Teasury yield outlook: higher in 2011
This post is a guest contribution by Richard Berner & David Greenlaw of Morgan Stanley.
Bearish on bonds. We think that 10-year Treasury yields are headed 75-100bp higher over the next 12 months, to 3.75% or so. Right now, yields remain an instrument of monetary policy, so they may decline from current levels as the Fed continues to buy securities. Notwithstanding the rise in rates of the past few days, together with other risk factors discussed below, the steady bid from the Fed could pull yields back down again.
Looking ahead, however, the direction of yields is clearer. We think that both real yields and term premiums are likely to rise; real yields at 70bp are inconsistent with even the modest improvement in the economy that we expect, and term premiums at zero are inconsistent with the notion that the Fed’s efforts will be even slightly successful.
Why did yields rise in the wake of QE2? In early November, the FOMC judged the outlook to be weaker than in June: It trimmed its outlook for growth in 2010 by 0.75pp to 2.4-2.5% and in 2011 by 0.5pp to 3-3.6%. In contrast, the combination of some better-than-expected incoming data and the post-election perception that Congress will extend the Bush-era tax cuts convinced market participants that the outlook for 2011 and beyond has improved. While it’s worth noting that the Fed’s growth outlook remains more buoyant than the consensus of private forecasters and market participants, the improvement in the latter has clearly been one factor behind the jump in yields.
Also at work, in our view, were three other factors:
1) The Fed seemed less committed to QE2 than investors earlier hoped, boosting real yields. Specifically, the FOMC statement noted that the Committee “intends” to purchase $600 billion of securities. While the language was stronger than “will purchase up to” $600 billion, it conveyed a less open-ended, scalable approach to the new Large-Scale Asset Purchases (LSAPs) than many expected. Prior to the FOMC meeting, speeches from several officials cited estimates suggesting that QE2’s bang for the buck was limited and uncertain, thus conveying expectations for a program with more heft and tilted towards the back end of the yield curve.
2) The domestic and global backlash against QE2 increased investors’ uncertainty about the Fed’s resolve. We believed that some officials abroad would respond to currency strength with an easier monetary policy. In contrast, criticism of the Fed abroad, particularly following the G20 meeting in mid-November, raised investor concerns that the Fed needed to tread carefully to avoid triggering counterproductive capital controls and a currency war. Domestic criticism and talk of changing the Fed’s dual mandate raised concerns about the Fed’s independence, contributing to the rise in 10-year yields.
3) Two technical factors – crowded long positions and reduced traders’ risk appetite – may have also played a role in higher yields. First, QE2 was well anticipated, and many investors pre-positioned long in the run-up to the announcement. From a technical perspective, this created vulnerability for a yield rise. Second, uncertainty about policies at home and abroad contributed to market ambivalence, thereby reducing the market’s ability to underwrite risk. In other words, even though many believe that yields should remain low, there is little resolve to position long against the technical factors pushing yields higher.
No Fed exit any time soon: The Fed still expects very low core inflation. The continued slide in core inflation through October to 0.6% in terms of the CPI and 0.9% as measured by the Fed’s preferred gauge (the PCE price index) leaves it well below the Fed’s comfort zone. Yields rose as markets looked ahead, and the anticipation of QE2 boosted inflation breakevens as investors gained some confidence that the Fed’s action would reduce deflation tail risks. While the Fed doubtless welcomes that rise in inflation expectations, it’s not sufficient to make officials comfortable with the inflation outlook; indeed, the FOMC’s central tendency of only 1.3% core inflation in 2012 and 1.6% in 2013 strongly suggests that it isn’t thinking of an exit strategy from its current policy stance any time soon. Taken at face value, the FOMC’s inflation outlook implies a ‘tighter’ relationship between inflation and slack in the economy than does ours; we expect a faster, albeit gradual rise in core inflation to 1.5% (down 0.1% from last month) over the course of 2011.
