Rising Bond Yields, Economic Recovery and the US China Tech Wars

• 10-May-21
• admin

Market action in the last week has been dominated by the rise in long term bond yields, especially in the US. Putting things in perspective, the main reason for the slide in bond prices (rise in yields) is a reversal of a previously overdone trend. During the early pandemic, fear of the unknown had led to the buying of the US dollar in foreign exchange markets, and then a further flight to safety in US treasury bonds, considered the default risk-free asset class. As a result, the benchmark 10 year bond was chased to an unsustainable 0.5 percent early in the pandemic. For those unfamiliar with bonds, this means that the investor commits to an investment that will get a return of only ½ a percent per year for ten years. You cannot get out of that deal unless you take a capital loss…How sustainable is that?

The pendulum had swung too far. Sooner or later, the overbought bond market had to correct. It has actually been doing so over the last six months when yields gradually crept back up, without much fanfare, until it was sitting at yield levels around 1 percent in early 2021. In the last two weeks, there was a sudden realization that bond yields have to correct even more. There must be a reversion to the mean of long term yield levels, as the economy recovers.

Normal yields on long term bonds should be a couple of percentage points above long term inflation, which is around 3 percent in the US. So, the current 1.5 percent bond yield is a long way from the average of 4-5 percent. Fortunately, the inflation rate is down to 1.5 percent, and long term bond yields may be thought of as reasonable if they were between 2 to 2.5 percent, if the inflation rate does not change.

When the bond yield was 0.5 percent and way below inflation at 1.5 percent, hindsight tells us that a rise in bond yields was inevitable.

They did rise. But the excuse (and it is an excuse) for that happening is that the vaccination campaign against the Covid 19 in the US seems to be going well, with vaccinations reaching 2 million a day, and abnormality in people’s lives would end by the summer of 2021. There is hope that the economy will recover strongly in the next three to five months, probably much better than previously forecast.

Then there is the 1.9 trillion stimulus package, the first significant legislative and economic initiative of the Biden Administration.

Putting the two together, there is the fear that the economy will overheat, and inflation will rise quickly. By the logic of the bond market, investors of long term money will need to be compensated by higher yields as inflation expectations go up. Otherwise, the yields are also unsustainable since capital will be eroded in real terms if invested at yields that are below the inflation rate.

There is no question that an economic recovery is brewing. The tricky part is whether there is job growth. It is very likely that job growth will lag behind improving GDP numbers, as the US economy is bifurcated, with the Upper X percent of the country not having experienced any real recession, and the Rest having taken it on the nose.

The US Federal Reserve, whose policies completely determine the level and direction of interest rates, has stated in no uncertain terms that they do not perceive inflation as a near term problem. Their focus is entirely on ensuring jobs recovery. They have stated unambiguously that they will keep interest rates low.

“Low” interest rates remaining “low” has two meanings. The first is that short term interest rates, which are directly and completely determined by Fed policies, will stay near their current levels, which is zero. The other meaning of "low interest rates" regards the bond market. The Fed has less influence on the bond market, which is where long term interest rates are determined. To the extent that the Fed has been buying bonds, they have prevented long term interest rates (ie bond yields) from going up as well. But this is an indirect effect – the Fed is just another participant in the bond market.

Up till now. Short term rates are staying low, but long term rates are shooting up.

The result of this is not a general rise in interest rates but a steepening yield curve. Short term rates are anchored by the Fed at zero, and long term rates are being bid up by the market. (For those who are not familiar with this concept of the yield curve, I will give an educational talk on this after the Covid restrictions in SG when we can all go back to the office). For those who do understand this, the obvious impact of a very steep yield curve is that all financial intermediaries like banks will make money hand over fist. The thinking behind this at the Fed is that a robust banking sector will provide an abundance of loans and credit to businesses, which will then power a jobs recovery.

All in all, it is very clear what the Fed wants to do. Keep interest rates low to engineer a jobs recovery, by seeding banks with the ammunition to make lots of low cost loans to businesses and individuals so that economic activity is rekindled. This ties in with the Biden stimulus program. Eventually the economic recovery will become sustainable after this massive kick-start.

But markets tend to second guess what the Fed does. First of all, market participants in the bond market want to articulate a reason for bonds selling off in this correction of the overbuying during 2020. Pundits do not sound too smart to say that there are just more sellers than buyers. They like to push a story - a rationale for that selling. So they speculate that inflation is coming back.

