The Outlook for the US Treasury Market
Following a spectacular 35-year decline, 2016 is likely to be a major inflection point for US interest rates. Market yields on ten-year US Treasury (UST) notes rose from an all-time record low of 1.36% in July to 1.85% just prior to the election and to 2.6% around yearend.
The extraordinary lows in interest rates over the past eight years can be attributed to four mega forces: A protracted deleveraging of household and bank balance sheets; widespread deflationary psychology; a stampede by risk-averse global investors into ultra-safe UST securities as the ultimate safe-haven asset; and the most expansionary monetary policy in the 100-year history of the Federal Reserve.
There is credible evidence that a trend reversal in each of these four factors may already be underway. Credit demand is steadily expanding; inflation has replaced deflation as the primary concern; business, consumer, and investor confidence are all on the rise; and the Federal Reserve has begun the multi-year process of interest rate normalization.
Investors should focus on two crucial quantitative variables to understand interest rate trends. The growth rate in nominal (current dollar) GDP has been an excellent proxy for the absolute level of government bond yields in the past. Changes in expectations regarding the FOMC’s policy rate is the other key proxy for bond yields.
Each of these fundamental forces should exert upward pressure on yields in coming years. Faster growth in real GDP and higher inflation imply that US nominal GDP growth should accelerate over the next two years; at the same time, the Fed’s rate-tightening cycle should gather momentum later this year and in 2018.
In the end, the FOMC’s federal funds target rate is the most reliable explanatory variable with respect to changes in long-term bond yields. The bond market’s implicit expectation for the future path of short-term rates over the next ten years can be approximated as the current market yield on ten-year UST notes.
In this regard, the 100 basis point rise in the market yield on ten-year Treasury notes during the past six months — from roughly 1.5% to 2.5% — implies that the market has raised its expectation for the average federal funds rate through 2026 by one percentage point.
From a purely quantitative standpoint, the market yield on UST bonds can be broken down into two discrete components: a real yield — which measures the underlying supply and demand in credit markets — and an inflation premium, which measures the consensus outlook for future inflation.
Today, the real yield on UST bonds as measured in the TIPS (inflation-linked bond) market is 0.35%. The current market expectation for inflation is in the vicinity of 2.0%, producing an all-in yield of 2.35% on UST securities with a ten-year maturity.
My forecast for rising bond yields assumes that the bulk of the uptrend will be in the form of an increasing level of real yields, which are currently artificially depressed. My estimate for a normalized late-cycle market yield for the ten-year Treasury is 4.5% — most likely in the period beyond 2018 — will be comprised of a real yield of 2.3% and an inflation premium of 2.2%.
My short-term forecast assumes a gradually rising trend in yields during this year, with considerable volatility in response to economic, financial, government policy, and geopolitical shocks. I expect yields on the ten-year UST note to reach 3% during the second half of the year, rising to a range of 3.5% to 3.75% during the second half of 2018.
The Treasury yield curve has steepened in recent months but should begin a sustained flattening trend as the year unfolds, extending through the remainder of the expansion. An inversion of the yield curve has occurred with a high degree of regularity roughly one year prior to the next recession. The flattening process expected within the next 12 months will begin
once monetary policy is no longer lagging the economy.
Interest rate forecasting will be a challenging endeavor again this year because of numerous wild cards in the outlook. The most important of these independent variables include the rate of US GDP growth, the rate of inflation, the pace of re-leveraging of consumer and business balance sheets, the direction of monetary policy, geopolitical risks, and shocks in the realm of US and European domestic politics.
From a very long-term perspective, it appears increasingly likely that 2016 marked a major inflection point in US interest rates, following 35 years of secular decline. Market yields on US Treasury (UST) securities roughly doubled during the second half of last year, with most of the gains occurring in the weeks following the election. Yields on the ten-year UST surged from a July low of 1.36% to 1.85% prior to the election and a high of 2.60% in December (See Chart 1).
This week’s Economic Perspective provides an analysis of the critical fundamental factors that determine the level and direction of government bond yields, along with a forecast of the likely trend in market yields in future years.
Global interest rates entered a new era in the aftermath of the 2008 world financial crisis. Long-term interest rates plunged from a cyclical peak of 5% in mid-2007 to an all-time record low of 1.36% during July of last year, as measured by the ten-year UST note. The previous all-time low occurred in the 1940-41 period, when market yields declined to nearly 2% during the late stages of the Great Depression and the melancholy period surrounding the Fall of France in the spring of 1940. The all-time high was in October 1981 at 15.8% during the latter stages of hyperinflation (See Chart 2).
