Is there any conceivable path for Japan – the world’s 3rd largest economy – to escape eventual default? The country owes one quadrillion yen ($8.4 trillion U.S. dollars), yet takes in only $460 billion annually. Even at negligible rates, the Japanese government must allocate approximately 40% of its total tax revenue on paying the interest – just the interest – on its government bonds. Is it any wonder that the Bank of Japan (BOJ) has never been able or willing to raise overnight lending rates beyond 0.5% for 15 years?
The only trick for a nation that cannot pragmatically reduce the size of its sovereign is to make certain that the rate it pays on interest payments moves lower and lower over time. The United States is no different. That is why it has been so easy for me to contradict prevailing wisdom on the direction of the 10-year U.S. Treasury Note for more than 16 months. Indeed, every prominent economist surveyed by Bloomberg at the start of 2014 predicted that the 10-year treasury yield would rise from 3.01%. The average forecast? 3.41%. In contrast, I explained that it would have to fall in order to service the interest on the $17-$18 trillion without adversely impacting government services. Ultimately, the 10-year dropped from the 3.0% level to the 2.25% level.
This is the reality for severely indebted countries. I have been making the same case for intermediate-term borrowing costs moving lower, not higher, throughout 2015 as well. Again, the experts universally anticipated the 10-year moving up from 2.25% to 2.75% by year-end. So far, the 10-year has moved lower towards my year-end target of 1.5%.
A non-profit organization (nationalpriorities.org) recently revealed where American tax dollars went in 2014. A staggering 15 cents on every greenback goes to interest payments on federal debt. If the U.S. intends to honor other obligations such as Social Security, unemployment, the public defense via the military, Medicare as well as universal health care, the percentage allocated to interest on treasuries cannot move appreciably higher. In fact, with the increasing number of boomers reaching the age of retirement and living so much longer, the allocation to servicing debt would actually need to move lower. The only way to do it? Make certain that borrowing costs keep sinking.
Although this singular theme of is enough to support the case for treasury bond price appreciation (lower yields), there are so many more reasons that treasury bonds will continue to defy rising rate fears. Economic weakness pushes investors into the perceived safe haven. Relative value against comparable government debt around the world, whether one looks at 10-year bunds in Germany at 0.16% or Japan’s 10-year at 0.34% or Spain’s at 1.25%, why on earth wouldn’t the world’s money pursue U.S. yields at 1.93%?
Admittedly, I have grown a bit weary of discussing the same topic; as a long-time advocate for ownership in funds like iShares 7-10 Year Treasury (IEF), iShares 10-20 Year Treasury (TLH), and/or iShares 20+ Treasury (TLT), I recognize that the discussion lacks pizzazz. On the other hand, since when did profits lose their sex appeal? After all, TLT has handily outperformed the S&P 500 SPDT Trust (SPY) since the start of 2014.
This is not to suggest that I regard bonds as the only portfolio-worthy investment. As I have for the last 16 months, I continue to favor the barbell approach for my clients. The safest of safer haven assets on the left hand-side of the barbell include funds like Vanguard Long-Term Bond (BLV), iShares 10-20 Year Treasury (TLH) and Vanguard Long-Term Government (VGLT). The right hand side? It still has price momentum stand-outs like SPDR Select Health Care (XLV), mid-cap movers like Vanguard Mid-Cap Value (VOE) as well as my long-time low volatility “fave” in iShares USA Minimum Volatility (USMV).
Have there been new additions to the right-hand riskier side since 2015 began? Absolutely – and I’ve talked about many of them along the way. The country that benefits the most from the battered euro is Germany – a country that exports more of its wares to the rest of the world than any other in the euro-zone. The iShares Currency Hedged Germany ETF (HEWG) has been a go-to asset for foreign exposure. Moreover, in spite of its price volatility, PureFunds ISE Cyber Security (HACK) is a thematic gem. While it has struggled to break through its February highs, it remains as attractive as any growth prospect in an insanely overvalued world.
For those who have not necessarily been reading me for the last decade, it is important to know that I am not a “buy-n-hold” investor. I protect positions with stop-limit loss orders, trendline analysis and hedges. It follows that if another “taper tantrum” were to occur, I would lessen the long-bond exposure and revisit reallocating to treasuries down the road. Similarly, if a broad market sell-off hits equities, client portfolios would see a greater allocation to cash until the storm clouds dissipate.