Even as the Fed Chairman, J Powell, says there is no inflation to be concerned about, there are too many wise cracks who think the Fed is wrong and there will be overheating and worrisome inflation rearing its head. This cannot be the case. The whole world is in recession, and it is a buyers’ market. There is no price pressure at any point in the global supply chain. There is also no wage pressure as people are hungry to get jobs at any price. There is no inflationary pressure anywhere.

Nevertheless, the rise in bond yields is now a fact, whatever the real reasons are. Whether there is in fact inflation, there are already higher bond yields. This has the following immediate investment implications:

1. Bond yields will keep rising until they reach, at a minimum, the level of what the market thinks is the real inflation rate. Right now, the inflation rate is 1.5 percent. The 10 year bond yield is hovering around that level. In terms of real returns, this is a break-even level, as investors would only get back their capital in real terms after an investment horizon of ten years. Even if there is no change in the inflation rate, bond yields are likely to go up some more to provide a real positive return. A continuing rise in bond yields is not so difficult to forecast.

2. The stale tale that the dollar will fall when the pandemic ends is over. That view was prevalent for a good six months, with very prominent analysts and some top economists calling for a dollar crash of up to a third (30-35%). And that it would lose its reserve currency status. Overnight, nobody is talking any more about the dollar in retreat. The dollar did go down in the past few months, but by no more than single digit percentage amounts, egged on by incorrect analyses. We disagreed with that view and alluded to this repeatedly in this blog. As it turns out, by late Feb 2021, the dollar was also oversold. Now when these dollar shorts see the rise in US dollar yields, they panic and run for cover. Dollar rates against the currencies with negative yields have shot up, starting with the Swiss Franc, the Japanese Yen and the Singapore Dollar. Even the Euro has begun to turn. This new trend towards seeking higher yields will continue for a while. The Dollar will rise the most against the lowest yielding currencies.

3. The overall stock market rally is still underwritten by the Fed’s control of short term funding costs. The bull market is not over. As bond holders bail out of bonds, the capital will have to go somewhere. The stock market will therefore enjoy an influx of funds from liquidated bonds, and will not reverse direction by much. It may in fact continue to go up, in spite of elevated valuations. Stocks like banks and financial companies, for example, will gain. But stocks with zero dividends will become less attractive.

4. Technology stocks which have gone up the most in the last year, will see profit taking. Such stocks do not pay dividends, and relies on capital gains to provide a return to investors. When there is no more prospect of capital gains, the search for yield will side-line these stocks. The best example is Tesla, which has already fallen 32 percent, nearly one third of its value, in just 5 weeks.

5. The assets that used to be called “inflation hedges” - in particular gold - is moving in a direction for the last six months that does not indicate that people fear inflation but that they don’t want to hold an asset with negative yield. If inflation is a real problem, then one would have expected gold to shoot up; it didn’t. Now, it has the potential to break major support and take a deep dive.

6. Esoteric speculative plays like crypto currencies or Gamestop will face higher funding costs which undermine whatever fantastical narratives they were previously on. These speculative games are over. The insane idea that crypto currencies run by nobody (well, actually there is a crypto mafia that in fact run things) can replace fiat currency run by governments, now proven by Covid 19 vaccinations and effective economic policy that such leadership can again work, will soon be dealt a fatal blow.

The great investment mindset reset is on.

If people with money to invest, who have made a lot of money during the pandemic, now lose money in this environment, it may be how wealth inequality corrects itself. It is not a bad thing.

The indisputable good news is that the US economy is recovering. On Friday, the unemployment numbers showed that, falling to 6.2 percent. This will help to drive global economic recovery.

A number that was also released on Friday but ignored by analysts, because of the overwhelming interest in the unemployment rate, is the US trade deficit. This is now at a historical high. According to a report from Yahoo Finance:

“The level of imported goods to the U.S. in January reached unprecedented levels and pushed the trade deficit 1.9% higher as the coronavirus pandemic continues to distort global commerce.

The gap between the goods and services the United States sold and what it bought abroad rose to $68.2 billion from $67 billion in December, the Commerce Department reported Friday. Exports rose 1% to $191.9 billion, while imports increased 1.2% to $260.2 billion.

Imports of goods, not including services, increased $3.4 billion to a record $221.1 billion in January, led by pharmaceuticals, which rose $5 billion, or 39%, to $17.4 billion. Imports of services fell about 1%.