Average Yields: Since the beginning of 2009, the weekly average market yield on ten-year US Treasury securities has been 2.5%. This compares with an average yield of 6.8% during the quarter century ending in 2007, just prior to the Great Recession. For UST securities with a five-year maturity, the corresponding average in market yields was 1.5% and 6.5%, respectively.
The New Normal: The new era of interest rates that began in 2008 can be broadly explained by what became known as “The New Normal” — an era of profound economic weakness, widespread excess capacity and underemployment, plunging inflationary expectations, and stagnant living standards. Specifically, the collapse in bond yields in the immediate aftermath of the demise of Lehman Brothers can be attributed to four factors:
- Federal Reserve Policy: The conduct of monetary policy during the past eight years has been the most expansionary in the history of the Federal Reserve System dating back to 1913, in two respects:
- Zero Policy Rates: The Federal Reserve’s primary policy rate — the federal funds target rate — was held at zero for an unparalleled seven full years through December 2015 (See Chart 3).
- Quantitative Easing (QE): The rapid expansion of the Federal Reserve’s balance sheet — from $900 billion in 2008 to $4.5 trillion today — was unprecedented, the result of the Fed’s highly aggressive asset purchase program (See Chart 4).
This combination of unprecedented monetary stimulus pushed government bond yields to record lows, operating through two systematic channels: (1) Expectations of bond investors were transformed by the notion that the FOMC would hold its policy rate at zero for many years; and (2) Aggressive purchases of long-term government bonds by the Federal Reserve exerted a potent gravitational pull on market yields.
Massive Deleveraging Cycle: The most intense deleveraging cycle since the 1930s produced massive downward pressure on market yields. In principle, deleveraging of household, bank, and business balance sheets is highly contractionary, as the process of debt reduction results in a deadly contraction in the amount of credit outstanding. A combination of shrinking demand for credit and surge in business and household savings — as spending was curtailed — resulted in rock-bottom interest rates.
Widespread Deflationary Fears: As the single most preferred financial asset during periods of deflation, the US Treasury market attracted massive flows of savings over the past seven years, exerting upward pressure on market prices and downward pressure on market yields.
Global Demand for Safe Assets: Economic, financial, and geopolitical crises always trigger an escalation in investor risk aversion and a “flight to safety” boosting investor demand for US Treasury securities, the quintessential safe-haven asset. Widespread fear, risk aversion, and anxiety sparked a stampede into government bonds, causing a spike in market prices and collapse in market yields.
Trend Reversals Underway: However, an analysis of these four mega trends strongly suggests that each is in the process of a sustained reversal: a steady rise in household and business credit points to the end of the deleveraging cycle; deflationary fears have already begun to shift to a rise in inflationary expectations; rising business and consumer confidence along with improving economic trends have sharply reduced investor demand for safe-haven assets; and the Federal Reserve has begun the daunting task of normalizing interest rates. The implication is that the era of rock-bottom interest rates may be behind us and that a new interest rate cycle lies ahead.
TWO KEY QUANTITATIVE FACTORS
Nominal GDP Growth: An analysis of historical data reveals a tight correlation between government bond yields and the underlying growth in nominal GDP:
|Past 50 Years (1966-2016)||+6.5%||6.5%|
|Past 25 Years (1991-2016)||+4.5%||4.4%|
|Past 10 Years (2006-2016)||+3.0%||2.8%|
The striking congruence between the average yield on ten-year UST securities is not a coincidence, but is actually based upon a credible relationship between the real economy and fixed-income market. It makes economic sense that yields on government bonds should equate to growth in GDP, measured on a current dollar basis (See Chart 5).
- Credit Growth and Yields: The explanation is straightforward: In theory, annual growth in current dollar output and spending (nominal GDP) should be roughly matched by annual growth in private credit needed to finance growth in the real economy. In turn, average annualized borrowing costs should be approximately matched by the annual growth rate in business and consumer credit. In a simple example, an economy with a nominal GDP growth of 5% should be accompanied by credit growth of 5%, and an average market yield on government bonds of roughly 5%.
- The Federal Funds Rate: The other notable linkage to UST bond yields is the overnight federal funds rate, the main policy rate used by the Federal Reserve to effectively manage the economy. Simply put, the current yield on UST securities can be approximated as the market’s expectation for the future path of the federal funds rate over the maturity of these bonds, (technically, the market’s expectation for the average yield on the federal funds rate is discounted to the present; the resulting average is then adjusted to include a small premium to take into account maturity risk).
