We believe that several economic and market factors are in play that could keep the long end anchored over an extended horizon. This perspective leads us to recommend that investors consider adding duration to take advantage of the recent rise in long-end yields (see: The Changing Shape of the Yield Curve and Fixed Income Positioning).
In this piece, we explain our thinking by analyzing the fundamental and technical factors that drive our view and help us determine where long-term rates are headed. In particular, we focus on the term premium and offer insight into why it’s currently under the market’s microscope.
In our view, forward fixed-income returns are primarily driven by the evolution in the fundamentals underpinning the level of yields. In the US, the Fed sets short term interest rates, and short-term yields are a function of the expected path of this policy rate. Understandably, making such predictions over long horizons comes with a higher degree of uncertainty. Simply put, long-term yields are not only a function of the expected policy rate (neutral rate of interest or R*), but also of the degree of certainty with which we can make such estimations (term premium).
Long-Term Yields = Expected long-term/Neutral Policy Rate (R*) + Term Premium
While there are several approaches to decomposing long-term yields, for the purposes of this exercise, we will assume that R* represents the current expectations of long-term growth and inflation, while all other factors (such as fiscal policy or supply/demand dynamics) are reflected in the form of the term premium. To give our thoughts on the trajectory of long-term rates, we look at each element in turn.
US economic growth has proven resilient for much longer than originally expected—especially in terms of consumer spending and wage stickiness. However, the lagged effect of Fed tightening is becoming apparent in several sectors of the economy, be it in the form of downward revisions to labor data, or headwinds facing the housing market. While home prices have not sharply corrected despite a marked deterioration in home affordability, we expect the recent rise in yields to weight on housing sales given its high sensitivity to long-end rates. Further weakness in the housing market would also support further deflation.
Inflation remains higher than what was experienced during the post-GFC era, and structural changes like net-zero country transitions are inflationary in the short-run. Nonetheless, we do not see any material risk of inflation becoming unanchored and morphing into a 1970s scenario. Factors such as declining demographics and technological breakthroughs (such as AI) are likely to counteract short-term inflationary pressures.
An improvement in energy security compared to the 1970s, alongside a healthy energy mix between renewables and fossil fuels in the US, also support our view that inflation in the US will stay well-anchored over the long term. Market-based estimates of long-term inflation continue to be well below pre-GFC levels—even now, following the last leg of rates selling off (Figure 1).
As a result of a still-strong consumer, labor and inflation data, the market’s R* expectations have moved slightly higher. While the Fed’s median estimate of R* continues to be at 2.5%, September’s Summary of Economic Projections showed that the mean had moved slightly higher to 2.75%. However, we don’t see any reasons for a significant “structural” move higher in R* given our outlook for long-term growth and inflation in the US.
As the lagged effects of Fed tightening percolate through various sectors of the economy, we expect the labor market to ease sufficiently to allow the Fed to acknowledge the progress on inflation and begin delivering cuts in 2024. We see scope for the Fed to deliver a higher number of cuts than that implied by current market pricing, especially if something “breaks” in the economy due to overtightening by the Fed.
With long-term yields trading through 5% in October, this would suggest that last leg higher in long end yields was mainly a function of a move higher in “term premium.”1
We attribute the recent rise in term premium to a confluence of technical factors rather than material changes to underlying fundamentals. We find some evidence to support this assertion, as the bulk of the recent bear steepening followed the US Treasury Department’s announcement that it would gradually be increasing auction sizes over the next 12-18 months to accommodate the growing fiscal deficit. Ongoing quantitative tightening by the Fed, along with concerns surrounding de-dollarization or weak foreign demand for US debt, could also have been potential contributing factors. We acknowledge that these technical headwinds to long-end rates exist in the short term, but we believe the following trends could mitigate further long-end rate increases:
To add clarity on #3 above, we see the Fed’s “data-dependent” stance as signaling a more nimble approach to policy. The Fed can react more proactively to incoming data without being bogged down by its own “forward guidance.” For instance, should the upcoming hefty Treasury supply threaten proper market functioning, the Fed should be able to respond quickly, like it did during the mini-banking crisis in March (see: Then and Now: Comparing Recent Bank Unrest to the 1980s S&L Crisis).
Similarly, the Fed was also quick to acknowledge3 the recent surge in long-term yields and its impact on financial conditions. We believe that this data dependent approach will not only add to the Fed’s ability to navigate through an uncertain macro outlook, but also contribute to its credibility, therefore keeping a lid on the risk premium.
As we look ahead, we consider two risks to our outlook:
In light of the above, we believe that we are close to the peak in rates for this cycle and recommend adding duration. Furthermore, as inflation becomes less of a worry for the markets, we would also expect fixed income to exhibit improved hedging properties. Considering the amount of cumulative tightening already delivered by the Fed, headwinds facing the growth outlook and late-cycle dynamics squarely in place, we see increased value in adding fixed income not only as a source of income, but also diversification in portfolios.
1Inflation expectations are captured in R*, and as discussed, we believe that there are disinflationary trends, and inflation expectations (5yr5yr forward inflation expectation rate) continue to be well-anchored. See: 5-Year, 5-Year Forward Inflation Expectation Rate (T5YIFR) | FRED | St. Louis Fed (stlouisfed.org).
2Source: The Mechanics of Fed Balance Sheet Normalization | St. Louis Fed (stlouisfed.org). Currently, bank reserves are $3 trillion, or roughly 12% of nominal GDP, which could drop to as low as 7% before impacting market functioning. This 7% number, or about $1.9 trillion, is among the lowest level reserves can drop, if we use 2019 as the example. A conservative estimate would be a 10% drop, and hence the remaining $0.5 trillion of bank reserves could be used to absorb the incoming supply.
3October 19, 2023, Speech, Opening Remarks, Fed Chair Jerome H. Powell, the Economic Club of New York Luncheon, New York, New York.
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