Our 2017 Outlook on U.S. Treasuries: 2.25% on the 10-Year

Last year at around this time, we published our 2016 outlook on the 10-year Treasury yield (“Our 2016 Outlook on U.S. Treasuries: 2.5% on the 10-Year“). To recall, 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

Note that the current “arbitrage” between the German & Japanese 10-year (typically done with a “dirty hedge” by hedge funds) with the U.S. 10-year is being taken into account in the above model, to the extent that ECB and BOJ purchases are driving such hedge fund “arbitrage” activity.

The reasoning behind our 2016 outlook of 2.5% (the 10-year is trading at 2.54% as of this writing) included: 1) higher U.S. inflation driven by the combination of a tightening U.S. job market, rising U.S. housing prices, and higher healthcare costs, and 2) the peaking of certain deflationary effects around the world, e.g. Chinese CPI was no longer declining while fears surrounding a larger-than-expected Chinese yuan devaluation would turn out to be unfounded.

Figure 1 below shows our timing calls on the U.S. 10-year from June 2015 to the present (note the prices of the 10-year Treasury rise as yields decline).

10yeartreasury2016

For 2017, I am targeting a 2.25% rate on the U.S. 10-year yield. The target is slightly out-of-consensus (Goldman, Morgan Stanley, and PIMCO are all expecting the 10-year to rise to 2.75% or above). The outlook, however, is very uncertain and I am again looking for significant (tradeable) volatility on the 10-year in 2017; by and large, however, I believe the factors that will drive the 10-year yield lower slightly outweigh the bearish factors on the 10-year:

  • As of this writing, speculative longs on the U.S 10-year futures are–with the exception of early 2005–at their highest level since the collection of COT records beginning in 1992. From a contrarian standpoint, this should provide some short-term support for the 10-year (in turn resulting in lower yields);
  • Much of the recent up-move in the U.S. 10-year yield occurred after the U.S. presidential election as investors speculated on a combination of higher growth and higher inflation, driven by the promise of: U.S. corporate & personal income tax cuts, a promised $1 trillion infrastructure spending package by President-elect Trump, potential repeal of the ACA and Dodd-Frank along with a myriad other U.S. “regulatory burdens.” As a reminder, however, this is all conjecture at this point. The Republicans are likely to pass their promised corporate & income tax cuts and to repeal the ACA through the reconciliation process (this is needed to avoid a Senate filibuster by the Democrats). However, such tax cuts passed through the reconciliation process needs to be revenue-neutral. Even with the potential to use “dynamic scoring” (where it is assumed lower taxes will result in higher GDP growth in order to offset some of the tax revenue lost), a significant part of the promised tax cuts will likely be scaled back in order to meet fiscal budget targets. E.g. The much discussed 15% or 20% statutory corporate income tax rate will likely be revised to 25%;
  • In the long-run, the U.S. economy is still limited by the combination of slowing population growth (the current 0.77% annual population growth rate is the lowest since the 1930s), older (and less productive) demographics, and a potential stall in immigration–the latter of which has historically benefited the U.S. disproportionately (immigrants are twice as likely to be entrepreneurs than native-born Americans). Another historic tailwind for the U.S. economy actually peaked in 1999: women participation in the labor force has trended down since 2009.

Unless productivity growth jumps over the next several years (not likely; the “fracking revolution” was the last enabler of U.S. productivity growth), the U.S. economy is likely to stall at 2% real GDP growth, especially given the recent 14-year high in the U.S. dollar index–which will serve to encourage import growth and restrict export growth. Note this outlook assumes that the long-term U.S. inflation outlook remains “well-anchored” at 2.0%–should the U.S. Congress adopt a more populist outlook (i.e. higher fiscal spending that is likely to be monetized by the Fed in the next recession), then the 10-year could easily surpass 3.0% sometime in 2017.

