Revising Our 2017 Outlook on U.S. Treasuries: From 2.25% to 2.50% on the 10-Year

In our earlier 2017 outlook on the U.S. 10-year Treasury yield published on December 21, 2016 (see “Our 2017 Outlook on U.S. Treasuries: 2.25% on the 10-Year“), we argued that the U.S. 10-year Treasury yield will close at around 2.25% at the end of 2017. Our target at the time was very much out-of-consensus, as most analysts (including those from Goldman Sachs, Morgan Stanley, and PIMCO) were expecting the 10-year to rise to 2.75% or above, driven mostly by late-cycle inflationary pressures and the promise of U.S. corporate tax cuts and a $1 trillion infrastructure spending package by the Trump administration.

Since the publication of our 2017 outlook on the 10-year Treasury, U.S. economic growth has disappointed, with the “advance” estimate of U.S. Q1 2017 real GDP growth hitting an annual rate of just 0.7%. As a response, the U.S. 10-year yield sank to a trough of 2.18% on April 18, before rebounding to a close of 2.33% earlier tonight.

Figure 1 below shows our timing calls as discussed in our weekly global macro newsletters on the U.S. 10-year from June 2015 to the present. Note that prices of the 10-year Treasury rise as yields decline.

us10year

Instead of our previous target of 2.25%, I now expect the U.S. 10-year Treasury yield to rise steadily from 2.33% today to around 2.50% by the end of this year. Note this target is still slightly out-of-consensus (e.g. Goldman Sachs is expecting the 10-year to rise to 3.00% by the end of this year). Given the still-uncertain U.S. political outlook, I am looking for significant, tradeable volatility on the 10-year for the rest of this year; on a net basis, however, I believe there will be an upward bias on the 10-year yield for the following reasons:

  • When our earlier 2017 outlook was published on December 21, 2016, speculators were holding a record short position on U.S. 10-year futures with the exception of a brief period in early 2005. An ensuing rally in the 10-year (a decline in yield) developed as a result; as of this writing, however, the net speculative position on U.S. 10-year futures has reversed dramatically from that of five months ago. In fact, net speculators’ bullish bets rose earlier last week to their highest levels since early 2008. From a contrarian standpoint, this should put downward pressure on the 10-year Treasury–in turn resulting in higher yields;
  • In our April 30, 2017 newsletter (email me for a copy), we switched from a “neutral” to a “bearish” positioning on German/French sovereign bonds, as: 1) after experiencing a near-Depression during the 2011-13 period, European economic growth was finally accelerating, and 2) ahead of the May 7th French run-off vote between Macron and Le Pen, it was clear that European political risk was dissipating. In fact, European forward rates at the time were showing a 60% chance of an ECB rate hike in March 2018. An acceleration in European economic growth is also being confirmed by the latest readings of our proprietary CBGDI (“CB Capital Global Diffusion Index”), as seen in Figure 2 below.

CBGDI.png

I have previously discussed the construction and implication of the CBGDI’s readings in many of our weekly newsletters and blog entries. The last time I discussed the CBGDI on this blog was on May 12, 2016 (“Leading Indicators Suggest Further Upside in Global Risk Asset Prices“).

To recap, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD-constructed leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. Moreover, the CBGDI has historically led the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%; and has led or correlated with the MSCI All-Country World Index, with an R-squared of over 40% (which is expected as local stock prices is typically a component of the OECD leading indicators).

The latest reading of the CBGDI has continued to improve after making a trough in late 2015/early 2016  (see Figure 2 above). Both the 1st and the 2nd derivatives of the CBGDI have continued to climb and are still in (slight) uptrends, suggesting a stabilization and in many cases, an acceleration (e.g. the economies of Austria, Canada, Denmark, France, Germany, Norway, South Korea, New Zealand, Brazil, and Russia ) in global economic activity. With Chinese RMB and capital outflows having stabilized in recent months, global economic growth around the world seems to be synchronizing. This should lead to higher U.S./German/French sovereign rates from now till the end of 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.