|MRP|| | JOE MCALINDEN's MARKET VIEWPOINT
July 23, 2015
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A long, long time ago when I first arrived on Wall Street in the early 1960s, 10-year Treasury bonds were yielding 4%. Although nearly double current levels, 4% was considered quite normal at the time. But then a secular bear market in bond prices began as yields moved higher for nearly two decades. That bear market ended in the late summer of 1981 when yields for the 10-year Treasury peaked at almost 16%. It was a major inflection point in U.S. financial history as both a cyclical and a secular bull market in bonds began. Ever since, bond yields have been in a very long but irregular downtrend … peppered by cyclical swings around the secular decline, as was the secular bear market that preceded it.
I strongly believe that a similar turning point is at hand and that interest rates will again be rising for years to come. The abnormally low levels of the past few years are the result of central bank policies around the globe that were put in place to prevent the financial crisis from plunging the world into a deflationary spiral. With global inflation pressures once again on the rise, albeit from very low levels, the U.S. has already ended its QE and is now close to ending its zero interest rate policy as well, although Europe and Japan will continue on this track for a while longer.
The Fed has described the period going forward as one of a normalization of monetary policy. But their euphemistic use of that term begs the question of what exactly is normal. Put another way, how high might interest rates go to find normal levels? Here are three models to help find an answer.
First, we can look at what Federal Reserve officials see on the horizon over the next few years. The Fed does not provide detailed interest rate forecasts. But every three months, in their Survey of Economic Projections, they publish the individual expectations of the 17 FOMC members for several economic variables as well as the federal funds rate itself -- the rate that they directly control. As of the June update, the median of the members’ expectations for year-end levels are 0.625 for 2015, 1.625 for 2016 and 2.875 for 2017. They also provide the members’ federal funds expectations for the “Longer Term,” which we believe to be around 5-6 years and currently shows a median expectation of 3.75%.
The last time the Fed targeted a 3.75% federal funds rate during the previous tightening cycle was in the fall of 2005 when 10-year Treasuries were averaging about 4.5%. As it happens, although the correlation between the two series is less than perfect, the 10-year has tended to yield about 100 basis points more than fed funds over the past half century. Based on that past relationship, if fed funds eventually go to 3.75%, as the FOMC members expect, then presumably the 10-year Treasury should eventually settle in around 4.75%.
Here’s another approach. Irving Fisher, nearly a century ago, recognized that a normal level of nominal rates can be calculated as the sum of a real rate of return, which itself would be influenced by secular GDP growth, plus a premium for the expected future rate of inflation. The Congressional Budget Office expects U.S. GDP to grow at least 2.5% over the next several years and CPI inflation to be 2.2%. Adding that up points to a 10-year bond yield of 4.7%.
Lastly, empirical evidence about the past relationship of bond yields to inflation leads to a similar conclusion. Since 1962, the difference between the year-over-year CPI and 10-year yields has averaged 2.7%. Assuming, as we believe, the Fed hits its inflation target of 2.0%, that historic relationship also gets us to a 10-year real yield of 4.7%.
All three of those models suggest 4.5-5.0% as the normal 10-year Treasury yield level that will eventually be reached. But these simple calculations are assuming inflation reaches the policy-makers’ goal and stops there. However, with the Fed having quintupled its balance sheet over the past 5 years, it is hard to believe that the inflation genie, once out of the bottle, will not go on a rampage. How far that might take bond yields is impossible to predict. But it is worth repeating that I have seen bond yields quadruple in my professional lifetime.
I do not believe bondholders and traders are prepared for the price declines they will experience if rates move up briskly. Interestingly, everything I have written here is well known by most investors … certainly most professional investors. But market participants seem stuck in the mindset of the “New Normal,” when a return to the old normal is imminent. Like a bunch of kids at a frat party, they continue to imbibe believing the inevitable hangover is a long way off. Foreign investors and governments continue to hold over $6 trillion in U.S. Treasury debt and, as of the latest Treasury International Capital report, they added to their holdings in May.
Moreover, there is evidence that even though the supply of outstanding bonds is bigger than ever, liquidity in the market may be inadequate if a price rout begins in earnest. Restrictions on trading desk activities under Dodd-Frank are said to have reduced liquidity. Violent moves in fixed-income prices during the Taper Tantrum and flash crashes are clear examples of the market’s vulnerability. Indeed, the so-called Volcker Rule became effective only a couple of days ago, but already the big five U.S. investment banks have reportedly cut their salesforce and traders on bond desks by almost a fifth over the past few years.
I strongly believe that fixed-income securities are now in a cyclical and, possibly, a long-term or secular bear market. The yield on the 10-year Treasury note hit a low point for this business cycle at 1.38% in 2012, and then more than doubled to a high of over 3% in late 2013. With the collapse of oil prices, yields fell again in 2014, reaching 1.7% early this year. But since the end of January, the 10-year yield has been moving up and is again above 2%. I believe it is on its way to the 4.5-5.0% range over the next 2-3 years.
|Joseph McAlinden, CFA, is the founder of McAlinden Research Partners and its parent company, Catalpa Capital Advisors. He has over 50 years of investment experience. Previously, he was at Morgan Stanley Investment Management for over 12 years, first as chief investment officer and then as chief global strategist. During his 10 year tenure as CIO, Joe was responsible for directing MSIM’s daily investment activities and oversaw more than $400 billion in assets. As chief global strategist, he developed and articulated the firm’s investment policy and outlook. Joe frequently appears in the financial media including Bloomberg Television. Follow JoeMac on Twitter|
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