Mind The Rise In The Term Premium!

Introducing the Term Premium

Through the use of economic models, academic research has decomposed the observable long-term bond yields (i.e. US 10Y Treasury bond yield) into the expected path of the real interest rate (r*) and the additional term premium, which is thought as the extra return that investors demand to compensate them for the risk associated with a long-term bond. Using the dominant measure developed by the NY Fed (Adrian et al., 2013), we overlay it with a set of macro and financial variables and look at the pros and cons of a rise in the term premium in the coming months.

Figure 1 shows that the evolution of the US 10Y yield along with the expected r* and the term premium. While we can notice that part of the fall on the 10Y was driven by the decrease in the expected r* from 3.15% to 1.80%, the elevated volatility in the short run was mainly coming from the moves on the Term Premium (TP). The TP hit a historical low of -1.47% on March 9th and is still standing at extreme low level of -1.1%. Many investors had expected the term premium to start rising the US in 2018 and in the first half of 2019, but it surprised most of them by constantly reaching new lows.

Figure 1

fig1Source: NY Fed

Term Premium: a counter-cyclical variable

One important characteristic of the term premium is that it is a counter cyclical variable that tends to rise when the uncertainty around unemployment (or the business cycle) and inflation expectations starts to increase.

Figure 2 (left frame) shows the striking relationship between the unemployment rate and the term premium since 1961. Periods of rising unemployment have been generally associated with a sharp increase in the term premium. Now that we expect the jobless rate to skyrocket following the dismal prints of NFPs and initial claims in recent weeks, could we see a response in the term premium as well?

Figure 2 (right frame) shows another interesting relationship between the US 2Y10Y yield curve and the term premium. We know that the inversion of the yield curve is usually marked by a sharp steepening effect within the next 12 to 24 months as the economy enters a recession. This is referred as a ‘bear steepener’ as the long end of the curve starts rising due to a surge in the term premium. Will the Fed’s emergency measures and QE purchases be enough to deprive the yield curve and term premium from rising significantly in the coming months?

Figure 2

fig2Source: Eikon Reuters

Term Premium vs. inflation expectations

The 2-trillion USD increase in the Fed’s balance sheet as a response of Covid-19 has brought its holding of securities to a new all-time high of $5.85tr. The Fed has recently been buying $625bn of securities each week, which corresponds to an annual pace of $32.5tr and is $25bn more than the entire QE2 run between November 2010 and June 2011. The balance sheet of the Fed is now expected to hit 8 to 9 trillion USD by the end of the year in hopes that it will bring back confidence in the market. Hence, it is fair to raise the following question: will we experience rising inflation in the medium term?

As the term premium is very sensitive to the uncertainty around inflation expectations, it shows an interesting co-movement with the 12-month volatility of the Fed’s balance sheet assets. When interest rates reach the zero bound, central banks run aggressive asset-purchase programs in order to decrease the shadow rate below the neutral rate of interest rate (r*) and stimulate demand and inflation. Figure 3 (left frame) shows that previous periods of rising 12M vol in Fed assets were associated with a short-term increase in the term premium.

Investors could argue that inflation expectations have been falling if we look at the market-based measures – the USD 5Y5Y inflation swap. Figure 3 (right frame) shows that the 5Y5Y inflation swap is currently trading at a historical low of 1.75%, down from nearly 3% in January 2014. However, we previously saw that inflation swaps have been very sensitive to equity and oil prices in the past cycle; in theory, an oil shock should not impact inflation expectations as better monetary policy readjustments from central banks will offset that shock. Hence, these products represent more the demand for inflation hedges (which decreases when energy prices fall), but do not tell us anything about long-term inflation expectations.

Figure 3

fig3Source: Eikon Reuters

Term premium and free-floating bonds

Certainly, moves on the term premium also depends strongly on the amount of free-floating securities in the market. As central banks keep increasing their balance sheet through the purchase of securities such as government bonds, the amount of free-floating bonds have dramatically been reduced in the past cycle. For instance, it was estimated that large asset-purchase programs in the Euro area have decreased the free float of German government bonds from approximately 40% in 2015 to 3% in early 2020 (figure 4, left frame). Figure 4 (right frame) shows how the relationship between the 10Y Bund term premium and the free float flattened in the past few years; low free float is associated with a flat term premium.

