Monday, December 8, 2014

Gloomy yield curve

Is the stock market overly enthusiastic about the future of economic growth and corporate profits? Some measures of investor sentiment suggest it is, and PE ratios are above average. But to judge by the bond market, the outlook for economic growth remains dismal. Which one is right?

The bond market currently believes that short-term Treasury yields are unlikely to rise above 3% for the foreseeable future (i.e., the next 5-10 years). Based on the current pricing of Treasuries and TIPS, the bond market further expects consumer price inflation to average about 1.4% per year over the next 5 years (thanks to falling energy prices), 2.1% over the subsequent 5 years, and 1.7% on average over the next 10 years. In addition, the bond market is priced to the expectation that real yields on short- and intermediate-maturity TIPS are unlikely to exceed 1% for the foreseeable future. It all adds up to a very gloomy outlook for the future of U.S. economic growth. The following charts help explain why.

The chart above shows the current Treasury yield curve (blue line), and the market's expectation for the yield curve 2 and 5 years in the future. I haven't shown the 10-yr forward curve because it is substantially similar to the 5-yr forward curve. For those unfamiliar with how the bond market works, forward yield curves are derived mathematically from the current yield curve. I've used Bloomberg's calculations as inputs to the chart.

The first of the above two charts shows the expected future path of the Fed funds rate, using Fed funds futures as the data source. The Fed funds rate used to be the Fed's primary interest rate target, but that's changed now that bank reserves pay an interest rate that is determined by the Fed. When the Fed starts to tighten (according to the futures market, sometime around the middle of 2015), they will simply increase the interest they pay on reserves, and presumably the Fed funds rate will follow rather closely behind. Here we see that the market expects the funds rate to reach about 2.5% within 5 years, which is consistent with the first chart in this post which shows the market expecting 3-mo. Treasury rates to be just above 2.5% within 5 years.

The second of the above charts shows the expected future path of 3-mo. LIBOR, using Libor futures as the source. 3-mo. Libor typically exceeds the Fed's targeted overnight rate by 20-30 bps, in order to compensate for banks' perceived credit risk. As the chart shows, 3-mo. Libor is expected to hit 3% within 5 years, and that's as high as it's going to get. This also is consistent with the 5-yr forward Treasury curve's projections of 3-mo. Treasury rates.

So, the bond market sees the Fed starting to raise short-term rates in about six months, and then raising them gradually until it stops in 5 years just short of 3%.

What does this say about expectations for economic growth? It's not very encouraging at all.

The above chart gives us some historical perspective. 10-yr Treasury yields have only been lower than 3% during the years following the Depression, and briefly in the years following the Great Recession; both periods were times of unusually weak growth and a lack of confidence. Yields were substantially higher in virtually all other periods. During the high-growth Reagan years, for example, when inflation averaged some 3.5% and real growth averaged about 4.5%, 10-yr yields averaged about 9.5%. During the strong-growth period of the Clinton years, when inflation averaged 2.5% and real growth averaged 4%, 10-yr yields averaged more than 6%. In other words, today's 2.3% 10-yr yield almost shouts "slow growth ahead!"

As the chart above suggests, nominal 2-yr yields have tended to approximate the nominal growth (inflation plus real growth) of GDP. Except, of course, for the past 10 years or so, when the Fed kept short-term rates unusually low for an unprecedented length of time. If we were living in "normal" times, today's 4% nominal GDP would give us 2-yr Treasury yields of 3.5-4%. But the bond market doesn't think we'll ever get back to normal again, because forward yield curves say 2-yr Treasury yields will never exceed 3%.

As the chart above suggests, real yields on 5-yr TIPS have tended to move in line with the economy's real growth rate. When real growth was very strong (4-5%) in the late 1990s, real yields were very high (3-4%). Now that growth has slowed considerably (averaging 2.3% for the past 5 years), real yields have traded within a -2 to 0% range. Real yields have moved up a bit over the past year or so as the market has stopped fearing another recession, but real yields on TIPS are still priced to miserable growth expectations. Based on forward curves, real yields on 5-yr TIPS are expected to rise to 0.8% within 5 years. According to this chart, that would be consistent with real economic growth of only 1-1.5% per year.

