Dan Fuss – Only Two Things Can Stop Rates from Rising

But this time, despite the tumultuous state of peace and politics in the world today, Fuss did not focus his analyses on either topic.

Fuss’ latest forecast featured the role of central bankers – including an assessment of how monetary policy will impact geopolitics and global markets.

While most of his outlook focused on the Fed, Fuss did say peace as is the dominant factor to consider.

“Peace – or lack thereof – is the dominant factor anytime, anywhere, for anybody,” according to Fuss. “And if that’s really going badly, then the rest of us aren’t worried about markets or P/E ratios or yield.”

“Now luckily, that’s not a bad topic right now,” Fuss said, “but it’s not as good as it was a few years ago; it was a more peaceful time then.”

Fuss spent little time discussing global conflicts, but rather urged investors to remember that peace “right now is the dominant factor because things can change.”

Fuss spent only a brief moment on politics. “This used to be a 22-second part of my speech, and I’m going to limit myself on this,” Fuss said.

“You have to acknowledge that the political setting, in a number of advanced parts of the world, is highly uncertain,” Fuss said. “Our own is a good example, and Europe is a very good example.”

He noted that the cohesion within the European Union does seem to have weakened, “so it makes it very difficult to deal with the problems we are analyzing in other parts of the world.”

“My political advisors said ‘you must keep your mouth shut,’” Fuss said jokingly, and moved on to the remaining topics.

“People – this is not the major threat to peace,” he said plainly, “the people part of it now is the movement and aging within society.”

Fuss explained that we are seeing historically unprecedented rates of population movement around the world, “It creates opportunity in very few places, but primarily, it creates friction,” he said. “Friction in a machine causes wear and tear,” he warned, “and it’s same thing on the investment side.”

“As far as the aging perspective, the basic situation we have in our society that really does impact fixed-income markets,” Fuss said, “is that the young people are gradually, more and more, starting to support older people as the society age structure changes.”

While this change is impacting the U.S. labor markets in a constructive way, according to Fuss, other societies such as Japan are experiencing economic issues due to shifting demographics.

Lastly, Fuss’ discussion of prosperity consisted of a positive overview of economic conditions.

“The employment as reported, and in reality, are quite a bit better than they were,” according to Fuss. “As far as the workforce goes, for those who want to work, the employment numbers are very encouraging on the surface.”

“The participation rate has been rising in more age categories of late,” he said, “even in the prime ages where it’s declined for years and years.”

Fuss said that it is a broadly shared suspicion that the unit cost of labor is being undercounted, but he concluded, “in general the labor environment is quite good.”

According to Fuss, “we’ve got a good economy, and there are no excessive inflation signs.” Commenting on the markets themselves, he said, “I cannot find anything that really looks like an egg ready to crack.”

This led to an extensive discussion of central banks. “[Monetary policy] is the thing that will start to unravel the hidden levers,” Fuss said.

“We are the base rate of interest,” Fuss said, “and other central banks have been pursuing extremely easy monetary policies”

“They even have negative rates at the short-end over in Europe, so that’s going to have an impact,” according to Fuss. He added that he is unsure how much of an effect this will have, but that it will be negative for those societies.

What will happen to interest rates?

I asked Fuss if there would have to be a geopolitical crisis to drive rates lower.

“I would say the answer is ‘yes’ – or an independent economic collapse,” he responded.

According to Fuss, existing deflationary forces in the global economy would not be enough to drive rates lower.

For instance, according to Fuss, although U.S. households at the lower end of the wealth spectrum currently have a net-negative savings rate – i.e. they are net borrowers not savers, which is deflationary – this would not have a significant impact.

“Let's assume that households decide they have enough debt,” Fuss explained. “They're not going to increase their buyout position,” he said. “So right there you'll get a slowdown in the economy, because household borrowing tends to be focused primarily on autos and housing,” he said.

“Not entirely by any means,” he added, citing credit cards as another example. But regardless, this wouldn’t drive rates lower, according to Fuss.

“You do probably need something extraordinary,” he said.

He doesn’t foresee an economic collapse. Fuss said, “it would be something out of left field.”

“Now I actually was around at the bottom of the depression,” he said. “I wasn't active in the markets, I was more active in diapers at the time,” he added, “but that came about really because of the aftermath of the geopolitical era.”

“Could you have a replay of that?” Fuss asked, referring to the German currency’s collapse. “Yeah, it's possible, we could have something like it.”

“Undoubtedly, if there is another problem, it's something that we haven’t thought of,” Fuss said. “What is it? I don't know,” he admitted.

Fuss drew from another past recession to consider the possible context for an impending economic recession.

“Despite a pretty good warning earlier in 2008 with Bear Stearns, the subsequent events late in the third quarter caught a lot of people by surprise,” Fuss recalled. “Even though it was well telegraphed, it was just one market,” Fuss explained. According to Fuss, investors made the mistake of assuming markets were not related. They did not foresee that market makers would have to liquidate assets in all areas when they bore heavy losses, according to Fuss.

“That's when something that's otherwise liquid becomes illiquid,” he cautioned. “So you’d look for that kind of covariance.”

“I would be surprised if it's going to be one of the major money-market banks,” Fuss said. “But it could happen.”

According to Fuss, “it would happen because they have a risk that they're not aware of, or a risk that they are not protecting.”

Fuss said that it’s not clear where the worries of financial leaders on Wall Street lie at the moment. “I don't see anything now, and it sort of bugs me,” he added.