The figure exceeded the previous record for imported goods of $218.9 billion set in October, 2018.

U.S. exports of goods rose $2.1 billion to $135.7 billion in January, while exports of services, like transport and travel, declined $0.3 billion to $56.3 billion.

The politically sensitive trade gap with China fell 3.2% to $27.2 billion. The trade deficit with Mexico rose $1.6 billion to $11.9 billion in January.

The coronavirus has upended trade in services such as education and travel, sections of the economy in which the United States runs persistent surpluses. Measured in dollars, monthly exports of U.S. services have declined by nearly one-fourth since the virus outbreak about a year ago.

Year-over-year, the goods and services deficit climbed to $23.8 billion, or 53.7%, from January 2020.

Last month, Commerce reported that in 2020, U.S. trade deficit rose 18.1% to $682 billion, the highest since 2008, as the coronavirus threw global commerce into disarray and stymied then-President Donald Trump’s attempts to rebalance America’s trade with the rest of the world.

Friday's January trade data release is the last to include the period covering the Trump administration, which started a trade war with China and imposed steel and other tariffs on American allies that upended seven decades of U.S. policy.

Matt Ott, Yahoo Finance

5 March 2011

Clearly, this data shows that American consumers have an insatiable appetite for imported goods, especially from China. Despite the attempt to reverse the trade deficit by the Trump Administration to Make America Great Again, narrowing the trade gap has failed. Maybe the Trump efforts might have slowed down the rate of deterioration of the trade deficit, but that’s hard to know. The fact of the matter is that America is not going to be Number One in manufacturing ever again. China has moved too far ahead. And in the context of a consumption-oriented society in America, this makes part of the global economic structure permanent, with China being the leader in manufactured consumer goods and America its biggest customer.

 

With that said, the US is still the leader in high technology, especially in chips. The Americans understand this, and the Biden Administration is, instead of trying to be all things to all men, not pursuing the populist approach of Donald Trump. It is focusing on the most valuable part of the value chain, the semi conductor, AI, supercomputers and the chip making industries. No more soybeans. At least, this is a good fight, and worth the effort to try.

There is no question that the Americans are way ahead in this battle. Chip makers in the US are four to five generations ahead against the leading competitors in China. If the US can maintain this lead, then the country can still dominate the most valuable parts of the manufacturing value chain, and it is less important if the trade deficit remains high over inexpensive and unsophisticated goods.

The following are extracts from a Yahoo Finance report on Biden’s opening shots in the chip wars:

The Biden administration is setting the stage for the US to invest in the domestic chip manufacturing industry over fears the country is becoming too reliant on foreign suppliers.

On Wednesday, President Biden will sign an executive order to help the US create a “more resilient and secure supply chain."

As Politico first reported, the order calls on the White House to review vulnerabilities in the supply chain in four areas: semiconductors, batteries for electric cars, rare earth minerals, and pharmaceutical-related manufacturing. During the 100-day review, the Biden administration will come up with recommendations that the president and Congress can take to address supply chain weaknesses.

One goal of the executive order is to ensure the US never again faces a shortage of essential products, including surgical masks and semiconductors. For example, the US auto industry has struggled recently to secure enough computer chips needed to build new cars.

The other goal is to maintain the US’s competitive edge. "The United States is the birthplace of this technology, and has always been a leader in semiconductor development," the White House says in a fact sheet about the EO. "However, over the years we have underinvested in production—hurting our innovative edge—while other countries have learned from our example and increased their investments in the industry."

The statement is likely a reference to South Korea, Taiwan, and China fostering their own chip manufacturing industries. Taiwan’s TSMC and Korea’s Samsung—which build processors for Apple, AMD, and Nvidia—now rank as the two largest contract semiconductor producers in the world, according to research firm TrendForce.

As for the US, the country still has Intel, which manufactures its own chips in states including Arizona, New Mexico, and Oregon. However, the company’s leadership in microprocessors is facing serious challenges amid repeated delays to manufacturing technology upgrades.

The US tech industry is also concerned the country is losing a competitive edge to Asia. Earlier this month, a trade group that represents Intel, AMD, and Nvidia called on the Biden administration to boost federal funding to domestic chip manufacturing and research in the US.

