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Summary

  • According to the Treasury market, economic growth is expected to stay weak and will fail to reach escape velocity over the next five to ten years.
  • Any disagreement with the above forecast implies that bond prices are too high and that you should be actively selling the long end of the yield curve.
  • Investors who believe the economy will reach potential in the long term should consider selling Treasuries until yields increase by 55–75 bps from current levels.

Do not expect economic growth to return to anything like we have experienced in the past. The unemployment rate will remain elevated and hold well above what the CBO views as full employment. Economic growth is expected to stay weak and will fail to reach escape velocity over the next five to ten years. The output gap will not disappear and the economy will stay below its potential.

If these dire forecasts sound extreme, it may come as a surprise to you that the Treasury market is actually pricing in these events as the most probable outcome. An analysis of long-term Treasury bonds, Fed fund futures, and TIPS rates says as much.

Any disagreement with the above forecasts implies that bond prices are too high and that you should be actively selling the long end of the yield curve.

In fact, the data show that the yield on the 10-year Treasury bond would need to increase between 55 and 75 bps in order for the Treasury market to be pricing in a return to potential growth in the five to ten-year time horizon.

The Treasury Market's Read on the Economy

Professor John Taylor created a monetary reaction function known as the Taylor rule to determine the optimal Fed funds rate given current employment and inflation conditions. The FOMC acknowledges that its rate decisions are not predetermined by the Taylor rule. However, in reality, the FOMC's decision to increase or decrease the Fed funds rate occurs almost simultaneously with the Taylor rule prediction of a rate change.

Since shifts in the Fed funds rate correspond with shifts in the predicted Taylor rule, we can reformulate the rule to solve for the unemployment rate given inflation expectations, the steady-state Fed funds rate and the unemployment rate when the economy is at full employment (NAIRU). This will give the Treasury market's read on long-term unemployment.

Information about the Treasury market's view of inflation can be derived from the five-year, five-year forward breakeven rates using the differences in the TIPS and Treasury yields. Federal Reserve researchers Gurkaynak, Sack, and Wright (2008) created a pure estimate of these inflation expectations that excludes the liquidity premium inherent in the TIPS data. Fortunately, the Federal Reserve constantly updates and releases these breakeven rates on a daily basis.

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The steady-state Fed funds rate is the market's expectation for the FOMC's long-term Fed funds rate. Essentially, the market expects the FOMC to raise interest rates until it reaches a maximum point and the rate to stay at that level, on average, for the duration of the bond.

Estimates of the steady-state Fed funds rate can be calculated using two methods. One method uses a linear extrapolation based on the current trends in the Fed funds rate futures market and the duration of a long-term bond.

Another method uses Treasury bond forwards, where the difference in yields between the two durations has to be equal to the expected average Fed funds rate during that time frame.

Inflation breakeven from TIPS yields is not available beyond the five-year, five-year forward period. Therefore, the only assumption required for the Taylor rule is that the steady-state Fed funds rate can be determined using the 10-year Treasury bond. In this case, the average Treasury yield for five years beginning five years from today is a suitable estimate of the steady-state Fed funds rate.

(For a more detailed analysis on the derivation of the steady-state Fed funds rate, please read my Instablog report: Estimating the Steady-State Fed Funds Rate)

Interestingly, the Treasury market shows a worse economy than the current FOMC economic projections. The latest economic projections show that the FOMC expects the long-term Fed funds rate, essentially the steady-state, to increase to 3.75%. The Treasury market is projecting a steady-state rate of only 3.4%.

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The Congressional Budget Office ("CBO") estimates NAIRU values during its long-term budget analyses, generally twice a year, and projects that rate out for ten additional years. The average NAIRU rate for the last five years of the forecast corresponds with both the steady-state Fed funds rate and 5-year, 5-year forward inflation breakeven rate.

To keep the data consistent, we use the CBO's long-term average NAIRU forecast at the time of its release. For example, the latest NAIRU value comes from the 2014 long-term budget analysis and is the average value from Q2 2020 through Q2 2024. Likewise, the 2003 value corresponds with the release of the 2003 budget projections and is the average value from 2009 - 2013.

There are two main derivations of the Taylor rule. The original model reacts more to shifts in inflation than changes in employment. A modified Taylor rule essentially reverses the weights so that the Fed is more concerned about unemployment.

According to the original Taylor rule, the Treasury market is predicting an average long-term unemployment rate of 6.4%. Given that the current unemployment rate is 6.1%, the Treasury market is predicting that the economy will be in worse shape in the future than it is today.

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Using a modified Taylor rule, the unemployment rate is expected to fall to 5.9%, which is only modestly better than the current rate.

From 2003 through the middle of 2007, the Treasury market's expectations of long-term unemployment matched up perfectly with the CBO's long-term forecast of full employment (NAIRU). That tells us the Treasury market expected the economy to grow at its potential in the long term.

Today, the Treasury market is predicting an unemployment rate that is much higher than NAIRU.

The shift in unemployment expectations above NAIRU implies that the Treasury market believes the economy will not grow at its potential rate in the long run. In other words, the economy is not expected to reach escape velocity, which is needed to return to potential growth.

Furthermore, without returning to its potential, the Treasury market believes the output gap will remain for at least the next 10 years.

Correct Pricing in the Treasury Market

If you believe that the economy is not going to return to its potential, then Treasury bonds are likely priced correctly for your viewpoint. If you believe the Treasury market is too bearish on the long-term economy, then current bond prices are too high.

The divergence in the value of the 10-year Treasury began roughly at the beginning of the year. At that time, economists were expecting the economy to accelerate toward potential. As the data weakened and economists blamed the problems on the weather, the Treasury market thought otherwise. Instead of pricing in a temporary phenomenon, a sustained drop in yields implied that long-term economic growth would not reach long-term economic expectations.

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The steady-state Fed funds rate with an unemployment rate equal to NAIRU is 4.5%. Currently, the steady-state Fed funds rate is 3.4%. Using a linear extrapolation from the Fed funds futures trends, the 10-year Treasury yield would have to increase to 3.11% from 2.53% currently (as of July 11, 2014) in order for the implied unemployment rate to equal NAIRU.

If we assume the FOMC increases interest rates by a steady 25 bps at each meeting until the Fed funds rate reaches its steady-state, the current 10-year Treasury yield should be 3.27%.

Investors who believe the economy will reach potential in the long term should consider selling Treasuries until yields increase by 55-75 bps from current levels.

Source: A Case For An Overvalued Treasury Market