In short, the bond market is behaving as if growth and inflation are going to be unusually low for the foreseeable future, and that therefore the Fed is not going to increase short-term rates by more than 3% over the next 5 years. The last time the Fed tightened, they increased the Fed funds rate from 1% in mid-2004 to 5.25% over the subsequent two years. The bond market is now looking for only a 3% increase spread out over 4 ½ years. If that isn't a timid projection, I don't know what is. The Fed is likely to pursue such a path only if the economy proves to be very weak and inflation stays unusually low.

If there's one thing positive to say about the yield curve, it's that it shows no indication of an impending recession for the foreseeable future. All recessions in the past 50 years have been preceded by flat or inverted yield curves, and we're miles away from that at present.

I would argue that the expectations of the stock market are necessarily entwined with the expectations of the bond market. They're both essential parts of one gigantic capital market. The stock market can't be "overpriced" if the bond market is convinced we're stuck in a slow-growth, low-inflation world for as far as the eye can see.

Consider: the bond market is saying that the proper discount rate for expected future earnings is 3% or so. That alone would justify PE ratios substantially higher than the long-term average, since discount rates have rarely been so low in modern times. Plus, are stocks expensive if their earnings yield, currently 5.5%, is substantially higher than anything we're likely to see from the Treasury market, and higher than BAA corporate bond yields? A relatively high earnings yield only makes sense if the equity market is priced to the assumption that corporate profits are going to decline in coming years.

To answer the question posed above, both the bond and equity markets are "right," because they are both priced to similar assumptions. That is, both markets believe we're going to be stuck in a very slow-growth world for many years to come, and inflation is going to be relatively low and stable (1.5-2%) once we get past the current period of falling oil prices. By the way, I think the pricing that is implicit in bond and stock prices trumps whatever investor sentiment surveys reveal. After all, "the market" incorporates the bets of everyone, not just those selected for a particular survey.

I've held the view that the market has been consistently underestimating future growth for the past 5-6 years, and I suspect it still is. As for inflation, I've been wrong to expect it to rise, but I continue to believe that there is more risk of higher inflation than there is of lower inflation. In a similar vein, I continue to think interest rates are likely to be higher than the bond market's current projections, even though I've been wrong on rates for years.


NormanB said...

Off of the 1940's 10-yr rate low at about the current 2% it took 9-10 years for this yield to get to 3%. Maybe this is a good analogy and thus fits the yield curve analysis.

Remember, too, that off of the last rate low the stock market went on a long and super tear.

Scott Grannis said...

Don't forget the distortions of WWII during which time we had price controls and an all-out effort to keep bond yields low.

William said...

Just for the record as of today I am 42% in cash - which I hate because of it's negative yield. I do not understand this world. There have been so many changes the past 6 months, any one of which could explode the present tranquility.

I have observed that the initial interpretation of major market changes are often wrong. I have no confidence that the recent crude oil price plunge is as positive as it has been interpreted; nor the recent dramatic rise of the US dollar. I can fore see how there could be major negative results.

Combine this uncertainty with the high market optimism of fund letter advisers and individuals; and the market complacency; and the absence of a significant correction in three years; and I find myself uncertain of future events and feel more comfortable with, for me, a high level of cash.

Andrew said...


Thanks again for sharing.

While many may wish for something stronger than a slow growth future, a positive is that it is probably a more realistic and sustainable scenario.

Scott Grannis said...

On the contrary, slow growth forever is very unlikely in my way of looking at things. Too much tension is building up among the middle class. Taxes and regulations are suffocating everyone. Pro-growth solutions are easy to implement and should prove very popular.

William said...

Scott - I think you are correct that your real market indicators are usually indicative of the future. BUT perhaps that is only 80% of the time and certainly not at major market turning points.

Did the 15+% yield on the 10 Treasury in the Summer of 1981 predict future inflation? Did the NASDAQ at 5000 predict future earning of most of those dot com companies? Not at all, no better than at other market tops or bottoms.

When an investment concept or a thesis has been spectacularly successful for a long time - like 6 years - it's time to seriously question its future validity. In investing, no theory works forever.

For me its time to consider alternative possibilities of what is going on in today's markets. The very idea that a US recession won't happen until the yield curve inverts?? Ask the Japanese, ask Italy, ask Brazil, etc. There are proofs right before your eyes.