“I raised a bunch of teenagers over the years,” Fuss said. “There's certain predictability to teenagers, there are certain predictable things that come with the maturing process – same thing with markets.”

“I tend to watch the newer markets and the newer ideas with a little bit of extra caution, to see if they're built on leverage,” he said. “Because I do think the Fed is going to try to raise short rates and stay at it to the degree they can.”

The Fed rate hikes

“I think they're very serious about normalization, that's serious talk,” Fuss claimed.

This is not the first time Fuss has forecasted higher rates. In October 2017, Fuss advised investors to exercise caution by building reserves, and suggested that they position themselves for an environment of rising interest rates. He also did so in October 2015, March 2015, and October 2013, causing his fund to miss the full benefit of bond rally in 2014. In April 2012 he made a similar, but incorrect, prediction.

According to Fuss, the Fed will be raising rates fearing that, if they let the expansion of liquidity continue, “it could eventually result in losing the stability of the currency – and then the ultimate storage value of the monetary unit.”

“If that happens, then head for the hills,” Fuss said. “That’s not a unique view, most people are afraid of that, and I would rather stay very far away from that.”

Fuss’ recent prediction that the 10-year Treasury yield will be above 4% in two years has garnered attention as rate hikes have come to dominate industry conversations. Fuss’ bold call was made with the big caveat that trade tensions don’t escalate.

When I asked Fuss about his estimate, he was quick to say “I’m pulling that number out of thin air.” He elaborated on his rate-level predictions, outlining the incremental shifts investors should fear.

“My best guess is we’ll get to 3.25% to 3.50%, wanting to be a 3%,” Fuss said. “And the 10-year will probably clear 4%, to a degree.”

“It will be viewed accurately as a spike,” he predicted, “and then the Fed will ease enough to drop the short rate back.”

According to Fuss, “the long rate will be artificial for some time as the corporate defined-benefit plans buy long bonds to match liabilities and get it off the balance sheet.”

“Those plans are maturing now and starting to decline in total assets anyways because they haven't taken new money or new entrants in such a long time,” he said. This cycle will eventually be in the past, Fuss explained, “and you could give a strong argument that that would have been it.”

“My own argument is ‘no, that's not it’,” Fuss said, “there are a couple more cycles beyond that.”

“How high rates will go, I don't know,” Fuss admitted, “but I will not be surprised if you eventually get short rates a couple cycles out.”

“Out a decade or more – the feds fund rate could be 4% to 4.25%, possibly 4.50%,” according to Fuss. “Ramifications are fairly severe when you start to get up into those numbers, unless that yield curve inverts right there, which I don't think will be the case.”

Bond ETFs to avoid

For years, investors have been concerned about bond ETFs that hold illiquid securities. If this becomes a problem, for instance in a market decline, which ETFs are most vulnerable?

“I won't mention individual ETFs that are vulnerable, just by type,” Fuss said.

“In the unlevered big areas, I would be most careful of the high-yield ETFs,” Fuss warned investors.

“I'm not going to worry too much about the unlevered ETFs,” he said, “I'm going to worry a lot about anything that implies leverage with the presumption of liquidity in the underlying market where the liquidity is a ‘sometime thing’,” he said.

“My number-one candidate is the high-yield area, because liquidity in high yield is a ‘sometime thing’ – some of the times it's there, other times it's not.”

“I know from conversations that this is an area of real focus of the Fed, and if they started to see that kind of problem emerging, I think they would be quick to respond,” Fuss predicted.

“If [the Fed] normalizes the yield curve, they'd be more able to respond than they can with current levels. “That's one of the strong arguments for normalizing, they speak about that.”

Fuss added that once in a while liquidity in the investment-grade area also disappears, but that it is rare.

Fuss noted that there are exceptions to his concerns about the high-yield space. He referred to two “big high-yield ETFs,” which presumably are HYG and JNK, and said he is “a little less worried about those really big ones.” According to Fuss, although they don’t have contracts, those ETFs have working agreements with the six major investment banks that they can call to offload when necessary. “So far, those have worked really well,” he said.

“But '08 was not a testing period for ETFs, because ETFs were not very big,” Fuss warned.

Aside from these two high-yield ETFs, Fuss explained, “the problem you run into is that the markets are liquid most of the time, but they are dealer markets.”

“There's nobody maintaining a market,” Fuss cautioned. “And even if there were, the sizes are such that unless you have an enormous amount of money, you could have a problem.”

“Now you still get the discounts over in the high-yield area,” he acknowledged, “but you still have to be concerned with that – those are not contracts.”

“If something happened that caused selling to start to peak for a few days at an increasing rate, that could present a problem,” he said. “We'll see, I don't see any signs right now,” he added.

According to Fuss, if something happens, investment banks are likely to go to great lengths to uphold agreements because ETFs are their most profitable business. In the case of unusual selling pressure in the markets, Fuss explained, investment banks would call firms like Loomis Sayles, who would be aware of what’s going on. “We know what to expect, the system more or less works,” he said.

However, Fuss warned, “if anything there was anything out there that would cause [Loomis Sayles] to be less willing to buy, or unable to for some reason – legislature and stuff like that – then you'd have to be careful.”

“Like the rest of life, there are a lot of surprises in the market,” Fuss said plainly. “Markets are fun – they have real consequences – but they're fun.”

Marianne Brunet is a financial markets analyst at Advisor Perspectives.

Read more articles by Marianne Brunet