- Recent Trends: As a current example, the nearly one percentage point rise in the ten-year UST since the weeks just prior to the election — from 1.5% to 2.5% — can be most effectively explained as a major shift in the market’s expectation with respect to the future path of short-term policy rates. Specifically, it appears that bond investors now expect the federal funds rate to average approximately one full percentage point higher over the next ten years than was assumed only three months ago.
To summarize, each of these primary indicators suggest higher bond yields in the future, based upon: (1) The likelihood of a faster growth rate in nominal GDP; and (2) A sustained rise in short-term interest rates.
TWO COMPONENTS OF UST MARKET YIELDS
From a purely statistical or technical viewpoint, the level of market yields at any point in time can be decomposed into two factors: (1) A real or inflation-adjusted component; and (2) A component that captures market expectations for the future trend in inflation.
- The Real Yield: Conceptually, inflation-adjusted (real) yields on government bonds can be thought of as a manifestation of economic optimism. Real yields tend to be high and rising during periods of rapid economic growth, robust productivity growth, and rising after-tax returns on invested capitalin the real economy.
- Economic Resilience: The opposite is also true: Real bond yields tend to shrink during periods of economic stagnation and weak productivity. Proponents of the “secular stagnation thesis” — including former Treasury Secretary Larry Summers — believe that the real fed funds rate should approximate zero.
- Tolerance for High Rates: In many respects, the sustainable real yield on government debt is a measure of the real economy’s ability or capacity to tolerate or withstand higher borrowing costs. In the post-crisis environment, there has been a general sense that real yields should be in negative territory in order to avoid choking off the fragile economic recovery.
- Historical Trends: The long-term (75-year) average rate of return on long-term government bonds has been roughly 6%, or 3% on an inflation-adjusted basis. The best metric to calculate real yields is the market for Treasury Inflation Protected Securities (TIPS), or inflation-linked bonds, which were introduced in 1997 (See Chart 6).
- The TIPS Market: The US TIPS market has experienced enormous volatility. Since its introduction in 1997 to the onset of the economic crisis in 2007, the monthly average yield on ten-year TIPS was 2.9%. This yield hit its all-time peak of 4.3% during the 1999 economic boom, plunging to a negative 1% in the aftermath of the eurozone debt crisis in 2012. Surrounding the election, the yield on ten-year TIPS surged from 0.25% in October to 0.75% in mid-December, settling back slightly to a rate of 0.50% at yearend.
- Medium-Term Forecast: The crucial element in my interest rate forecast is that the current real yield on long-term UST bonds as measured in the TIPS market is unjustifiably low and will gradually rise over the next several years, based upon the following factors:
- Elevated Returns on Capital: Currently above-average after-tax returns on invested capital along with rapidly improving business confidence should provide a favorable environment for spending on plant and equipment.
- Secular Stagnation: Intellectual (and emotional) support for the widely embraced secular stagnation thesis is likely to diminish as economic and profit growth accelerate over the next 12 to 18 months.
- Productivity: A long-awaited rise in the capital-to-worker ratio should have a salutary effect on measures of output per hour.
- Expectations for Inflation: Inflationary expectations can be best measured in the financial futures market: The CPI swap rate, which indicates investor expectations for inflation in five years, five years forward, i.e., expectations for inflation for the subsequent five years beginning in five years.
- Historical Trend: The current long-term inflation rate implied on CPI swaps is 2.4%, up from 2% just prior to the election. The peak and trough in recent years was 3.3% just prior to the euro crisis and 1.8% in the midst of heightened recession fears during the first half of last year. The long-term average since 2000 has been 2.75%.
Long-Term Equilibrium Yield: The key point is that real yields are artificially depressed, while market expectations for future inflation appear to have normalized at a higher level. From its current level of 0.75%, the inflation-adjusted yield on ten-year UST notes should approach a peak of 2% in coming years, most likely just prior to the next recession. Inflationary expectations are likely to remain in the vicinity of 2.5%. When combined with an estimated real yield of 2.0%, an inflation premium of 2.5% would imply a target market yield on ten-year UST notes of 4.5% during the period leading up to the next recession later in the decade, all else equal.
INTEREST RATE FORECAST
The US Treasury market is at an important crossroads. Following 35 years of secular declines in long-term interest rates, government bond yields appear to have hit bottom when the ten-year UST note reached a long-term trough of 1.36% in July of last year.
Treasury Market Assumptions: My forecast for market interest rates is based heavily on the expected path of short-term rates — as measured by the overnight federal funds target rate — which in turn is a function of economic growth, inflation, credit conditions, and the FOMC’s estimate of full employment.
