Friday, March 21, 2014

How much are yields going to rise?

The chart above shows Treasury yield curves past, present, and future, as calculated by Bloomberg. The date I chose for the past (April 30, 2013) marked the modern-day, all-time low for the 10-yr Treasury yield (1.6%). At the time, the Fed was half-way through its Operation Twist—buying 10-yr Treasuries and selling short- and intermediate-term Treasuries in an attempt to flatten the yield curve. QE3 wouldn't start until four more months or so. Economic growth had slowed meaningfully in the first half of last year, registering only 1.3% in the first quarter and 1.6% in the second quarter of 2013. The Eurozone was in a recession, the ISM index was disappointing, and retail sales were weak; the market didn't hold out much hope for the U.S. economy and so yields collapsed.

In the past year, the economic outlook has brightened, and yields have risen across the board. The Eurozone has come out of its recession, the Fed is winding down (tapering) QE3, there is no sign of recession, GDP growth has picked up, and stocks are 15% higher. 10-yr Treasury yields are up about 100 bps, even though QE3 has been in place throughout. Looking ahead, the bond market currently is pricing in a further increase of 60 bps in 10-yr yields over the next two years. Short-term rates, currently near zero (0.05% for 3-mo T-bills) are expected to jump to 3.3% in five years, at which time the yield curve is expected to be quite flat. In short, the market is pricing in at least 300 bps of Fed tightening over the next five years, and as much as 100-125 bps of tightening within the next two years.

The point of looking at future expected interest rates, which can be derived mathematically from today's yield curve, is to appreciate how much of an increase in future interest rates the market has priced in today. If future rates end up being equal to what they are expected to be, then it is impossible to make money by being either short or long. You can win a bet on interest rates only if they are higher or lower than what they are expected to be. Similarly, if you want to hedge against a rise in rates, then your hedge will only pay off if rates are higher than they are currently expected to be; if they aren't, your hedge will cost you money.

This is all very relevant for leveraged players and for those who make a living off the slope of the yield curve. The active players know very well that interest rates are expected to rise, so their strategies must be calibrated accordingly. Will the Fed raise rates faster or slower than is already anticipated? That is the question they must answer.

It is reasonable to think that a slower than expected economy and/or a lower than expected inflation rate would result in the Fed moving slower to raise rates, while a faster economy and/or a higher than expected inflation rate would result in the Fed moving faster.

In judging the risk of these two alternative scenarios, I'm inclined to favor the latter. I don't think it's possible for short-term interest rates to be 0-2% for the next two years when a) alternative asset classes offer substantially higher yields, b) a recession seems very unlikely, c) the public's demand for safe, short-term assets appears to be waning, d) banks appear to be relaxing their lending standards and have an almost unlimited capacity to lend, and e) businesses appear to be more inclined to borrow. These represent the stirrings-to-life of an economy that has been dragged down by risk aversion and is beginning to seek out risk. If short-term rates don't rise and become more competitive with riskier alternatives, speculative pressures could build and/or inflation could begin to rise, as money formerly socked away in risk-free places attempts to chase higher prices.

I've been worried about this sort of thing for a long time, and I've been premature as it turns out. But that's not a reason to stop worrying now. I don't think this risk poses a threat to growth, however. It's mainly relevant to those who are exposed to higher-than-expected increases in short-term interest rates and haven't taken steps to hedge that risk. For the rest of us, there's nothing necessarily wrong with higher interest rates. Indeed, they're already baked in the cake.


Benjamin Cole said...

"I've been worried about this sort of thing for a long time, and I've been premature as it turns out. But that's not a reason to stop worrying now." --Scott Grannis.

Bravo. Scott Grannis has just become an honorary member of my family. If one cannot worry, what is the point of living?

Possibly to help salve Grannis' worries he should take a look at this chart, which portrays the The “five-year forward break-even rate,” on TIPS.

It was at 2.39 percent on Sept. 14, 2012.

Now it is at 1.75 percent.

Great charts btw.

The market is showing no inflation even for the next five years---indeed, the Fed will undershoot its 2 percent target.

Well, maybe the market is wrong.

But the USA may be one full stride already into an era of very low inflation and interest rates. Japan was in this zone for 20 years.

