A classic head fake?
THE REAL ECONOMY |
Over the past year, the improved picture for the financial services community has been predicated on rising interest rates, strong financial conditions, modest inflation and an overall improving economy. Recently, however, a flattening yield curve has fostered concern about a premature end to this positive business cycle.
Our view, however, is things may not be quite what they seem.
In our estimation, these worries represent a classic financial sector head fake related to residual seasonality in growth that often impacts the first quarter and a term premium that has recently turned negative, suppressing the long end of the curve. Moreover, the Federal Reserve's ongoing policy normalization features both increases in the policy rate and the paring down of the central bank’s prodigious $4 trillion- dollar balance sheet. Rather than facing stark harbingers of recession, we believe middle market business managers will likely see a series of positive economic events that will trigger an increase in fixed income yields and a decline in bond prices. Indeed, it would not be surprising to see a reversal in the term premium, placing upward pressure on U.S. fixed income yields partially triggered by the expected increase in short-term interest rates.
In our estimation, these worries represent a classic financial sector head-fake.
If one examines current and forward- looking estimates of term premiums along the maturity spectrum, they remain historically low. Absent a major systemic event, the probability of an increase in the term premium will move higher from current levels. The risk of rising bond yields is clearly to the upside, underscored by equity markets and the Chicago Board Options Exchange’s Volatility Index, or VIX, now emerging from a long period of low volatility, coupled with uncertainty linked to rising protectionist policies stemming from the Trump administration.
Stock and the US term premium
US bonds and the term premium
Four primary components underscore Fisher’s long-term interest rate model: the expected real rate of interest, forward-looking inflation expectations, the real risk premium and the inflation risk premium. A combination of long-term trends in declining yields and inflation, in addition to the decade-long shift in monetary policy by the Federal Reserve (which included the purchase of assets across the maturity spectrum), caused both nominal and real yields to decline. Over the past several years, the risk premium built into U.S. Treasuries, which has been declining, was a primary cause of low yields in addition to aforementioned reasons. Between July 2016 and December 2016, the term premium trended higher, temporarily moving into positive territory. However, since January 2017, the term premium has resumed its decline and bottomed out on Dec.15, 2017. During that time, the yield on the 10-year bond has increased to a high of 2.95 from 1.35 before retreating recently to near 2.75 percent.
Feds five-year forward break-even inflation rate
Real interest rate remains historically low
Another three expected rate hikes from the Fed in 2018 and three more in 2019 (the Fed’s most-recent summary of economic projections implies a policy rate of 3 percent to 3.5 percent by mid-2020) will almost certainly trigger an increase in the term premium. This environment should boost merger and acquisition activity and net interest margin for credit unions and banks, as well as improve business conditions for insurance firms, consumer financial companies and private equity funds.
In past economic cycles, the term premium often acted as a neutralizing factor as long-term rates increased. Given the very unusual set of conditions outlined above, the term premium could, in the near term, act to push rates higher as the Fed takes the next step in normalizing monetary policy. When will this occur? Timing is always difficult to identify. Given that there is a strong fiscal boost linked to the Tax Cuts and Jobs Act passed in late 2017 and the recent two-year budget agreements (which should throw another $320 billion in accelerant to the fiscal fire), it will likely occur in the second half of 2018.
Regardless, with the Fed implying a much higher policy rate on the way, and the consensus pointing to a 3.67 percent median forecast on the 10-year Treasury yield by mid-2020, something must give. Either the Fed must slow or end its normalization process, the term premium must increase, or the economy is going to fall into recession in the near term. That said, we continue to anticipate a significant increase in the term premium later this year, which should spill over into 2019 and trigger a much steeper yield curve, thus alleviating conditions the market is, for now at least, identifying as a potential harbinger of recession.
Forward rates are often useful indicators of where market participants expect yields to move along the maturity spectrum. Yields along the spectrum can be decomposed into a series of short-, intermediate- and long-term dated securities. This permits an analyst to estimate if long-term yields are shifting due to changes in short- or long-dated market expectations.
This model, put forward by economists Gurkaynak, Sack and Wright at the New York Federal Reserve Board, implies that long-dated forward rates have increased modestly, with a much sharper increase in short-dated forward rates, most certainly due to Fed rate hikes and considerations of market participants about changing growth and inflation considerations.
US one-year yield
US one-year, nine years forward rate