In the US, the amount of free float is much higher due to the large quantity of marketable debt securities (USD 16tr) held by the non residents; non-resident holders (NHR) hold nearly 40% of the US debt. Hence, even though the Fed’s aggressive purchases will reduce the free float in the medium term, there is still the risk of a sudden rise in the term premium in the short run as the economy enters a recession.

Figure 4

fig4

Source: Danske, ECB

To conclude, the risk of higher long-term interest rates in the US is still there in the coming months; even though we do expect long-term rates to eventually go to zero, there is still a high probability to see a little short-term surge in the 10Y -plunge in US Treasury prices (TLT), which would significantly steepen the yield curve coinciding with the drastic rise in unemployment.

Great Chart: Gold vs. US 5Y Real Yield

We showed in many of our charts that 2017 was the year where some of the strong correlations between assets classes broke down. We showed USDJPY vs. TOPIX (here, here), Cable (here) and EURUSD (here) vs. the 2Y and 10Y interest rate differentials, and this week we chose to overlay Gold prices with 5Y US real interest rates. As we explained it in our study on Gold (here), the relationship between Gold and US [real] rates is easy to understand. The precious metal is a non interest-bearing asset, meaning that a typical investor doesn’t get any cash-flow from owning it (unlike dividends for stocks and coupons for bonds), and has usually a storage cost associated with it. Therefore, the forward curve of the ‘currency of the last resort’ (Jeffrey Currie) is usually upward sloping, in other words Gold market is in contango, with the forward price equal to the following:

Reg.PNG

Hence, if real interest rates start to rise, a rational investor would prefer to reallocate his wealth to either US Treasuries or Treasury Inflation Protected Securities (TIPS) and receive coupons rather than keeping a long position in a commodity that has a ‘negative carry’.

As you can see it on the chart, Gold prices (in US Dollars) and the 5Y TIPS real yield have shown some strong co-movements over the past 5 years, until the summer of 2017 when the two times series diverged. If we would follow recent moves on the market, the late surge in Gold prices (currently trading at 1,340 $/ounce) would imply a 50 to 60 bps decrease in US real interest rates (note that if we regress the change in Gold prices on the change in the 5Y real yield using weekly data since 2013, we find that a 1% increase in real yields lead to an 8.7% depreciation in Gold prices). And lower real rates would either come from higher inflation expectations or lower nominal interest rates. With the 5Y5Y forward inflation swap currently trading at 2.11% and up 30bps over the past 6 months, core inflation and core PCE YoY rates at 1.8% and 1.5% slightly moving to the upside, and oil prices still trending higher with WTI front month contract trading at $64.5, there is room for higher inflation prints coming ahead. However, if the two curves were to converge in the short term, the [sharp] move would come from either [lower] Gold prices or [lower] Treasury rates.

Our view is that the divergence will persist in the beginning of 2018, with inflation remaining steady / slightly increasing and US interest rates failing to break new highs on the long end of the curve (5Y and 10Y). The main reason for that is that we think market’s confidence on the Fed’s 4 or plus hikes will slow down in the coming months on the back of lower-than expected fundamental, depriving the yield curve from steepening too much.

Chart: Gold prices vs. US 5Y TIPS (inv.) (Source: Reuters Eikon) 

WeeklyGold.PNG

 

Could we survive without QE?

As we are approaching the end of QE (the Fed will probably announce a $10bn / $10bn and then 5bn cut in the next three meetings), we thought it is a good time to have a quick recap of the US QE history since the Great Financial Crisis and its impact on the equity market.

QE1 (December 2008 – March 2010): On November 2008, roughly two-and-a-half months after the Lehman Brothers collapse, the FOMC announced that it will purchase up to $600bn in agency MBS and agency debt and on March 18, 2009, Bernanke and its doves announced that the program would be expanded by a further $750bn in purchases of MBS and agency debt and $300bn in T-bonds. At that time, the Fed had approximately $750bn of Treasuries ad MBS on its balance sheet.

QE2 (November 2010 – June 2011): After 9 months of stagnation in the stock market, the FOMC decided to go for another round of quantitative easing on November 2010 and announced that it will purchase $600 bn of LT Treasuries, at a pace of $75bn per month. Stock market started to rallied once again (S&P was up approximately 10%) as by applying this un-conventional monetary policy, the Fed brought interest down to the floor and ‘forced’ investors to move to the stock market in order to receive a more interesting real rate.

