Great Chart: US Term Premium vs. Business Cycles

Academics and economists have often decomposed the long-term bond yield of a specific country (i.e. US 10Y Treasury) into the sum of the expected path of real interest rate (r*) and the additional term premium, which compensate investors for holding interest rate risk. Two major risks that a bond investor typically face in the long-run are the change in supply of and demand for bonds and the uncertainty around inflation expectations. If the uncertainty increases, the market will demand a higher premium as a response. As the premium is not directly observable, it must be estimated using econometric models. For instance, a popular one that practitioners use is the one developed by Adrian, Crump and Moench (2013), who estimated fitted yields and the expected average short-term interest rates for different maturities (1 to 10 years, see data here).

As you can see, the term premium has been falling since 2009 and is currently negative at -51bps, which has not happened very often. Instead of having a positive term premium for long-term US debt holders carrying interest rate risk, there is actually a discount. The term premium for the 10Y reached an all-time low of -84bps in July 2016, at the same time that the yield on the Treasury reached a record low below 1.40%. However, there are also interest findings when we plot the ACM 10Y term premium with macroeconomic variables. If we overlay it with the US unemployment rate, we can notice a significant co-movement between the two times series. The jobless rate went down from 10% in Q3 2009 to 4.1% in March 2018, tracked by the term premium that fall from roughly 2.5% to -50bps in that same period. In other, it seems that the term premium follows the business cycles, trend lower in periods of positive growth and falling unemployment and rises in periods of contractions. Therefore, for those who are expecting a rise in the US LT yields in the medium term, driven by a reversion in the term premium, what does it mean for the unemployment rate going forward?

Chart. US Unemployment Rate vs. 10Y Term Premium

US Term Pr.png

Source: Reuters Eikon and Adrian et al. (2013)

 

Dollar pause, but when?

Since the beginning of July, the US Dollar has entered into a bull momentum and nothing seems to stop its trend. The USD index surged by almost 9% in the past three months and is now trading at a four year high at 85.65 (June 2010 levels to be precise). With the Fed about to finish tapering at the next meeting in October ($15bn cut) and policymakers acting much more confident (compare to H1) due to stronger macro indicators and an equity market still ‘rallying’, the market didn’t hesitate to position itself back into US Dollars.

If we have a look at the last Fed’s dot plot below, Fed Officials raised their median estimate for the FF rates at the end of 2015 to 1.375% (vs 1.125% in June). Moreover, by the end of 2017, the majority of the committee expects the FF rate to rise to 3.75%.

imagedotplots

(Source: Federal Reserve)

With the unemployment rate sitting at 6.1% (below the once-used-to-be 6.5% threshold), growth revised higher in Q2 at annualized 4.6% (vs. 4.2% in previous estimate) and most of the fundamentals being stronger (except August NFP and dismal durable goods that came in at -18.2% MoM), the market is looking at an earlier-than-expected rate hike in the US. We heard and read Q2 seems likely. In our opinion, US policymakers are making a mistake as they should have let the market ‘swallow’ a period without QE before starting to be more explicit concerning their ST monetary policy (see article Could we survive without QE?). We agree the Fed’s recent ‘move’ has probably made the joy of most of the central banks as all the currencies have been trending lower against the US Dollar. However, it looks to me that the recent talks we’ve heard have been premature [a bit] and in case of disappointing fundamentals, the Fed could easily switch to another mute period (aka BoE lately).

Based on our latest discussion with the strategy team, we agreed there are several factors that could continue to hold back a significant growth acceleration in the near term. For instance, mortgage applications (MBA Purchase Index: orange line) in the US stands at a 14-year low even though the 30-year fixed mortgage rate (black line) is still trading at ‘decent’ low levels (4.39%, vs. an average of 6% between 2002 and 2008) as credit conditions are much tighter now.

HousingMarck(1)

(Source: Reuters)

Moreover, wage growth continues to increase only at a modest pace (except for skilled workers in areas such as health care) and will continue to weigh on personal consumption expenditures, which represents roughly 70% of the US economy.

US data this week:

 – Important figure to watch this week will be September Non-Farm Payrolls on Friday, which is supposed to print above the 200K (215K according to pools).

 – September Average Earnings and Workweek Hours (Friday) are expected to print at 0.2% MoM and 34.5h.

 – ISM Manufacturing PMI should remain strong at 58.5 on Wednesday.

Chart on STIRs: As we mentioned it in some of our previous research, the implied rates on the FF December 2015 and December 2016 futures contracts suggest that the Fed’s target rate will the end the year at 75bps in 2015 and 112bps in 2016 respectively.