Incoming data not nearly strong enough to sway the Fed. Most incoming data have been somewhat stronger than expected, with 3Q GDP growth at 2.5%, and we think that a further pick-up in 4Q is likely (we are tracking 4Q at 3.5%). Finally, it appears that the fundamentals are working to improve final demand: Despite disappointing November employment data, job and income gains are boosting income and thus consumer spending, pent-up demand and favorable financial conditions are helping capital spending, and a reacceleration in global growth appears to be helping net exports. (Some of the acceleration we see in 4Q is purely statistical, reflecting the seasonal quirks in US net exports; we expect net exports to add 2.6pp to GDP this quarter, following subtractions of 3.5% in 2Q and 1.8% in 3Q.)
But two headwinds seem likely to restrain growth to 3% next year: Housing markets and housing activity are weak and, barring aggressive new policy actions, are likely to remain so through 2011. Home prices may slide by another 10%. And while state and local government revenues have begun to rebound, those governments are still apt to raise taxes and cut spending. Most important from the Fed’s standpoint, the unemployment rate, at 9.8% in November, is unacceptably high, and much stronger, sustained economic and job growth will be needed to change that reality. The upshot is that yields -legitimately – don’t reflect a material change in the future path of monetary policy.
Three risks that could lower yields near term. A committed Fed will continue to buy Treasuries and pull 10-year yields lower through year-end, in our view. In addition, three fundamental risks could contribute to lower yields in the coming months. First, gridlock in Washington could make it difficult to extend expiring tax cuts and emergency unemployment insurance (UI) benefits, resulting in fiscal drag. At the time of writing, negotiations are underway to resolve both issues in the lame-duck session of Congress; in our baseline outlook, we have long assumed that the tax cuts would be extended for those with incomes below $250,000 and that the UI benefits would be extended at least until mid-2011. If the tax cuts were extended for all taxpayers, as now seems likely, the extra stimulus might add 0.2% to GDP growth; conversely, a full ‘sunset’ of the expiring cuts would cut growth by 0.75pp or a bit more. If the UI benefits aren’t extended (they expired this week), the loss of these payments would be worth about -0.4% of personal income; the direct negative (annualized) impact on 1Q GDP could be as much as 1 full percentage point. Renewed uncertainty around these issues could erode risk appetite and help bonds.
Second, the European sovereign crisis could intensify further, draining risk appetite. Although Ireland now has an €85 billion bailout package, the aid is conditional on fiscal austerity, bank restructuring and structural reforms, all of which must be agreed to and implemented. Moreover, Portugal and Spain are not immune from further turmoil. As our colleagues Elga Bartsch and Daniele Antonucci recently noted, “The main risk is contagion. If markets behave in ‘systemic mode’ and continue to associate the current difficulties in Portugal with, say, those in Ireland or Greece, the chances are that investors will keep testing the next weak link once a more distressed country is removed from the market through some kind of bailout.”
Finally, China’s monetary policy tightening could dim expectations for future growth. Qing Wang expects CPI inflation to rise further, peaking at 5.5% by mid-2011, and to decelerate to 4% by year-end. As a result, he expects a front-loaded approach to monetary tightening, with three 25bp interest rate hikes through mid-year and a further appreciation of CNY to 6.2 to the dollar by end-2011. He notes that potential policy missteps are the primary risk to his outlook: “If Chinese authorities were to mainly rely on administrative controls over monetary aggregates instead of allowing price-based policy instruments such as rate hikes and appreciation of the renminbi to control inflation, the risk of a policy-induced boom (in 2010) and bust (2011) cycle would rise.”
Three risks that could raise yields by more than we expect longer term. A first risk factor is potentially stronger-than-expected US growth. Although market expectations of future growth likely have increased lately, they are still low, probably lower than ours (3% in 2011 and 3.3% in 2012). Accordingly, judging by 2-year OIS rates, expectations of future Fed rate hikes have risen by about 15bp over the past month. A general expectation of moderate (3-4%) but sustainable growth could boost those expectations and yields more quickly. Second, combined with still-heavy Treasury issuance and expectations of the end of QE2, a pick-up in credit demands could boost real yields. A stronger economy and further actions to fix housing and housing finance could restart the private demand for credit. Finally, following the President’s symbolically important action to freeze federal pay for two years, and the report of the National Commission on Fiscal Responsibility and Reform, there is a growing expectation that the Administration and Congress will agree to some fiscal restraint over the medium term. If extending all tax cuts and UI benefits is followed by partisanship and gridlock on deficit reduction, the disappointment could boost term premiums and thus longer-term yields.
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