U.S. Yield Curve Dynamics And Global Effects

by: Michael Roat


Bond yields are driven by inflation expectations and monetary policy. Bond prices move inversely with yields. Longer-end bonds tend to yield more except when the curve inverts.

The Fed is going to move faster than currently priced in while inflation expectations are unlikely to rise due to a downturn in emerging markets and commodity prices.

The Fed is influencing short-end yields higher through rate increases, and the longer-end bonds will be impacted by the unwinding of the Federal Reserve balance sheet.

There is a misalignment between market expectations as to the path of monetary policy and the Fed's. I think this is important because the longer is it there, the more abrupt and significant it will be when it is corrected (NYSEARCA:TLT) (NYSEARCA:TBT). Market expectations are doubting another rate increase this year and haven't in my opinion started pricing in a balance sheet strategy from the Fed. The communication from the FOMC is quite clear and real U.S. rates are going to rise in my view.

The idea is the expansion will be extended through being preemptive on inflation. Inflation caused recessions in the early 1980s during the Volcker years in the U.S. This is because the Fed was forced to respond to high inflation through tightening policy in a major way.

An early and gradual approach will hopefully allow the Fed to keep inflation in check while avoiding a more rapid increase later that could potentially cause a recession. I don't think pushing real (inflation adjusted) interest rates up a little risks that much harm to the U.S. economy, but there are negative effects to emerging market economies (NYSEARCA:EEM) (NYSEARCA:FXI) (NYSEARCA:EWZ).

The Fed's influence is usually exerted on the short end of the curve through the Federal Funds Rate, but with a plan to end the reinvestment of maturing securities thereby reducing the balance sheet, longer-end yields could also rise. The Fed has multiple tools in its kit here and can semi-effectively manage the entire curve. I think the Fed moving faster than discounted by the market will place upward pressure on yields, but a headwind for longer yields is declining inflation expectations. I think the 2-year yield and 10-year yield will both rise but the 2-year yield will rise more rapidly, yet not enough to invert the curve. This creates a bearish flattening.

Over the last three months, inflation hasn't been trending in the right direction, but it likely will later in the FOMC's view. The Fed seems very willing to describe anything as transitory and continue with its tightening cycle. Yellen, Bernanke and Fischer have all described the U.S. economy as resilient. As inflation and inflationary expectations decline or stay stable while interest rates and bond yields rise, this leads to higher real inflation-adjusted interest rates. Inflationary expectations are unlikely to rise for three main reasons:

1. Appreciating U.S. dollar with the Fed being significantly more hawkish than most central banks globally especially the ECB and Bank of Japan which are in full easing cycles and intent on staying that way.

2. Global bond yield differentials are supportive of the U.S. dollar (NYSEARCA:UUP), and I expect the 10-year U.S. and German (NASDAQ:DXGE) (NYSEARCA:VGK) (NYSEARCA:HEDJ) bond yield differential to diverge further which will push the U.S. dollar index higher against the heavily weighted euro (NYSEARCA:FXE).

3. Commodity prices (NYSE:FCX) (NYSEMKT:LNG) are likely to decline as oil is oversupplied, China experiences a hard landing, and many EM currencies and economies face pressure. This affects inflation expectations.

Potentially declining inflation expectations are supportive of 10- and 30-year bond prices. I think though the market is ignoring the impact of Federal Reserve policy specifically the balance sheet policy. The 10-year yield will move higher as rises in short-end rates reverberate throughout the yield curve and demand from the Federal Reserve for Treasuries is withdrawn. This will be significant enough to offset any decline in yields from falling inflation expectations.

I've spent significant time researching the Chinese economy, and I've reached some concerning conclusions. China's investment-led growth model is out of steam, facing diminishing returns and overcapacity. According to the South China Morning Post, the incremental capital output ratio has increased significantly. For 15 years prior to 2009, it stood between two and four, meaning 2-4 yuan of fixed asset investment created 1 yuan of GDP. Now it takes 13 yuan to achieve the same GDP result. This is a startling statistic given the fact that 40% of China's GDP growth is from investment. Massive industrial overcapacity is also a concern and a headwind for continued investment-led growth. China's corporate debt at 170% of GDP is unsustainable and a large amount is USD denominated. I believe WMPs are going to falter and Chinese real estate, stock prices and corporate bonds will decline. Non-performing loans are going to surge and the Chinese banking system may face significant losses leading to the need for a recapitalization. PBOC will have to move to a more accommodative stance and lower rates.

I think the one of the most important question in financial markets right now should be what is the Fed's reaction function to a hard-landing in China. I believe the FOMC will likely look through it and compare it more to 1997 than 2008. Other central banks such as the ECB, PBOC, Bank of Japan (NYSEARCA:DXJ) (NYSEARCA:FXY), and many commodity-based economy central banks will lower rates or continue easing. Emerging market currencies will be under pressure. Carry trades into emerging markets funded by the U.S. dollar will likely collapse for the reasons stated above. Gold is also likely to be negatively affected through rising real yields and real interest rates. This reduces the attractiveness of gold which yields nothing and is used to hedge inflation. With inflation nowhere to be found and the Fed pushing up yields, this equates to rising real interest rates or yields, a gold price negative. Also, China's explosive growth will likely continue to ramp down which is bearish for gold prices (NYSE:ABX) (NYSE:GG) (NYSEARCA:GDXJ) (NYSEARCA:GDX) (NYSEARCA:GLD).

Although recent inflation readings are fairly muted, it is important for the Federal Reserve to be preemptive on inflation after several years of QE and zero rates. Monetary operates with variable time lags. The longevity of the expansion will be extended from raising rates sooner even with inflation below target because it will hopefully avoid a more steep rise later that could prove recessionary. Waiting for the whites of the eyes of inflation risks an inflationary overshoot and a Volcker-type recession.

Disclosure: I am/we are short GG, ABX, LNG, FCX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.