Bond yields on a leash
How high will bond yields rise and where does the rout in US Treasury securities cease in the short term?
This question has been on bond investors' minds for some time now.
Much of the recent rise in yields is likely related to investor concerns over the Fed's intentions to taper its purchases of government bonds as soon as this month and potentially end its purchases completely by sometime next spring.
If this does happen, how high will 10-year rates rise over the next year or so?
On May 2nd, yields bottomed at 1.62% and have been on an upward trajectory since, rising almost 150 basis points.
So where do we go from here?
In my opinion it is likely that the most violent part of the bond bear market is probably over in the near term, and we are unlikely to see a large additional sell-off in bonds unless there is some drastic surge in inflation and/or a rapid improvement in economic data.
Looking at historic spreads of the 3-month T-bill yield (a close proxy for the Fed Funds Target rate) and the 10-year yield, the maximum spread or difference over the last 30 some years was 368 basis points or 3.68%.
The average was only 1.21%.
Given that the Fed has suggested rates will remain pinned near zero out until 2015, it is likely that 10-year yields could rise up to this maximum historic point of roughly 4%.
At a yield of roughly 3% it looks like we are about 3/4s of the way there.
Here is another way to look at it.
Think of it like a dog on a leash.
The 10-year bond is the dog at the end of the leash, he runs in and out and the leash slackens and tightens.
The stake in the ground that the leash is tied to is the Federal Funds Target Rate, currently sitting at 0.25%.
The leash between the stake and the dog is the yield spread or the difference between the yield on the 10-year US Treasury security and the Federal Funds Target Rate.
As long as the leash doesn't break (and the stake stays in the ground!), there really is only so far that the dog (and 10-year- yield) is likely to go.
The threat of hyperinflation would really be the main reason the leash might snap.
Of course there are those who will point to the fact that historically we have never been in such a period of manufactured monetary policy.
That is we have never witnessed central bank intervention or quantitative easing at the levels we have today.
They would, of course be correct so it is of course possible that historic spreads do not do justice to our current environment.
To this I would suggest that we still need some whiff or evidence of an inflation bump.
If we agree that long term nominal growth in the US is about 4.5%(2.5% real growth plus 2.0% inflation), fair value on 10-year yields could be argued to be about 4.5%, so only marginally higher than the spread assumption.
Again inflation expectations are the key.
Investors have been concerned about the rapid increase in yields.
Although this was not unexpected and I have written about my concern regarding overvaluation, the sheer speed of “normalisation” has been dramatic.
Fortunately, it would seem that the adjustment process is likely to be less dramatic at this point.
This is not to say that yields will not rise over time, it just suggests that the bulk of this early move, at least in the near term, has run its course.
Nathan Kowalski can be contacted at email@example.com or 296-3515
Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
The opinions expressed may change as subsequent conditions vary.
The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Anchor Investment Management Ltd. to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy.
Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass.
Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks.
Readers should consult their financial advisers prior to any investment decision.