February 23, 2024
By Steve Blumenthal
“The U.S. deficit has been going up, and it’s been going up because of higher interest rates. $17 trillion of treasury bonds come due in the next three to six months. The average interest rate on them is well below where interest rates are today. A lot of them are at 50 basis points. And if you have to reinvest them at 4% – you got an arithmetic problem.”
– Jeffrey Gundlach, DoubleLine Capital
While Nvidia stole the show this week, Wednesday’s Treasury auction of 20-year Treasury bond notes was the worst on record, leading to a broad-based selloff in government debt.
Why did it happen? And why does it matter?
When the government needs to borrow money, they sell bonds to investors—you, me, institutions. You can also think of these investors as lenders. The government sells these bonds by holding auctions, where they indicate the specific amount of money that they want to borrow at a specific interest rate. Investors can say “yes” and put in a bid to buy the bonds at that rate, or they can pass. Investors can also offer to lend money to the government at a higher interest rate than what the government proposed.
Say the government says, “We’re willing to offer a 4.50% yield on the 20-year Treasury bond we’re selling at this auction.” Some parties at the auction will accept that rate while others may counteroffer, saying, “I won’t buy that yield, but I’ll buy a 4.59% yield.” At Wednesday’s auction, 4.44% was the low-yield bid, and 4.595% was the high bid.
The government will start with the investors who accept their proposed interest rate. If they can’t borrow the full amount they need from investors willing to buy at that rate, they move on to the investors wanting to buy at a higher yield. At the end of the auction, everyone gets the same yield—the yield at the highest accepted bid, or in this week’s case, 4.595%.
The difference between the proposed yield and the final, accepted yield at is called a spread. The larger the spread, the worse the auction is deemed to have gone. Why? A large spread signals weak demand, lack of faith in the government’s fiscal situation, lack of liquidity in the financial system, etc. While there have been large spreads at other auctions recently, Wednesday’s spread broke the record for a 20-year Treasury bond auction. The media called it “ugly.”
When we talk about the bond vigilantes calling the government to task, we’re talking about this. The government needs to fund itself, and the task is getting more challenging.
In conclusion, the government wanted to borrow new money at a lower rate, but investors said, “We’ll only lend you the money at a higher rate. Otherwise, we walk.” The record-high spread required to complete the auction is a sign of mounting troubles in the financial system.
In a picture, it looks like this:
Investor Jeffrey Gundlach points out that the U.S. is running a deficit of over 6% of GDP. And the economy is currently in ok shape. In recessions dating back to 1969, the deficit jumps higher at an average of about 5% of GDP. The last three recessions got sequentially worse. So now we’re running 6%-plus of GDP, and there’s every reason to believe that in the next recession, the deficit could increase to as much as 12% of GDP. Well, here’s the real kicker: If we go to 12% of GDP and stay there—which is a big “if”—with interest rates at 6% (guessing on Treasury yields), the interest expense, as a percentage of tax receipts, will go up to 80% of tax receipts. That is an impossible position to be in. It cannot happen.
Gundlach added that the one thing that Jay Powell should be thinking about is that maybe we shouldn’t be so dogmatic about the inflation target; maybe we need to worry about the solvency of the entire financial system.
The big macro point here is that the debt hole is getting deeper. We must figure it out. It will take great leadership and won’t be easy, but we must figure it out. There is a way out. I just can’t envision an easy way out.
This Isn’t New
If you’ve read Edward Chancellor’s book The Price of Time: The Real Story of Interest, you know that what much of the developed world is currently experiencing is not new. Chancellor delves into the historical evolution of lending and borrowing, examining how central banks’ manipulation of interest rates has influenced economies and societies over centuries. He argues that artificially low-interest rates have led to significant economic distortions, including asset bubbles, excessive debt, and widened inequality. Through a blend of historical analysis, economic theory, and current examples, Chancellor presents a critical view of monetary policy and its consequences, warning of the potential dangers of continuing on the current path. The book serves as a historical account and a cautionary tale about the power of interest rates and the cost of disregarding their natural, market-driven levels. We can—and should—learn from history.
Grab your coffee and find your favorite chair. As I’ve mentioned in past letters, we’re in the early innings of a growing commercial real estate (CRE) problem. More specifically, in the CRE office space market, the defaults, write-downs, and risks within the banking system are likely to ripple through the economy. The challenges are already impacting small and regional banks and certain real estate investment trusts (REITs). Below, I briefly summarize what Tan Kai Xian of Gavekal Research calls in his recent article, “Day of Reckoning for U.S. Commercial Real Estate,” a “slow-motion train wreck.” He concludes that the risks in the system are somewhat bifurcated, with small banks and small businesses at greater risk than larger banks and large companies. Ultimately, this puts pressure on growth in the economy, but it’s not systemic. Rising interest costs and accelerating government debt are the bigger problems for the economy and risk markets. I must add that very few thought the subprime crisis in 2008 would be systemic. It sparked the Great Financial Crisis. Systemic indeed.