The Fed Paves the Way for Running a “High-Pressure Economy” (Along with Higher Inflation)

Since the beginning of last year (see my February 4, 2015 commentary “U.S. Inflationary Pressures Remain Muted” and my March 1, 2016 Forbes commentary “Why Federal Reserve Tightening Is Still A Distant Event“), I have consistently asserted that the Fed’s ultimate tightening schedule would be slower than expected–from both the perspective of the Fed’s original intentions, as well as those of the fed funds futures market. Indeed, the most consistent theme since the beginning of the 2008-09 global financial crisis has been this: The tepid recovery in global financial conditions and global economic growth has consistently forced the Fed to ease more than expected; and since the “tapering” of the Fed’s quantitative easing policy at the end of 2013, to tighten less than expected. E.g. the October 2008 Blue Chip Economic Indicators survey of America’s top economists predicted the fed funds rate to rebound to 4.0% by late 2010. Subsequent forecasts were similarly early.

According to the CME Fed Watch, the probability of a 25 bps Fed rate hike on December 14 is now over 70%. I expect the December 14 hike to occur as the Fed has been prepping the market for one 25 bps hike for months; however–similar to what I asserted last year–I do not believe this rate hike will signal the beginning of a new rate hike cycle. Rather, the timing of the Fed’s third rate hike will again be data-dependent (more on that below). Fed funds futures currently peg the Fed’s third rate hike to not occur until more than a year from now, i,e. at the December 13, 2017 FOMC meeting. This is the most likely timing for the third rate hike, for the following reasons:

1. U.S. households remain in “deleveraging” mode. Haunted by the 2008-09 global financial crisis, record amounts of student loans outstanding (currently at $1.3 trillion), and a shorter runway to retirement age and lower income prospects, U.S. consumer spending growth since the bottom of the 2008-09 global financial crisis has been relatively tepid (see Figure 1 below), despite ongoing improvements in the U.S. labor market;

Fig1PCE.png

2. The developed world & China are still mired by deflationary pressures. While the Fed had not been shy about hiking rates ahead of other central banks in previous tightening cycles, the fact that all of the world’s major central banks–with the exception of the Fed–are still in major easing cycles means the Fed has no choice but to halt after its December 14, 2016 hike. Even the Bank of England–which was expected to be the first major central bank to hike rates–was forced to reverse its stance and renew its quantitative easing policy as UK policymakers succumbs to the rise of populism. In a world still mired by deflationary pressures, the U.S. could easily succumb to another deflationary cycle if the Fed prematurely adopts a hawkish stance;

3. The Fed is no longer in denial and finally recognizes the uniqueness of the 2008-09 deleveraging cycle that is still with us today. In a June 3, 2016 speech (titled “Reflections on the Current Monetary Policy Environment“), Chicago Fed President Charles Evans asserted why this isn’t a normal recovery cycle and because of that, argued why the Fed should foster a “high-pressure” economy (characterized by a tight labor market and sustained inflation above 2%) in order to ward off downside risks in both economic growth and inflation. Quoting President Evans: “I view risk-management issues to be of great importance today. As I noted earlier, I still see the risks as weighted to the downside for both my growth and inflation outlooks … So I still judge that risk-management arguments continue to favor providing more accommodation than usual to deliver an extra boost to aggregate demand … One can advance risk-management arguments further and come up with a reasonable case for holding off increasing the funds rate for much longer, namely, until core inflation actually gets to 2 percent on a sustainable basis.

President Evans’ speech was followed by similar dovish sentiment expressed by Fed Governor Daniel Tarullo in a September 9, 2016 CNBC interview, Fed Governor Lael Brainard in a September 12, 2016 speech at the Chicago Council on Global Affairs, as well as the September 2016 FOMC minutes. Finally, Fed Chair Janet Yellen explored the potential benefits of running a “high-pressure economy” after a deep recession in her October 14, 2016 speech at a recent conference sponsored by the Boston Fed. Quoting Chair Yellen:

If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects. In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient–and, hence, more-productive–job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.

Bottom line: The Fed continues to back off from committing to an official tightening schedule. After the December 14, 2016 rate hike, probability suggests the next rate hike to not occur until the December 13, 2017 FOMC meeting. Until the year-over-year PCE core rate rises to and maintains a rate of 2.0% or over, the Fed will not recommit to a new rate hike cycle. This also paves the way for higher U.S. inflation; as such, clients should continue to underweight U.S. long-duration Treasuries and overweight gold.

Our 2016 Outlook on U.S. Treasuries: 2.5% on the 10-Year

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.

10yeartreasury

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.