Central banks have taken numerous measures to inject liquidity into their domestic economies. This has helped boost risk appetite and investor sentiment.
- The European Central Bank’s stabilization programs have successfully reduced financial market and sovereign tail risk for banks.
- Global growth troughed in Q2 2012, but has been on an upward trend since.
- Market concerns over the U.S. debt situation are easing as the U.S. economy proved surprisingly resilient to many uncertainties.
As a result, investors are concerned that bond yields, which move inversely to prices, have bottomed for the U.S. 10-year Treasury and will surge, raising fears of a bond bear market along the lines of the Great Bond Bear Market of 1994.
Disconnect Between the 10-Year’s Current Yield and Fundamentals
We believe 10-year yields do not reflect current fundamentals and that the risk/reward ratio increasingly favors a gradual rising trend in yields. The key force behind a gradual pull higher in yields is the economy. Qualitatively, factors that drive long-term interest rate valuations include inflation expectations, growth expectations and the debt/fiscal outlook. Quantitatively, consider the results of a fairvalue model of the U.S. 10-year Treasury used by Citigroup’s fixed income research team, which covers fundamental variables in three key categories: growth, inflation and asset markets. Based on measurements of these, it projects the fair value for the 10-year U.S. Treasury yield to be 2.60%, compared to 1.99% currently (as of 3/15/13). Analyzing these key variables, it becomes clear that the 10-year yield is out of sync with current fundamentals. So let’s take a look at them.
Inflation Expectations and 10-year Yields
The Fed’s measure of inflation expectations the five-year forward breakeven inflation rate has been more or less stable between 2 and 3 percent since its inception in 1999. Following the Global Financial Crisis (GFC) beginning in 2007, there has been a convergence between inflation expectations and 10-year yields. Remarkably since 2012, 10-year yields have been trading “through” inflation expectations.
We think this condition is unsustainable. Investors will eventually demand higher yields to compensate for higher inflation expectations and not see the value of owning Treasuries. This risk could rise measurably the longer the Fed maintains its excessively easy monetary policy.
Where Should 10-year Yields be Trading?
We sought to calculate a proxy measure of where 10-year yields should be trading in light of the current real GDP and inflation environment. Presently, both real GDP (GDP discounting inflation) and inflation (the Consumer Price Index, or CPI) are growing around 2% in the U.S., which would equate to 10-year yields intuitively yielding around 4% more than double current levels.
Debt-to-GDP and 10-year Yields
There is a reasonably strong relationship between debt-to-GDP and 10-year yields. Since the mid-1990s, debt-to-GDP has been on a gradual rise while 10-year yields have moved in the other direction. Since the GFC, there has been a clear decoupling of these metrics. With debt-to-GDP skyrocketing from 36.3% in 2008 to 74.2% in 2013, and recent 10-year yields near their all-time lows, there appears to be little debt risk premia priced into the Treasury market. Yields have no place to go but up, unless you believe the status quo can persist. But the economy is growing, as I discuss below.
The pressure on yields to rise comes from . . . the economy
Gathering momentum in the economy will put persistent pressure on 10-year yields to rise rather than decline. The Fed maintains a fairly cautious view of the U.S. economy. But we believe the economy is stronger than many believe.
During the last few years, there has been a good deal of uncertainty over the U.S. economic outlook, especially public consumption, as the government focuses on cutting expenditures to reduce the fiscal deficit. If we strip out government consumption, the U.S. economy has been growing at a relatively robust rate between 3.0-3.5% year-over-year – similar to the mid-2000s.
Nonfarm payrolls have been averaging around 160k/month, not too far from previous peaks over the last 40 years. The housing market has been on a nice upswing with housing starts up 86% from the trough in 2009. The external environment is contributing to U.S. growth, with net exports rising 8 out of the last 9 quarters. A relatively weak USD and a pickup in global growth are the main factors boosting net exports.
Despite the Fed’s dour view of the U.S. economy, the markets will increasingly look past government consumption and focus more on the other sectors of the economy. We do not believe the recent softening in U.S. economic data is sustainable and expect yields to move higher on stronger macro-economic data. In my next blog, I’ll review the factors we believe are gathered behind sustainability for a rise in long-term rates.
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