ImpliedFFRates(1)

(Source: Bloomberg)

Quick update on the Euro

This morning, EZ August flash inflation came in at 0.3% YoY and confirmed falling trend (from 0.4% in July). The ECB meets next week (September 4) and the market is pricing some action: talks of corridor rates cut, updates on the ABS program…

Our advice is ‘stay short EURUSD’ for those who got in already, or wait for a bounce back above the 1.3200 level for entering a short position. Large offers are seen at 1.3200 – 1.3250 (combined with huge expiries, 4bn Euros of vanilla option according to Reuters). Though the first support stands at 1.3100 where we might see a pause, our MT target remains at 1.3000. After German retail sales printed much lower than expected at -1.4% MoM in July (vs. 0.1% consensus), Italian quarterly unemployment rate rose to 12.6% in July (vs 12.3% expected) and preliminary inflation (EU Norm) entered into a negative territory, printing at -0.2% YoY and joining Greece, Spain and Portugal in recording annual consumer-price declines.

Peripheral yields picked up a bit, with the 10-year Italian and Spanish yields trading at 2.44% and 2.24% respectively, up from Wednesday’s low of 2.36% and 2.09%.

Our view goes for a corridor rate cut in order to optimize the T-LTROs (first starting on Sept 18). ABS purchases sound a bit premature…

EURUSD-29-Aug(1)

(Source: Reuters)

Another way to play the Euro at the moment would be against GBP as we believe the market has overreacted to the some data disappointments and a slightly dovish QIR (Quarterly Inflation Report) back on August 13th. Good resistance level is at 0.7960/5, therefore going short EURGBP at around that level with a first target at 0.7880 (stop loss above 0.8020) could be a good strategy. Bank of England is also meeting next week but we expect it to be a non-event.

FOMC meeting: the impacts

As expected, the Fed reduced the asset purchase programme by another $10bn in April to $55bn, adding $25bn of agency MBS and $30bn of LT Treasuries to its holdings every month. The surprise though came from the upward revision to the Fed funds rate, which is expected to increase to 1% or more by the end of 2015 (up from 0.75%) and to 2.25% by the end of 2016 (up from 1.75%). US interest rates increased sharply after the statement, pushing the value of the US Dollar higher (US Dollar index was up 60 pts to 80.10).

In addition, US policymakers lowered the 2014 GDP growth range to 2.8% – 3.0% (from 2.8% – 3.2% in December) and are targeting a 6.1% – 6.3% jobless rate by the end of this year (see the details below). With the unemployment rate standing close to the 6.5-pecent threshold (6.7% in February), Janet Yellen announced during her first conference as a Fed chair that the central bank would shift to a more qualitative approach and will consider a ‘wide range’ of variables instead of relying mainly on the unemployment rate.

(Source: Federal Reserve website)

Now let’s review the impacts of the Fed funds rate forecast change. Firstly, as you can see it on the chart below, the 10-year US yield increase by 10 bps to 2.77%, sending Gold to end-of-February lows (trading at 1,328 after the statement).

(Source: Reuters)

The FOMC meeting also put the Euro under pressure, a currency that has remained resilient in the middle of this Risk-ON / Risk-OFF market driven by Russian-Ukrainian tensions and the weakening Chinese Yuan episode. EURUSD, which had been traded around the 1.3900 level (1.3850 – 1.3960 range) for the past couple of weeks, was pushed back towards 1.3800 (1.3810 after the statement), frustrating the bulls (who were expecting 1.4000) and easing ECB concerns about a ‘strong exchange rate’.

EURUSD-FOMC

(Source: Reuters)

Eventually, Cable broke its 1.6545 support and found support slightly above the 1.6500 level. As you can see it on the chart below, the plunge in the 2-year UK-US spread (purple line) from 31.5 bps to 22.5 bps pushed the pair (orange) to mid-Feb levels. The 2-year spread has been one of the major drivers of Cable since Carney adopted the forward guidance in August last year. As unemployment rate has decreased faster than expected and is now standing close to the 7-percent threshold (7.2% in the three months to January), traders have been speculating on a rate hike in the first quarter of 2015. However, some MPC members put the British pound under pressure stating that a ‘strong exchange rate’ could weigh on the BoE’s decision to start tightening. With policymakers’ recent comments and an annual inflation at its lowest level since 2009 (1.9% YoY in January), the market is now pricing in a BoE action in the second quarter of 2015.

GBPUSD - Sp

(Source: Reuters) 

UK Budget: In the early afternoon, the Chancellor of the Exchequer Osborne presented the new budget and as expected, it contained a few surprises in the aggregate numbers of the deficit path (real news was the incentives for savers, which we are not going to cover in this article). As the UK economy is expected to accelerate this year (2.7% according to the Office for Budget Responsibility – OBR), the deficit is expected to decrease gradually in the following years and switch to a small surplus of 0.2% in 2018/19 according to the OBR.