By Alex Temple
To the casual observer, the US rates market has never had it so good. We have had Ben Bernanke and now Janet Yellen. We’ve had calendar guidance and forward guidance. We’ve had a buyer who telegraphs all purchases, publishes all holdings and has bought almost 40% of all long Treasuries.
We have detailed minutes and friendly Q&A sessions. Every quarter we even receive the individual projections for inflation, growth and the path of Fed funds from each of the FOMC participants – although if you are being picky they have anonymised the data. However, despite all of the additional clarity and communication from the Fed, market participants are as polarised as they ever have been.
It does not help that the Fed decided to share its innermost thoughts in the ‘dot plot’ and then, after the market reacted to them, it turned around and told us to ignore them. You can’t close the lid on Pandora’s box. What is interesting is that, despite the +/-10 basis point moves after FOMC minutes and payroll numbers, actually volatility in the US rates market is approaching seven year lows. Since the middle of January, 10-year treasury yields have traded in a 2.60% to 2.80% range.
So what is the market telling us and why the polarity?
Treasury yields (or nominal yields) are a combination of the inflation rate and the ‘real’ yield, both of which include a risk premium to compensate the investor for the term of the investment. Ten-year Treasuries currently yield 2.62% of which the 10-year inflation rate is 2.19% and the implied real-yield is 43bps.
But like watching a 3D television without the glasses, the picture you get from spot rates is blurred as the 10-year rates are polluted by what’s going on at the short-end of the curve. To see the bigger picture you need to look into the curves, in this case the Treasury curve, the inflation curve and the real yield curve. These are built from treasuries and US Treasury inflation protected securities (TIPS – the US equivalent of index-linked gilts). Once we have the curves we can start to extract the interesting stuff, in this case the five-year, five-year forward rates.
The five-year, five-year forward rate tells us where the market thinks five-year rates will be in five years’ time. The five-year, five-year rate is a function of the five-year and 10-year spot rates. So if the five-year Treasury yield is 1.66% and the 10-year yield is 2.62%, the implied five-year, five-year Treasury rate is around 3.82%. Similar readings from the other curves show the five-year, five-year inflation rates is around 2.44% and the implied five-year, five-year real rate is 1.38%.
The reason these observations are important is that they help us get a better picture of what is driving yield curve movements as well as where longer term rates might eventually settle – the much debated neutral (or terminal) Fed funds rate. Economic theory implies that the longer run nominal rate is a combination of the neutral Fed funds rate and a term premium. The real rate can be viewed as a proxy for real long-term growth. Now the relationships are not bullet proof but neither are long-term growth projections.
Since the start of 2014, the five-year, five-year nominal yield has decreased from 4.60% to 3.82% – decomposing this, the five-year, five-year inflation rate has fallen from almost 2.70% at the start of the year to 2.44%; inflation expectations have come down. The five-year, five-year real rate has fallen from 1.90% at the start of the year to 1.38% currently; longer term growth expectations have also come down and as mentioned earlier, rate volatility is at seven-year low which has compressed the term premium.
So what do these rates tell us about the implied neutral Fed funds rate? If long term nominal rates are a function of the neutral rate and a term premium we need to calculate the five-year, five-year term premium. There are many different ways to approach this so we might as well use the Fed’s own model and inputs which according to Citi imply a term premium for five-year, five-year nominal rates of just under 100bps. So with five-year, five-year Treasury rates at 3.82%, stripping out the 100bps term premium implies a neutral Fed funds rate just under 3%.
The Fed’s own neutral Fed Funds rate projection from the March summary of economic projections (SEP) is around 4% and the Congressional Budget Office (CBO) forecast real GDP growth at 2.2% and inflation at 2%, implying a neutral Fed Funds rate of around 4.2%. It is also worth bearing in mind that the neutral Fed Funds rate in the 94/96 and 04-07 hiking cycles was around 5.25%.
There have been numerous discussions as to why this time is different; demographic-led declines in labour force, the “stock effect” of asset purchases etc. This might all have a “back on an envelope” feel to it but if inflation, growth and term premium are all below average and the Fed is telling us it sees the neutral rate 100bps higher than the market is current pricing them then an implied five-year, five-year Treasury rate of 3.82% is still too low. This means five-year and 10-year Treasury rates need to rise further.
Alex Temple is a portfolio manager at ECM Asset Management
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