US 10Y Treasury Yield: Framework and Forecasts

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1 US Y Treasury Yield: Framework and Forecasts Minggao Shen, PhD SFC CE No. ATQ771 minggaoshen@gfgroup.com.hk Jianghui Chen, PhD SFC CE No. BLG georgechen@gfgroup.com.hk Thanks to Zheng Ying* for his contribution to this report. *Please note that Zheng Ying is not a registered licensee with the Securities and Futures Commission of Hong Kong and is not allowed to conduct regulated activities in Hong Kong GF Securities (Hong Kong) Brokerage Limited 9-/F, Li Po Chun Chambers 9 Des Voeux Road Central Hong Kong US Y Treasury yield an anchor for global interest rates It determines other major macroeconomic variables through spreads, and term spreads determine the relationship between long-term and short-term interest rates, acting as leading indicators of GDP growth and share prices. Country spreads determine the relationship between interest rates in other countries and in the US, which in turn affect currency values against the US dollar. The risk spread determines the level of risk premium, and is thus an important parameter for major asset allocation. Shifting cycle of global low-end manufacturing determines a to -year-long cycle in the US Y Treasury yield This was discussed in our previous report The Great Turning Point: Starting a long upcycle of interest rates. We believe the global economy is experiencing a turning point that occurs roughly every years. The fall in the US Y Treasury yield, which lasted for years since 191, has come to an end, and the yield is now rising, from its low of 1.% in to above % this year. It is set to continue to rise. In this report, we analyze the short-term determining factors of the US Y Treasury yield from a micro perspective Based on empirical analysis of data since 19, we find the US Y Treasury yield is mainly determined by economic fundamentals, represented by real GDP growth and PMI, price changes reflected by CPI and expected inflation, and risk appetite, represented by the term premium. Based on this model, we expect the US Y Treasury yield to fluctuate between.-.% over the next five quarters To get to this conclusion, we use the average of major institutions expectations from Bloomberg as a reference, we take the impact of the trade conflict between China and the US into consideration, and we assume the term premium will bounce back from the low in Aug this year. This is a summary of a report originally written in Chinese. Please contact us for more information of the original report. The Chinese version shall prevail in the event of any discrepancy between the two versions.

2 1. The determinants of the US treasury yield Many factors can have an influence on the US treasury yield. Broadly, there are three categories: economic fundamentals, inflation and the term premium. Solid economic fundamentals mean a higher overall return for an economy, and treasury yields rise accordingly. Rising inflation leads to higher expectation of interest rate rises, thus investors require a higher return from Treasuries. The term premium acts as compensation for bearing the extra risk of holding long-term securities. When there is less risk appetite among investors, a higher risk premium will push up long-term treasury yields. 1.1 Economic fundamentals Treasury yields are determined by the economic fundamentals of the issuing country. In essence, sovereign debt is backed by expectations for national economic development. As the largest economy in the world, US fundamentals also determine the outlook for the global economy. Since the 19s, the monthly yield of the US Y Treasury has moved in line with nominal GDP growth, and there is also alignment in their inflection points (Figure 1). Nominal GDP growth consists of two parts: real GDP growth and inflation. Real GDP growth represents economic fundamentals, which is the change in output excluding price changes. Since the 19s, real GDP growth rate has slowed along with the decline in the US treasury yield (Figure ). Figure 1: US Y Treasury yield and YoY nominal GDP growth (%) Figure : US Y Treasury yield and YoY real GDP growth (%) US nominal GDP growth US Y Treasury yield US real GDP growth US Y Treasury yield Source: CEIC, GF Securities Aside from GDP growth, the Purchasing Managers Index (PMI) is another important indicator reflecting economic fundamentals. Figure shows the historical trend of the US Y Treasury yield and the US PMI. Overall, there is a strong similarity in the inflection points of the two. When using HP filtering to exclude trend items in PMI and yield, consistency can be found in the cycle terms of the two (Figure ), meaning that the fluctuations of the PMI determine the direction of yield fluctuations.

3 Figure : US manufacturing PMI and Y Treasury yield (%) Figure : PMI and Y Treasury yield cycle terms US Y Treasury yield PMI(RHS) USY Treasury yield PMI(RHS) Source: CEIC, GF Securities 1. Inflation Inflation expectations reflect market expectations of central bank interest rate policies. Higher inflation expectations can push up expectations of interest rate hikes, and the required return for investing in US treasuries rises accordingly, and vice versa. Based on the Fisher effect, while real inflation is rising, investors require a higher nominal return to keep their real returns unchanged. Figures and show the relationship between the US Y Treasury yield, YoY US CPI and expected inflation (published by Michigan University). Inflection points occur at the time that yield turns, there is continued low inflation or inflation expectations have depressed US treasury yields. Figure : Y Treasury yield and YoY CPI (%) Figure : Y Treasury yield and expected inflation (%) Y Treasury yield CPI Y Treasury yield Expected inflation Source: CEIC, UMich, GF Securities 1. Risk preference Generally, demand for US Y Treasuries reflects investors demand for low-risk or safe assets. The fluctuation in yield is therefore dependent on global investors risk judgment to a certain extent. The most common indicator that describes US investors risk preference is CBOE Volatility Index (VIX). VIX is based on the S&P index; when it is high, market participants usually expect a higher volatility and anxiety increases. Therefore, the logical connection between the VIX and yield can be concluded as: rising VIX more anxiety increased demand for safe assets (treasuries) higher price of treasuries lower treasury yield. As shown in Figure 7, there has been a significant negative correlation between the VIX and US Y Treasury yield since 199.

