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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation Report for 03/03/2025. I'm Phil Adler. Mortgage rates in the neighborhood of 7% are are dampening housing demand leading into what is normally a busy time of year for sales. Confluence Associate Market Strategist Thomas Wash joins us today to discuss why long term interest rates have been slow to come down even after the Federal Reserve lowered short term rates. Thomas, the gap between short term and long term interest rates known as the term premium has been widening.
Phil Adler:Why?
Thomas Wash:Thanks so much for having me. So the term premium has been climbing over the last few months, and there are a few key reasons behind it. One of the big ones is the rise in inflation expectations along with worries about the growing deficit. When the market started pricing in the current administration's victory, there was a lot of optimism that their policies could boost GDP growth, but that optimism also brought concerns that the economy might overheat. On top of that, all the back and forth over the debt ceiling has really added to the uncertainty.
Thomas Wash:It's been a bit of a roller coaster and has definitely played a role in pushing the term premium higher.
Phil Adler:What is the normal term premium, and and where do we stand now?
Thomas Wash:Well, the term premium refers to the additional yield that bondholders demand from the government as compensation for holding longer term debt, reflecting the risk associated with inflation, interest rate changes, and other uncertainties. In an ideal scenario, the term premium would be zero as investors would not require extra compensation if they were fully confident in the government's ability to manage inflation and debt levels. However, in recent years, the term premium has risen significantly. This increase is largely driven by growing concerns that the Federal Reserve may struggle to rein in inflations and concerns that the government debt will continue to rise, leading investors to demand higher returns for taking on longer term risks.
Phil Adler:The demand for housing is a key part of the economy. Thomas, how is the Trump administration addressing the issue of persistently high mortgage rates?
Thomas Wash:Well, the current administration has identified reducing borrowing costs for households as one of its key priorities, aiming to provide relief to the middle class. To achieve this, the administration plans to focus on lowering the ten year treasury yield given its strong correlation with various consumer interest rates across the economy.
Phil Adler:Well, cutting the national debt seems like an obvious way to hold rates in check and and even bring them down. How is the debt cutting strategy shaping up, do you think?
Thomas Wash:So the president has made reducing government spending a central priority, ensuring that his new policies do not significantly increase the deficit. To achieve this, he has enlisted Elon Musk and his DOSE team to review government expenditures, identify inefficiencies, and push for the downsizing of workforce redundancies within the government agencies. Additionally, fiscal conservatives within the GOP have advocated for reforms to the social safety net and the closing of several tax loopholes as part of broader efforts to curb spending.
Phil Adler:How do the markets seem to grade the Trump administration's debt cutting efforts so far at the time of our recording, which is in late February?
Thomas Wash:Unfortunately, the bond market has shown limited responsiveness to recent proposals. Although the ten year treasury yield has declined, this decrease is largely driven by growing concerns over an economic slowdown and, you know, some optimism stemming from the treasury's decision to keep its issuance levels roughly in line with those of the previous administration. Notably, the S and P Global PMI Services Index fell into contraction territory in February for the first time in over two years, signaling potential economic headwinds. Furthermore, government plans to increase the number of treasuries issued into the market suggests confidence that it does not need to expand its borrowing capacity significantly.
Phil Adler:Thomas, you mentioned in this week's report other methods the government might employ to manage the ten year treasury yield. One is for the treasury to emphasize shorter term debt when it sells bonds. This is a method that has been used in the past. Has it been successful?
Thomas Wash:Oh, in short, yes. This strategy has been employed in the past by the previous administration as a means to ease pressure on long term treasury yields. The issuing more short term debt, the government can reduce the need for long term debt issuance. This approach was implemented to address liquidity concerns as investors have shown resistance to holding long term debt due to growing concerns at the size of the deficit.
Phil Adler:Would managing bonds in this way lead to a rise in shorter term rates?
Thomas Wash:Well, shorter duration bonds carry significantly less price risk but are more exposed to reinvestment risk, making them highly sensitive to changes in Fed policy. Consequently, the shift towards shorter duration issuance has seen sustained demand as investors are repaid more quickly, providing them with greater flexibility.
Phil Adler:Is there any downside to employing this strategy?
Thomas Wash:Basically, moving money into treasury bills, for example, allows the government to act as an alternative for investors looking to park their cash in the reverse repo facility. However, if too many bills are issued, it could drain this facility, making the strategy only effective in the short term. Once this money runs out, issuing more treasury bills could become challenging unless the Fed steps in to intervene.
Phil Adler:Thomas, we've heard that the Trump administration is thinking about issuing one hundred year legacy bonds and forcing foreign governments or trying to force foreign governments to buy these bonds to avoid tariffs. This might stabilize long term yields. We did address this possibility in a previous Confluence podcast on tariffs. Do you think we can expect something along the lines of strong arming other countries to buy one hundred year debt?
Thomas Wash:The individual who has spoken the most extensively on this topic, particularly in reference to what he termed the Mar A Lago accords, is James Bianco. However, he appears to be uncertain about the idea, suggesting that the Trump administration may or may not pursue it. So while there appears to be some willingness within the administration, particularly from CA director Stephen Merren to consider this approach, there has been no clear indication that other countries would be receptive to the idea.
Phil Adler:Could you explain regulatory changes that might be coming down the pipe to try to lower longer term yields?
Thomas Wash:So there is speculation that the Trump administration may consider easing the supplementary leverage ratio requirement, which is a regulatory measure used to determine the amount of capital banks must hold against US debt and central bank deposits. Now if implemented, the rule change would reduce the amount of capital banks are required to hold when dealing with safe assets, such as treasury securities. Consequently, the freed up capital could potentially be used to purchase additional government bonds providing further support to the treasury market.
Phil Adler:To promote, market stability, the Federal Reserve, Thomas, has announced plans to slow its balance sheet drawdown. What's the possibility that the Fed may end its drawdown entirely or even resume bond purchases to help keep interest rates in check?
Thomas Wash:So the January FOMC meeting minutes revealed that Fed officials have begun discussions about ending the drawdown of its balance sheet. The primary focus is now on timing. Though it remains unclear when this will occur, we suspect the Fed could halt the drawdown by late spring or possibly early summer. As for bond purchases, I am less certain about when or if they will resume, particularly in the absence of a severe recession. A key concern is that the size of the balance sheet remains significantly larger than pre pandemic levels.
Phil Adler:Well, how is Confluence Investment Management expecting this to play out in the coming months? Do you think that long term bond yields may experience at least a modest decline?
Thomas Wash:We think the president has a solid chance of lowering the term premium if he follows throughs on everything we outlined in this report. That said, to see long term rates drop back to two to 3%, which would be a huge win for any households looking to reduce borrowing costs, he'll likely need some help from the Fed. This could come in the form of rate cuts or even restarting quantitative easing. But realistically, the Fed might only take action if inflation drops sharply or if the economy slips into a recession.
Phil Adler:Which brings me to my final question. Is a slowdown in economic growth a likely component or a likely outcome in this effort to manage long term rates?
Thomas Wash:Although a slowdown would help bring down long term rates although a slowdown would help bring down long term rates, this is certainly not an outcome the administration is aiming for as it prefers to drive growth through productivity improvements, which would allow the economy to expand without triggering inflation. Therefore, we do not believe that the current administration will deliberately slow the economy.
Phil Adler:Thank you, Thomas. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
Phil Adler:Our audio engineer is Dane Stole. I'm Phil Adler.