PMC Weekly Review - February 16, 2018
Warren Buffett once said, “Interest rates act like gravity on valuations.” In physics, gravity translates mass into weight, so the higher the gravity, the harder it is for previously levitating objects to continue to do so. So why, after many years of almost zero “financial gravity,” are yields suddenly spiking?
To answer the above question, we first need a brief review of the components of yields. Nominal yields can be broken down into three main components: 1) bond risk premia (also known as “term premia”), 2) the market’s expectations of the average real short-term interest rate, and 3) the market’s expectation of inflation rates. The last two components are measured over the lifetime of the bond.
Investors are assessing two things when contemplating what a “fair” price (or, equivalently, yield) on a long-term nominal bond should be: the sequence of short-term real rates over the lifetime of the bond and the sequence of inflation rates over that same period. Additionally, the harder it is for investors to determine the future path of real short-term rates and inflation (e.g., due to large and erratic recent inflation readings) or the more fearful they are feeling (e.g., due to general economic malaise), the higher additional yield bond risk premium they will require on their long-term bond investment as an additional reward for greater uncertainty. This component also responds to supply-demand imbalance for long-term debt. To wit, the various iterations of the Federal Reserve’s (Fed) quantitative easing (QE) were aimed at compressing this component by increasing the demand for Treasurysthrough outright purchases of these securities.
Keeping in mind the above-noted three components of nominal yields, we can understand why they have changed so drastically over the last several months, with the yield on the 10-year Treasury Note rising from 2.33% on November 15 to 2.91% on February 14—a nearly 60-basis points rise (see chart on page 8).
First, note that inflation expectations are very stable through time, and all survey-based evidence points to these expectations staying close to the Fed’s current 2% inflation target. Second, the estimates show that the expected average nominal short-term interest rate (or the sum of two out of the three components that make up the yield) rose by about 24 basis points during the span of November 15 through February 14. Incidentally, the Tax Cuts and Jobs Act of 2017 was making its final rounds through Congress during mid- to late November. This suggests that tax reform was the impetus behind the rise in expected future real short-term rates, as the tax bill’s aim was to raise the US economy’s productivity.
Finally, the term premium rose by about 35 basis points over a span of about 10 days—between February 2 and February 122 . The timing of this rise in term premium suggests that it was related to inflation uncertainty as well as supply/demand imbalance issues, which we analyze next.
During this time, the unit labor costs in nonfarm business sector increased significantly. Also, Congress passed a budget agreement that will add a “temporary” increase in discretionary spending. The Committee for Responsible Federal Budget estimates that this could add $2 trillion to the more than $20 trillion of existing US government debt, which is unsustainable. Also, Washington is currently abuzz with President Trump’s fiscal year (FY) 2019 budget proposal, which prominently features trillions of dollars for infrastructure spending. Finally, the Fed has begun the process of normalizing its massively bloated balance sheet, which calls for not rolling over an increasing portion of maturing Treasury debt. The result is the Fed has increased supply by not purchasing around $44 billon (and counting) worth of Treasuryssince October of 2017, which constitutes a significant percentage of US debt sold by the Treasury.
These events combined have created an excess supply of Treasurys, which has caused the term premia to expand, resulting in significantly higher long-term yields. If the Fed sticks to its guns about maintaining stable and low future inflation, then the above-mentioned budgetary issues will likely lead to higher future real rates. Everything else being equal, this “financial gravity’s” rise should inexorably precipitate an end to stocks’ decade-long levitation.
Janis Zvingelis, PhD, CFA SVP,
Director of Quantitative Research