US 10- year yields: Move above 3.0% could spur another wave of adjusting and hedging - BBH

Analysts at BBH suggest that at the end of 2017, many expected the US 10-year yield to rise to 2.90% by the end of this year and that target has been met this month. 

Key Quotes

“Already, many investors recognize that the 30-year downtrend in long-term US yields has been broken, but a move above 3.0% could spur another wave of adjusting and hedging.”

“The 10-year TIPS yield may be used a practical measure of the real rate.  The yield had risen from about 42.5 bp at the end of last year to 79.5 bp last week.  That 37 bp increase explains two-thirds of the increase in the nominal 10-year yield (from 2.40% to 2.94%). The rise in real rates has been impacted by the shifting expectations of Fed policy.  The implied yield of the December Fed funds futures contract, which settles at the effective average Fed funds rate for the month, has risen 16 bp this year.  The December FOMC meeting concludes on the 19th, so the 16 bp increase reflects actually a greater increase in overnight rate expectation.”  

“By nearly any measure, real interest rates remain very low.  The average over the past 20 years is closer to 1.75% rather than the prevailing rate a little below 80 bp.  This is remarkable given what appears to be an unprecedented amount of fiscal stimulus directed at an economy that is growing above trend. At the same time, the Federal Reserve has been quite transparent about its intention to buy $420 bln fewer Treasuries this year, just as the supply is increasing.  Moreover, the tax changes may reduce corporate treasurers' demand, while demographics will likely see Social Security buy fewer (non-marketable securities) as well.”

“Market-based measures of inflation expectations have risen, but remain modest, given the fiscal consideration and now the new tariffs (solar panels, washing machines, and soon, likely aluminum and steel) that raise prices for consumers of those items.  The recent string of reports, including average hourly earnings, CPI, PPI, and import prices was above expectations.”

“The shift in expectations of Fed policy has not been dramatic.  Several bank economists now forecast four hikes this year.  There is much discussion that the updated forecasts by the Fed will see the median forecast increase from three to four hikes.  What is the problem?  The market has not even discounted three.”

“Here is a way to conceptualize the issue.  The Fed funds futures settle at the average effective rate over the course of a given month.  Since the December hike, the effective average has been 1.42%.  Three hikes would lift the effective average to 2.17%, while a fourth hike would generate an effective average of 2.42%.  The January 2019 contract may give the best read of the end of 2018 rate.   It finished last week with an implied yield of 2.09%.”

“Our hypothesis in the equity market is that we have not entered a new investment paradigm that is a bizarro (or opposite) version of the current one. We do not believe that investors have been awoken from the Soma-like narcotic effect of central bank aggressive policy stance that blurred the distinction between monetary and fiscal policies, as the consensus narrative would have it.  Nor in their awakened state will rationality will return, and equity prices will return to valuations closer to their long-term cyclically-adjusted price-earning ratio averages.   Our hypothesis in the bond market is that the ample capital available, and the fact that the ECB and BOJ are buying the net new supply by their respective governments, will serve to keep US rates lower than what many macro models may suggest, given supply and demand considerations and rising inflation expectations.”