If you watched the DoubleLine Capital Roundtable 2023, Part I discussion on macroeconomics featuring Jeffrey Gundlach and Jeffrey Sherman from DoubleLine Capital as well as Jim Bianco, David Rosenberg, Charles Payne, and Danielle DiMartino Booth that I mentioned in last week’s OMR, today you’ll find hot links to Part II (Market Outlooks) and Part III (Best Ideas). Finally, I conclude with an optimistic note about opportunity from our favorite coach.
On My Radar:
- Day of Reconning For U.S. Commercial Real Estate – GavekalResearch
- Macro Discussion Parts II and III – Gundlach, Sherman, Rosenberg, Bianco, DiMartino Booth and Payne
- Current Price to Book and Probable Returns
- Random Tweet’s
- Personal Note: Coach Sue
- Trade Signals: Weekly Update, February 21, 2024
See Important Disclosures at the bottom of this page. Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.
Day of Reconning For U.S. Commercial Real Estate, by Tan Kai Xian, GavekalResearch
“The stocks of big US commercial real estate services companies leaped by 8-9% (mid-February) after CBRE bosses claimed the worst is over for the US office leasing market,” wrote Tan Kai Xian in his February 16 article for Gavekal Research. “There may be an element of wishful thinking behind their optimism. The fallout from the US CRE slump is only just beginning.”
Here are some high-level, bullet-point quotes:
- Despite upbeat talk, three big problems continue to plague the CRE sector:
- 1) Vacancy rates remain high compared with pre-Covid levels, which means the CRE sector’s return on invested capital is lower.
- 2) The Federal Reserve’s monetary tightening over the last two years has pushed the sector’s cost of capital up.
- 3) Credit conditions have tightened, meaning that loan financing, which the CRE sector relies heavily on, is less readily available.
- So far, the fallout has been limited. There have been few forced sales, markdowns, and bankruptcies—partly because transaction volumes have fallen, meaning price discovery has stalled.
- However, this may be starting to change. Facing their own domestic property slump, Chinese real estate investors are reportedly seeking to raise cash by selling their international holdings—transactions which are likely to provide some transparency in market valuations and lead to more widespread markdowns.
- More than USD $1 trillion in commercial mortgages is set to mature over the next two years. This will erode the collateral’s value, making refinancing harder.
- Bankruptcies are likely to rise, which will hit CRE investors.
- Listed REITs have already sold off. The FTSE Nareit all equity REITs total return index of US-listed REITs is down -25% from its peak at the end of 2021.
- However, there is a sizable cohort of nontraded (i.e., unlisted) REITs that calculate their net asset values using appraisal-based methods. These have seen much smaller drawdowns and, in some cases, no drawdowns at all.
- This anomaly suggests further asset markdowns are likely among nontraded REITs as rising transaction volumes set new benchmarks for current market values.
- Direct and indirect lenders in the CRE sector are both set to suffer.
- Examples in recent weeks include New York Community Bancorp, which was forced to make large provisions against losses on its commercial real estate book (see Regional Bank Crisis, Round Two), and KKR Real Estate Finance Trust, which cut its dividend by -40% after taking losses on its loans.
- Further losses are likely to follow.
- Further losses are expected to hit the US regional bank sector, which accounts for much of US CRE lending and in which CRE loans make up 30% of the balance sheet, compared with 6% at large banks.
- Banks lending to private equity funds and the like, which provide financing to the CRE sector, are also likely to suffer.
- It’s hard to determine the size of exposure we’re likely to see, but in recent years, there has been a proliferation of private lending by non-banks to the CRE sector, including mezzanine financing extended to real estate companies and not secured against individual properties. While the losses will be locally painful, the macro-scale impact on the US economy is likely to be small.
- The principal channel of transmission to the broader economy will be a further tightening of regional bank credit as loan loss provisions mount.
- This will not hurt as much as it might have in previous cycles. In the current cycle, businesses have been able to finance more of their capital expenditure from internally generated funds and have been less dependent on external financing.
- It will, however, hurt small businesses that are reliant on external funding. Typically, these businesses depend on bank loans, often from regional banks. The NFIB Small Business Survey shows a clear tightening of credit conditions and a decline in loan availability over the past two years.
- Gavekal Research believes this will likely persist, leading to bankruptcies among small businesses. However, bigger companies reliant on external funds will be less affected.
Gavekal concludes: “As a result, the slow-motion trainwreck in the US CRE sector and its impact on regional banks may be one more factor contributing to the outperformance of large-capitalization stocks over small caps.
“But the broader economic impact is unlikely to be big enough to threaten total US growth. Of course, the troubles in the CRE sector are in part a reflection of the tightening of monetary policy over the last two years, which is having a constraining effect on growth. For now, at least, the pain remains largely localized.”