4 To be more precise, the term premium can effectively quantify the extra return required by investors for being locked into a longer investing term. The New York Fed provides estimates for term premiums (see the New York Fed website for details). Theoretically, holding others constant, the higher the term premium, the higher the US Y Treasury yield. However, in terms of correlation, the relationship between term premium and US Y Treasury yield is not significant (Figure ). Figure 7: VIX index and Y Treasury yield (%) Figure : Term premium and Y Treasury yield (%) Y Treasury yield VIX (RHS) Y Treasury yield Term premium Source: CEIC, Fed, GF Securities. Empirical analysis We have established a simple empirical model to conduct quantitative analysis on the determinants of the US Y Treasury yield. First of all, for this model, we choose real GDP growth and manufacturing PMI to represent US economic fundamentals. Theoretically, GDP growth may have a reciprocal causation with interest rates, while interest rate is less important in terms of the direct impact on PMI. Secondly, we choose CPI and expected inflation to reflect the variable of inflation, among which, expected inflation is more forward-looking. Thirdly, we use risk premium as a representative of risk appetite. And lastly, we add an annual variable into the model to control the trending effect, which has made the US Y Treasury yield keep falling since 191. According to quarterly and monthly data since 191, we see four empirical regressions. For the first two models, we applied GDP growth rate to represent economic fundamentals, while for the other two regressions we use PMI. Meanwhile, CPI and expected inflation are used respectively in each group to reflect inflation changes. The regression results are shown in Figure 9. The regression result shows that, the trend of the US Y Treasury yield is explained by the three chosen factors. Generally speaking, inflation and risk premium are far more important than GDP growth, acting as major variables to drive short-term yield fluctuations. What is noteworthy is that, the US Y Treasury yield has experienced an overall downward trend since 191 and bottomed out in, so the trend may have already begun to rise. Figure shows a comparison between the estimated value under regression one and the actual observation. We can see from the comparison that, our model estimates fit the inflection points quite well.

5 Figure 9: Monthly data regression result (***, significant) Figure : Model estimates and actual yields (%) Reg 1 Reg Reg Reg GDP growth.7***.*** Manufacturing PMI.***. CPI (YoY).9***.*** Expected.7***.71*** inflation Term premium.***.9***.7***.*** Year -.*** ***.19***.*** Constant Term 7.***.1*** 9.7***.*** R-Squared Observations Source: CEIC, GF Securities Y Treasury yield Reg 1 estimation. Outlook for the US Y Treasury yield On Oct, the US Y Treasury yield reached a new high since 11 of.% (Figure 11). Based on the above analysis framework, we make a projection for US Y Treasury yield over the coming five quarters by looking at economic fundamentals, inflation and term risk. The US is set to maintain its solid economic fundamentals, which will be stimulated by tax reform until Q19. Inflation will face upward pressure from two factors: firstly, for the labor market, the US unemployment rate has fallen since the global financial crisis, and even come down to the lowest level since 19 of.% in May this year. Secondly, the trade conflict between China and the US can push up US inflation to some extent. The trade conflict will accelerate the process of low-end manufacturing moving away from China, Chinese exports may start to rise, and push up global inflation and interest rates. Figure 11: Monthly yield of US Y Treasuries (%) Figure : US term spread (between Y and 1Y Treasury) Source: CEIC, New York Fed, GF Securities Amid the US-Sino trade conflict, global uncertainty has increased and investors have lower risk appetite, pushing up risk premium accordingly. The interesting things is, according to the estimates of the New York Federal Reserve, the US Y Treasury yield s term premium has remained negative since. Recently, the term spread between Y and 1Y Treasury yield has also been negative, at the lowest level since 191 (Figure ). Since, the term spread of the Y Treasury yield has rallied off its bottom three times,.1pp in Nov,.pp in Nov, and -.11pp in July. In the five quarters after each bottom, the term premium rebounded by 1.1pp.

6 In Sept this year, the Y Treasury yield reached to a new low of -.pp, reducing the average Q premium to -.pp. The possibility of the term premium rallying is increasing, thus we use the average of the three historical rebounds to derive the trend in the coming five quarters, and show our projections in Figure 1. Figure 1 also shows this year s actual values and an average of major institutions projections for real GDP growth rate and CPI, provided by Bloomberg. In line with what we have discussed above, the US will clearly maintain relatively rapid real GDP growth until 1Q19. However, institutions seem to be conservative when making inflation projections the impact of the trade conflict on US inflation may not be completely accounted for in their estimates. In our own projection, we have added.pp to forecasted CPI in the coming five quarters. Based on regression 1, we have listed our forecasts for the US Y Treasury yield on the right-hand side of Figure 1 below. Figure 1: US Y Treasury yield and forecasting, quarterly data for /19 Quarter GDP growth and forecasts (%) Manufacturing PMI CPI and Forecasts (%) Term premium (pp) 1Q Q Q QE Q19E.1... Q19E Q19E Q19E Source: Bloomberg, GF Securities US Y Treasury yields and forecasts (%) Based on the above, with an assumed term premium, we believe the US Y Treasury yield will fluctuate between.% and.% until Q19 (Figure ). This is higher than the average forecast of major institutions from Bloomberg (Figure 1).. Figure : US Y Treasury yield: our forecast (%) Figure 1: US Y Treasury yield: Bloomberg forecast (%) US Y Treasury yield Our forecast US Y Treasury yield Avg High Low Source: CEIC, Bloomberg, GF Securities

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