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.