Perhaps our Fed will be more aggressive in seeking growth than the BoJ was. I hope so.

Young Saver said...
This comment has been removed by the author.
Young Saver said...

Is it normal for the yield curve to be so flat in the 10-30 range?

At what point do you start thinking "inverted yield curve"? Would it be truly inverted, meaning any higher maturity bond will have a lower yield than any lower maturity bond?

theyenguy said...

Out of the financial chaos of a continually rising US Ten Year Bond, ^TNX, coming at the hands of bond vigilantes, who aggressively call credit investments of all types lower, such as US Ten Year Notes, TLT, International Corporate Bonds, PICB, Junk Bonds, JNK, World Government Bonds, BWX, Chinese DSUM Bonds, Emerging Market Bonds, EMB, as well as investors derisking out of stocks, VT, the beast regime of regional economic governance will rise to rule in policies of diktat in each of the world’s ten regions, and to occupy in schemes of totalitarian collectivism in every one of mankind’s seven institutions, as revealed in Bible Prophecy of Revelation 13:1-4.

Under the diktat of authoritarianism, banks everywhere will be integrated into regional governments; with the Eurozone and the US being leading examples of economic fascism. Savings and Loans, Regional Banks, and the Too Big To Fail Banks, such as BOFI, SIVB, HBAN, BAC, will be integrated into the banks and be known as the Government Banks, or Gov Banks, and the banks current Excess Reserves captured by the Government.

I recommend that now with a trade lower in the price of Gold, $GOLD, from $1380, one start to dollar cost average, an investment in the physical possession of Gold Bullion, as in the age of destructionism, diktat and gold will be the only two forms of sustainable resource and wealth.

PD Dennison said...

I understand your scenario and believe market expectations match it.

I differ in where the EU, Japan, China and EM are versus where the US appears to be in the economic cycle.

China and EM seems to have already peaked. The EU and Japan seem to be going nowhere fast, with Japan the poster child of where I see the global economy.

The US appears to be mimicking the EU and Japan in many ways (government regulation and crony capitalism), such that I see our rates heading toward Germany's (1.6% 10YR), as the EU heads toward Japan's (0.6% 10YR).

Unless the US make structural political changes, I see US interest rate heading down and not breaking much through 3% on the 10YR T. The "normal" US business cycle stays the "new normal", with a lack of a business cycle, just a slow drift downward, with lots of hope (like that past 5 years).

The speculative bubble concerns you note are where I think we are at and this could have the blow-off you fear, which I think is inevitable at this point.

Hello NASDAQ 7000, crash and then a new fresh US 10 YR T low!! Could be very interesting...

PD Dennison said...


I do have a question.

What do you see that has changed in the past few years that justify the US economy turning up and interest rates up? (Energy is the only thing I see jumping off the page).

Normally a "recovery" like the past 5 years would result in government growth policy being implemented. Instead, we are seeing cronie capitalism and higher taxes as a prescription from Washington.


Scott Grannis said...

For the economy to growth significantly faster I think we will first need to see growth-oriented policies coming from Washington (e.g., tax reform, lower corporate income taxes, reduced regulatory burdens). Inflation could rise if the Fed is slow to reverse QE. Either one would likely result in higher-than-expected interest rates.

Hans said...

salve 1 (săv, säv)
1. An analgesic or medicinal ointment.
2. Something that soothes or heals; a balm.
3. Flattery or commendation.
tr.v. salved, salv·ing, salves
1. To soothe or heal with or as if with salve.
2. To ease the distress or agitation of; assuage: salved my conscience by apologizing.
[Middle English, from Old English sealf.]

Bravo, Scott Grannis has just become an honorary member of my family. - Ben Jamin

It is time for you to treat, Mr Grannis, to a fine grilled prime steak.

Reform? No, America needs to gut the last fifty years of laws and regulation imposed upon the American people (folks for Obama supporters), just like one dresses a deer..A revolution in morals and governing and not window dressing.

You can remodel a 200 year old farm house but it will still be a farm house.

America has lost a decade and a half of prosperity because
citizens have not discharged their civic duties; filling the seats of arenas nationwide and leaving their council seats empty.

The decline in economics and power is and will always be preceded by declining societal values..

I am sorry about the lack of economic content.