Operation Twist (September 2011 – December 2012): While the stock market was plummeting (S&P was down 300 pts to hit 1,075 a few months after the end of QE2), it didn’t too long for the Fed to react and on September 21st 2011, the FOMC announced Operation Twist. In this program, the Committee intended to purchase, by the end of June 2012, $400bn of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. The main goal was to lower long-term rates in order to stimulate consumer spending and corporate borrowing as growth was judged sluggish by US policymakers at that time. In the middle of 2012, the FOMC downgraded its growth expectations from 3.5% (a year earlier) to 1.9% – 2.4%.

By the end of June 2012, the Fed extended the monetary twist program and said it would purchase another $267bn LT Treasuries by the end of the year, bringing the program up to $667bn.

QE3 (September 2012 – December 2012): With inflation in the US plummeting from 3.9% in September 2011 to 1.4% in July 2012 and credit continuing to contract and still disappointing unemployment figures, the FOMC decided at the September 2012’s meeting (13th) to initiate additional open-ended purchases of residential MBS for an outstanding amount of $40bn every month. Combined with the (approx.) S45bn monthly purchase of US LT Treasuries, the FOMC will increase the central banks’ holdings of LT securities by about $85bn each month, which should ‘put downward pressure on the LT interest rates, support mortgage markets and help to make broader financial conditions more accommodative’ according to the Fed’s statement.

QE4 (December 2012 – December 2013): With Operation Twist coming to an end and US policymakers still judging the recovery as ‘fragile’, the Fed decided to continue to purchase $45bn worth of US LT Treasuries, raising the amount of QE to $85bn on a monthly basis. Its goal at that time was to drive economic activity so that unemployment rate drops to 6.5% (it was standing at 7.7% at that time), as long as inflation remains below 2.5%.

And it went on, that year the Fed increased its balance sheet by a trillion+ dollars, bringing it to a record high of $4trn in December 2013 and which could totally explain the 30% increase in the stock market and the 10% appreciation in the housing sector (Reminder: for the 2013 fiscal year ended Sep. 30th 2013, the US Congressional Budget Office – CBO – announced that the deficit fell drastically to $680bn from $1.087tr in 2012).

QE Taper (December 2013 – ): As the unemployment rate was falling faster than expected in 2013 (down 1% to 6.7% in December 2013), the Fed officials decided to start its QE Taper, announcing that it would scale back its monthly purchases by S10bn each meeting (Auto-pilot strategy). After almost two years of extended QE and with the Fed’s balance sheet up 1.5tr USD (according to FARBAST index), we are now three meetings ahead of the QE exit (last cut expected to be on December’s meeting). The real question now is: would the ZIRP policy on its own be enough to support the equity market (and the housing sector)?

We saw some turbulence back in January this year when the market corrected 5.5 – 6 percent (between mid-Jan and February 3rd) and also in end-July/August where we saw another 4.5-percent correction in the middle of high geopolitical tensions (11.7% of the World is at war according to a DB analysis, see chart at the end). However, it seems that the market has perceived those ‘corrections’ as new buying opportunities and the S&P 500 has been flirting with the 2,000 level for the past week (closed four days out of five above 2,000 over the past week). The index is already up 8.3% since December 31st 2013 close (1,848.36) and we are asking ourself, how far could this go? Especially now that the Fed is now giving us some updates concerning its ST monetary policy, and is potentially considering raising rates (currently at 0 – 0.25%) sometime next year (Q3 seems to be the market’s view). We are going to steal Stanley Drunckenmiller’s sentence: ‘Where does the Fed’s confidence come from?’

Aren’t policymakers supposed to wait a little bit after Taper ends in order to start focusing on its ST interest rate policy?

Even though the rate hike is priced for Q3 next year based on the market’s expectations, we don’t see the point of starting talking about an ‘eventual rate hike’, and especially after the only excuse you had to explain a 2.9% contraction in the first quarter (because there has to be always an explanation) is to blame the weather. In our opinion, US policymakers’ plan sounds a bit ambitious.

Chart: S&P 500 index and QE history

S&PQE(1)

(Source: Reuters)

Another popular chart that we like to look at is the equity market (S&P500 index) overlaid with the Fed’s balance sheet (FARBAST index). As you can see it, it is clear that the Fed’s balance sheet expansion have played in favour of the equity market. Liquidity drives asset price higher and we believe that we are about to hit the high of the asset price inflation we have seen for the past six years…

FEDSP(1)

(Source: Bloomberg)

Appendix

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