Perhaps you should test the validity of your guide posts for anticipating recessions by looking around the globe at what has occurred in the past three years.

Does an Italian 10 year yield of 1.92% make sense or a Spanish yield of 1.79% ? When the world begins to focus on the build up of their debts - actually most country's debts including the US - and becomes concerned about those countries ability to repay their debts, surely those yields will rise dramatically. Investors "reaching for yield" again - like in 2006 - 2008 - will again end in disaster.

There are a lot of economic statistics around the world which don't make economic sense given the risks.

In the end it's a matter of investor perspective. When their focus changes (stops reaching for yield, for example), their interpretation of the data can change dramatically.

Anonymous said...

Rapid economic growth will have to be political, not economic. That is, a congress will have to pass supply side friendly laws and a president will have to sign them.

Benjamin Cole said...

Well, you gotta admire Scott Grannis for wrangling with these unruly stats.

A few thoughts:

1. Global capital gluts due to non-market forces. Sovereign wealth funds are huge, public pension programs are huge, insurance pools of capital (often required by law) are huge.

Also, much of the world has developed upper classes who have the means to save.

Capital, for the first time in history, is not scarce. Get used to it. It means lower interest rates. This is the new normal.

2. Inflation may be overstated by official measures. The markets "know" this, and so are willing to lend at what looks like low rates, but only by imperfect inflation measures.

Suppose the true rate of inflation is mild deflation? There is a lot about official inflation stats that is questionable and subjective. With rising incomes, real estate becomes more valuable, more costly--and shows up as inflation. What are the new marvelous electronic devices worth, or new medical cures? Radical decreases in pollution (as seen in Los Angeles air) are not captured by inflation stats. But that makes property worth a lot more.

3. The market may be correctly gauging major central bank sentiments, and central banks are in a permanent war on inflation. That will mean slow growth and very low inflation for a very long time---as independent public institutions, there are no market forces to change Fed behavior. Central banks can self-exalt, even as they ossify. Gee, a federal agency that ossifies--who'd a thunk it?

4. The markets know there will be little structural reforms in Western democracies--for example, who will get rid of ethanol, or rural subsidies, the USDA, or the VA (a federal social welfare program for former federal employees)?

Can will kill food stamps? Cut FICA taxes? Eliminate the Commerce and Labor Departments?

CATO says U.S. defense spending could be cut in half. By who?

The market may be correct in expecting slow growth and minute inflation for many years. And very low interest rates. And a sclerotic federal state.

The new normal. Get used to it.

steve said...

so my view is that the world is awash in money and there's only so many places you can put it. there's literally trillions in cash earning NOTHING and the stock market is arguably at least fairly valued. prices of all assets are always driven by supply/demand and the demand is so high relative to supply and there is an insatiable demand for yield that treasuries can demand a price higher than logic might expect. fully expect to see yields UNDER 2% on the ten year note at some point in the relative near future.

Unknown said...

Yield curve shape may have less to do with economic projections over the next few cycles because of the distort ions resulting from near free carry trades.

Forecasting recessions will become an even greater challenge if developed countries are at risk of becoming "japanzied." It is hard to imagine an economic recovery of any magnitude when unemployment rates are sub- 4%, as in Japan and or NAIRU is pushing higher in a step like fashion.

Structural problems such as deteriorating demographics can easily create havoc on long-term historical relationships used for providing guidance.

Scott Grannis said...

Hi Tom: good to hear from you, thanks for the comment.

PD Dennison said...

Wow, great article and great comments.

My theory for the past 10 years is...Europe is becoming Japan and US is becoming Europe.

I am half right so far.

The reason is the size and scope of government (and over stated inflation measures). Others have touched on both here.

Corporations are under investing and squeezing the hell out of profits. Employees and customers are feeling it, the equity holders benefits. But the free market works and profit margins vs GDP will revert to the mean.

Hopefully, growth policies out of Washington will change all this, but we are far away from a limited government movement in America (just like EU and Japan).

Unknown said...

Kinda funny - the 2016 and 2014 forecasts from 2014 actually match up very well with 2017 and 2018 reality. i.e. it took longer but happened faster than expected.