For all the talk of rising rates, long-term interest rates continue to decline around the developed world. Disinflation concerns and signs of slowing global growth are dominating capital markets. Some investors and pundits are now looking to central banks to stop the madness in the markets. This is ironic as market bulls would retort harshly when critics would pose the possibility that it was the Fed and other central banks which were propping up markets. One can deny the truth all one wishes, but one cannot suppress the truth forever.

In spite of the rhetoric warning of spiking long-term rates, the yield of the 10-year UST note stood at 2.10% at the time of this writing. The yield of the 30-year U.S. government bond stood at 2.90%. On Tuesday, I opined that I expected yesterday’s 10-year UST auction would be strong, in spite of the fact that it was the second re-opening of the existing 10-year note. Re-openings tend to garner less interest, particularly from indirect bidders (which include foreign central banks).However, yesterday’s auction of $21 billion 10-year notes was met with strong demand, particularly from indirect bidders which purchased 71% of the new issuance, the strongest indirect bidder participation since November 2009 (the month in which QE1 was launched).

A combination of capital flight from troubled EM countries, a slowing (disinflationary) global economy and strong demographic-driven demand is helping to keep long-term bond yields/interest rates low.

Run with the Pack

The demand for high quality fixed income remains robust and is probably getting stronger. AB InBev’s (BUD) $46 billion bond offering, the proceeds of which will be used to finance its acquisition is SAB Miller (SBMRY), was met with demand I could only describe as “impressive.” The $46 billion was raised via seven bond issues with maturities ranging from three to 30 years. All tranches were well oversubscribed, Credit spreads over U.S. Treasuries ranged from +85 for the three-year trance to +205 for the 30-year tranche. Actual pricing (credit spreads) were significantly narrower than what was initially expected. This indicates strong investor demand. So much for concerns that investors could flee the fixed income markets due to “rising rates.”

Market participants are trying to draw correlations in attempts to figure out what is driving risk assets, including equities and high yield bonds, lower. By now it should be obvious that it is the Chinese yuan and commodity prices which are roiling the markets.

There is a tug of war in China between the government, which is trying to defend its currency and investors, and citizens which are fleeing the yuan. China had its banks buying yuan to counter currency flight. Much currency market commentary I have read indicate that the yuan should be 10% to 15% lower versus the major currency basket, based on economic fundamentals. The government is trying to prevent this from occurring as it would seriously damage its communist/capitalist hybrid economic plan. In today’s Wall Street Journal, Greg Ip has published an excellent article about how investors, once again, thought trees grow to the sky. Just as they thought that home prices would never fall during the housing bubble, they never thought that commodities prices and China’s demand for commodities would ever decline. This led to misallocation of capital and malinvestment.

In my opinion, what we are now witnessing is a deflating of the China/commodities bubble. Instead of allowing the markets to take their course, China is trying to keep the bubble inflated (at least somewhat). In the U.S., investors are now beginning to cry for central bank intervention (including from the Fed) to halt the slide of asset prices. This is not what free market economics and investing is supposed to be about, but investors have become spoiled, like children with indulgent parents.

St. Louis Fed president, James Bullard spoke this morning. Mr. Bullard is noted for his bipolar attitude toward monetary policy. Most recently he was hawkish, but today he sounded decidedly dovish, stating:

“With renewed declines in crude oil prices in recent weeks, the associated decline in market-based inflation expectations measures is becoming worrisome.”

He also stated:

“Headline inflation will return to target once oil prices stabilize, but recent further declines in global oil prices are calling into question when such a stabilization may occur.”

It is one thing when the Fed doves express dovish views, but when the hawks (even bipolar hawks) speak dovishly, markets pay attention. My base case is for the Fed to tighten twice in 2016, but if market, inflation and economic conditions continued to deteriorate, the Fed could remain on the sidelines for 2016.

The Fed’s Beige Book assessment of U.S. economic conditions reported only “modest” growth during the past six weeks and essentially flat wage growth (in spite of strong hiring). The Boston district was described as “upbeat,” while the New York and Kansas City Fed districts reported “essentially flat economic activity.” The report stated: “Just two districts -- New York and San Francisco -- indicated some acceleration in upward wage pressures.”

The Beige Book data is consistent with an economy that continues to expand, but dominated by low wage and/or part-time hiring. I believe that anyone who expects the U.S. economy to grow much above 2.0% (on average) for 2016 will probably be disappointed.