The fact sheet for Biden's executive order suggests the administration will try to facilitate additional funding for domestic chip manufacturing. “The task of making our supply chains more secure can also be a source of well paid jobs for communities across our country, including in communities of color, and steps will be taken to ensure that the benefits of this work flow to all Americans," it says.

However, other media outlets point out the upcoming supply chain review may also entail US partnerships with allies in Asia, including Taiwan, South Korea, and Japan. The financial newspaper Nikkei Asia describes the executive order as the Biden administration trying to create a supply chain free from Chinese influence amid ongoing tensions with Beijing on trade and state-sponsored hacking.

In the meantime, both TSMC and Samsung are working to build new chip factories in the US”

Perhaps coincidentally, within the same week of the Biden announcement, China had its annual National People’s Congress. It gave its economic report card, which is quite good, as well as insights into its economic development strategy for the next five years. Extracts from Yahoo.Finance:

China’s No. 2 leader, Premier Li Keqiang, set a healthy economic growth target Friday and vowed to make the nation self-reliant in technology amid tension with the U.S. and Europe over trade and human rights. Another official announced plans to tighten control over Hong Kong by reducing the public's role in government.

The ruling Communist Party aims for growth of “over 6%” as the world's second-largest economy rebounds from the coronavirus, Premier Li said in a speech to the National People's Congress, China’s ceremonial legislature. About 3,000 delegates gathered for its annual meeting, the year’s highest-profile political event, under intense security and anti-virus controls. It has been shortened from two weeks to one because of the pandemic.

The party is shifting back to its longer-term goal of becoming a global competitor in telecoms, electric cars and other profitable technology. That is inflaming trade tension with Washington and Europe, which complain Beijing's tactics violate its market-opening commitments and hurt foreign competitors.

Li promised progress in reining in climate-changing carbon emissions, a step toward keeping President Xi Jinping's pledge last year to become carbon-neutral by 2060. But he avoided aggressive targets that might weigh on economic growth.

China became the only major economy to grow last year, eking out a multi-decade-low 2.3% expansion after shutting down industries to fight the virus. Growth accelerated to 6.5% over a year earlier in the final quarter of 2020 while the United States, Europe and Japan struggled with renewed virus outbreaks.

The 6% target is higher than expectations for the United States and other major economies but less than the 7%-8% forecasters expected Li to announce.

Li vowed to “work faster" to develop tech capabilities seen by the country’s leaders as a path to prosperity, strategic autonomy and global influence. Those plans are threatened by conflicts with Washington over technology and security that prompted then-U.S. President Donald Trump to slap sanctions on companies including telecom equipment giant Huawei, China's first global tech brand.

The ruling party’s latest five-year development blueprint says efforts to make China a self-reliant “technology power” are this year’s top economic priority.

The party sees "technological self-reliance as a strategic support for national development,” Li said.

The ruling party earlier announced it achieved its goal of doubling economic output from 2010 levels by last year, which required annual growth of 7%. Xi has talked about doubling output again by 2035, which would imply annual growth of about 5%, still among the highest for any major economy.

The ruling party’s desire for the prosperity produced by free-market competition also clashes with its insistence on playing a dominant role in the economy and strategic goals of reducing dependence on other countries.

Beijing will promote “domestic circulation,” Li said, a reference to official pressure on industries to use more Chinese-supplied components and technology and rely less on foreign inputs, even if that increases costs.

Joe MacDonald

Yahoo Finance

5 March 2021

There we have it. The two economic superpowers clearly recognize that they need to win in the ongoing technology fracas that was first brought into the world’s consciousness with the Huawei ban. Now, it is full scale war. Not of the shooting kind, but of a contest in human ingenuity with two completely different eco-systems for supporting such scientific and technological endeavors.

Eric Schmidt, former CEO of Google, interviewed on CNN, said that China may overtake the US in this chip war, especially since China has set its sights on being ahead in technology by 2030. Our thoughts? On the one side, one should never underestimate the Americans, especially the ingenuity of its Upper X percent economy; on the other side, the Chinese are highly motivated, with deep talent in government.

Whoever wins will rewrite Francis Fukuyama’s End of History.

May the best man, or shall say, economic system, win.

 

 

Wai Cheong

Investment Committee

 

The writer has been in financial services for more than forty years. He graduated with First Class Honours in Economics and Statistics, winning a prize in 1976 for being top student for the whole university in his year. He also holds an MBA with Honors from the University of Chicago. He is a Chartered Financial Analyst.