it rises and stays above 3%, it’ll strongly suggest the 10 year yield is moving into a higher range.

But if it stays below 2.90%, the 10 year yield could decline to as low as 2.50%.  For now, we continue to recommend avoiding bonds until we see how the trade war unfolds.

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