In our June 28 global macro newsletter (please email me for a copy), I upgraded our outlook on U.S. Treasuries when the 10-year Treasury yield closed at 2.49%. We believed the 10-year was too high given the ongoing deflationary pressures stemming from the European sovereign debt crisis, the Chinese economic slowdown, and lower commodity prices. I subsequently downgraded U.S. Treasuries in our August 30 newsletter–when the 10-year Treasury yield closed at 2.19% (after dipping to as low as 2.00% during the August 24 global equity market correction)–as I believed global deflationary pressures were in the process of peaking. At the time, I noted that: 1) Chinese disposable income was still growing at high single-digits, 2) the Chinese CPI for the monthly of July sat at 1.6% year-over-year, and 3) fears over a further, deeper-than-expected devaluation of the Chinese yuan against the US$ was unfounded, as Chinese policymakers still have political incentive to support the country’s currency, along with the firepower to do so (as of today, China’s FOREX reserves stands at $3.43 trillion, while its November 2015 trade surplus is still near a record high at $54 billion). This means any further deflationary pressures from the Chinese economy were dissipating.
Combined with the Greek government’s 11th hour deal with the European Commission (i.e. Germany and France), fears over a more catastrophic financial market dislocation was adverted. This means that U.S. Treasury yields should rise further in the coming months. In our August 30 newsletter, I slapped a target yield of 2.50% for the 10-year Treasury over the next six months.
For 2016, I am reiterating our 2.50% yield target for the 10-year Treasury. We model our 10-year Treasury yield expectations with the following “building blocks” model:
10-year Treasury Yield = expected 10-year U.S. inflation + expected U.S. real GDP growth + global central bank purchases (including U.S. QE) + geopolitical premium
While both energy and base metal prices have either broken or are approaching their December 2008-March 2009 lows, I am of the opinion that U.S. inflation will be higher next year as the combination of a tighter U.S. job market, rising U.S. housing prices, and higher healthcare costs overwhelm the deflationary effects of lower commodity prices on the U.S. consumer economy (of which the CPI is based on).
As the markets price in higher U.S. inflation and a more hawkish Fed policy next year, I expect the 10-year Treasury yield to rise to 2.5% sometime in the next several months. For now, I remain bearish on U.S. Treasuries, but may shift to a more bullish stance should: 1) the Chinese economic slowdown runs deeper-than-expected, 2) the U.S. stock market continues to weaken, or 3) the Fed adopts a more dovish-than-expected bias post the December 16 FOMC meeting.