Forecast: Assuming a federal funds rate in a range of 1.5% to 1.75% by the end of this year, ten-year UST notes could rise to a range of 2.75% to 3% by the fourth quarter of the year. Assuming a further rise in the federal funds rate to a range of 2.5% to 2.75% at yearend 2018, bond yields could exceed 3.5% by yearend 2018. Long-term UST bond yields could exceed 4% just prior to the next recession later in the decade. Assuming rates follow this general pattern, calendar year 2016 will mark the end of the 35-year bull market in government bonds.
THE TREASURY YIELD CURVE
The yield curve — also referred to as the term structure of interest rates — depicts the level of interest rates for all maturities of comparable-quality fixed-income securities at a given point in time. Under normal economic and financial conditions, the yield curve is upward sloping, simply reflecting rising term premiums as a function of rising maturity.
Yield Curve Slope: Shifts in the shape or slope of the yield curve can be generally explained by purely business cycle factors: Economic growth, inflation, credit demand, and monetary policy. More specifically, the shape of the yield curve at any point in time can be explained as the interaction between central bank policies and trends in the economy.
Expectations Thesis: While there are competing theories to explain changes in the slope of the yield curve, I believe that the most satisfying explanation is the expectations theory. According to this postulate, changes in the shape of the yield curve are triggered by changes in market expectations with respect to the future direction of interest rates. A steeply sloped curve is an indication that bond investors expect the rate structure to rise; a flat or inversely sloped curve is a signal that investors expect interest rates to fall.
Monetary Policy: This explanation can be refined further to incorporate the role of the Federal Reserve. A steeper-than-average yield curve indicates that monetary policy is lagging the economy, i.e., not sufficiently restrictive given current trends pertaining to economic growth and inflation. The converse is also true: A flat or inverted yield curve indicates that the conduct of monetary policy is overly restrictive in relationship to trends in the realm of economic growth and inflation.
Recent History: While The yield curve steepened in the immediate aftermath of the election, in specific response to increased economic optimism regarding economic growth, and expectations for higher policy rates in the future. Other market indicators suggest that a portion of the curve steepening can be attributed to an upturn in expectations for future inflation (See Chart 7).
Yield Curve Forecast: My forecast for the slope of the yield curve can be divided into two periods:
- Next Six Months: In the short term, the yield curve is likely to remain in an above-average steepness, for two reasons:
- Investor expectations for economic growth and inflation are likely to drift higher, at least for a brief interval.
- Monetarys Policy:Perhaps more importantly, I expect the Federal Reserve to continue to lag the economy, i.e., to hike its policy rate at a slower pace than would be consistent with improving prospects for economic growth.
- Next Two Years: For the majority of the next two years, a traditional late-cycle flattening in the yield curve appears likely. This anticipated flattening could begin as early as the middle of this year, and persist until the end of the current expansion (and onset of the next recession). The critical assumption for this forecast is that the Federal Reserve will eventually be compelled to tighten policy more aggressively, in an environment of robust economic growth, full employment, rising inflationary pressures, and an overheating economy.
Interest rate forecasts have been extremely hazardous in recent years, and 2017 is unlikely to be an exception. Investors should be fully cognizant of numerous risks to the outlook for interest rates, both on the upside and the downside:
Economic Growth: My rate forecast for 2017 is based upon an assumption of 3.5% growth in US real GDP. Actual growth of 4.5% or only 2.5% would significantly alter the level and direction of rates versus my forecast.
Consumer Inflation: The current year could be a pivotal year for inflation. Compared with my assumption of 2.25% for all of 2017, an inflation rate below 2% or above 2.75% on the upside would also alter the direction of bond yields.
Fed Policy: My forecast assumes three FOMC rate hikes during the year. There is disagreement among market analysts over the pace of tightening in 2017, with an expected range of one to as many as four rate hikes. The actual pace of FOMC tightening will be the principal determinant of the level and direction of UST yields.
US Dollar: The foreign exchange market is a major wild card in the outlook. In particular, continued appreciation in the value of the dollar would negatively affect domestic manufacturing and exports, dampen inflationary pressures, and encourage capital inflows into the US, all of which combined would exert significant downward pressure on bond yields.
US Politics: The outlook for domestic politics is another wild card given the enormous uncertainty over a wide range of policies in the aftermath of the election. Bond yields are unlikely to rise in a hypothetical climate of political discord and gridlock over pro-growth initiatives. Adoption of anti-trade protectionist policies would likely trigger a plunge in government bond yields worldwide.
Geopolitics: Negative shocks in the international arena — relating to European elections, Brexit, Russian aggression, China, the Middle East, or elsewhere — would also trigger an increased demand for safe-haven assets, culminating in a rally in the US Treasury market and plunge in market yields.