You can learn more about Gavekal Research here.
Macro Discussion Part’s II and III – Gundlach, Sherman, Rosenberg, Bianco, DiMartino Booth and Payne
Here are a few bullet-point highlights from the roundtable Part II:
During the markets segment of its 2024 edition, participants in DoubleLine Round Table Prime present their outlooks on various markets and topics for 2024. Coming together for Round Table Prime are DoubleLine CEO Jeffrey Gundlach and moderator DoubleLine Deputy Chief Investment Officer Jeffrey Sherman with their guests James Bianco, President and Macro Strategist at Bianco Research; Danielle DiMartino Booth, CEO of Quill Intelligence; Charles Payne, author and Fox Business Anchor; and David Rosenberg, President of economic consulting firm Rosenberg Research & Associates. Round Table Prime was held Jan. 11, 2024.
- (5:06) Jim Bianco says the art of stock picking is very much alive, breaks down “a multi-year bear market in bonds,” talks the resilience of the U.S. dollar as a reserve currency, and discusses China’s slow recovery and its impact on commodities.
- (10:44) Jeffrey Gundlach looks at valuations and price-to-earnings since the November start of the Everything Rally then talks about how a secular shift from a long period of declining interest rates to a period of rising interest rates will impact participants’ and prognosticators’ understanding of the markets. He also discusses the potential economic backdrop that would have him looking at EM and lower tiers of credit, and he shares why he has put money in India and doesn’t even look at it. He closes with his thoughts on mortgage spreads, high-yield bond defaults, and TIPS.
- (25:18) David Rosenberg talks about how the CPI is a flawed statistic, the S&P 500’s flat two-year performance with no improvement in valuations, how there’s so much psychology involved in the stock market, the equity risk premium, and how the soft landing is real and how historically it has served as a precursor to contraction. He also shares his thoughts on positioning and the outlook for several countries, including Japan and Canada.
- (42:08) The markets section concludes with Danielle DiMartino Booth discussing private markets juxtaposed against public markets and the impact of public pension funds flowing into private equity a few years ago, and speculating on who will be living in Illinois if Indiana gets rid of its state income tax.
Put your sneakers on and earbuds in and head out for a nice walk—or do what I do and play it via Bluetooth in my car. It’s really worth a listen.
Click on the photo to link to the full Part II Macro Discussion.
Roundtable Part III (13 minutes)
Panelists gave their best ideas for 2024. Please note that the recommendations are not to be deemed advice from CMG or me in any way. It is not a recommendation to buy or sell any security. Please talk with your advisor before making an investment. The views expressed may or may not align with CMG’s and/or my personal views.
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
Current Price to Book and Probable Returns
This is another look at the overvaluation of U.S. Equities:
Source: Bloomberg, @TaviCosta, Crescat Capital LLC
What this means in terms of probable returns:
Note the S&P 500 Index annual gain (grey shaded area upper left in chart). I continue to find it challenging to see the reward vs. risk in buying and holding cap-weighted index funds.
Source: Ned Davis Research
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
Random Tweet’s
An Interesting Look at Biggest 2024 Risks from Visual Capital
Source: VisualCapitalist.com
The Sequence of Events – 2008 Great Financial Crisis:
Food Inflation (I wonder what Ozempic inflation looks like?):
This has only happened 12 times since 1948. The recession drums are beating louder.
“Don’t look Ethel!” Insiders are streaking out of their stocks. Old timers will get the humor (a lot was going on in the late 1970s).
This chart shows insiders racing to the exit doors.
Source: @GameofTrades
You can follow me on X (formerly Twitter) @SBlumenthalCMG.
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
Personal Note: Coach Sue
Last night, my wife Susan and I sat at our kitchen table with wine in our hands, and Susan played a dozen or so motivational Instagram video clips for me. As you probably know by now, Susan is a youth soccer coach and is always looking for a way to connect, help, and motivate her players. I was amazed at how she sorted select video clips into different categories.
The following short clip – John Rohn’s advice on opportunity, resonated in an especially big way,- so I thought I’d share it with you. It’s short, simple, and sage advice: Keep watching for opportunities—in your career, personal life, and, most importantly, friendships. If you feel inclined, please share it with your kids, as we did with ours.
Speaking of opportunity, we tend to think we can control most situations. The truth is, though, opportunity most often presents itself when we least expect it. Put your intentions out in the universe and patiently watch for the signs of opportunity.
That happened to Billy Crystal early in his career, and it’s a wonderful story.
If you have the time, fast forward to the 17-minute mark in the following video, where Crystal talks about Johnny Carson and tells the story about how he met Mohamed Ali. It’s spectacular.
I hope you felt as much joy watching Billy Crystal as I did. His imitations of Howard Cosell and Mohamad Ali… priceless!
Wishing you a wonderful week,
Steve
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Trade Signals: Weekly Update – February 21, 2024
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