Dollars and Sense: Yields Jump, We Ask How High!

TD Economics Dollars and Sense: Yields Jump, We Ask How High! Beata Caranci, SVP & Chief Economist 416-982-8067 James Orlando, CFA, Senior Economist 416-413-3180 October 17, 2018 Highlights Strong economic data and comments by Federal Reserve Chair Powell have caused U.S. Treasury yields to breakout above previous trading ranges - with the UST 10-year hitting a seven year high. For the long-end of the curve, the rise has largely been attributed to a shift up in the long-term expectations for the fed funds target. This neutral rate is widely debated and a rise in its level is highly dependent on the structural evolution of the economy via elements like productivity and demographics. Even with the recent jump, we still see a bit more upside for yields, with the Fed set to hike through 2019 and inflation likely to marginally overshoot the Fed s target. One of the biggest developments in recent weeks has been the upward shift in bond yields, particularly the U.S. Treasury curve. On the back of strong economic data and hawkish comments from the Federal Reserve, the UST 10-year yield increased from a low of 2.81% on August 22nd, to a seven year high of 3.26% on October 9th (Chart 1). Since the Federal Reserve first started hiking rates in 2015, the 10-year yield consistently struggled to sustain upward momentum. With this breakout breaching the previous high set in May, many clients are now wondering how much higher yields can go. Latest move caused by Fed repricing To answer that, we must return to discussing the fundamentals that drive yields. The long-end of the Treasury curve is influenced by expectations for the Fed over the next several years and the premium demanded for locking into prevailing Chart 1: Treasury Yields Are Breaking Out! % rates. The narrative for higher rates started when the Fed first 4.0 Fed Funds Target UST2Y hiked rates in December 2015, and then solidified when they 3.5 UST5Y UST10Y became increasingly hawkish in late-2016/early-2017. The Fed s 3.0 follow-through of rate hikes, combined with strong economic data, has lent us confidence that they can and should continue raising the policy rate to an upper bound of 3.25% next year. This level is slightly above our estimate of the neutral rate of 0% to 2.75%. We believe the Fed will have to slightly overshoot due to the large fiscal stimulus packages (both the budget and TCJA) that risk over-heating the labor market and the economy, in general. 1.5 1.0 0.5 2012 2013 2014 2015 2016 2017 2018 Source: TD Economics, FRB

2 Chair Powell reaffirmed this on October 3rd, when he stated that the Fed may have to move above the neutral rate (also referred to as r* for the real rate and i* for nominal). But, in the same statement, he noted that the current policy rate was a long way from neutral. This is a loaded statement. There appears to be little agreement within the Fed on where the neutral rate precisely sits. In fact, the Fed s projection for the longer run policy rate shows a wide % to 3.5% range. Powell s predecessor, Janet Yellen, held that the real neutral rate was (at the time) sitting close to zero, which would place the nominal rate below the lower end of this range. The model created by New York Fed President Williams currently calls for a real neutral rate of about 0.60%, which also places the nominal rate at the lower end of the range. Put differently, under both of these views, the Fed s policy rate is either already at neutral or will be very soon. Under our policy assumption and estimate of the neutral rate, the Fed will hit that target in early 2019. In contrast, if Fed Chair Powell believes they are a long way from neutral, this suggests his sights may be set on the upper end of that range, meaning closer to the 3.0 to 3.5% mark. Determining the neutral rate Importantly, the concept of a neutral rate is non-static because it will evolve with developments within the economy. This can account for the Fed s current varying estimates, as well as why they can change their view of the range over time. Specifically, the neutral rate is estimated as the interest rate that balances expected savings and investment 3.3 2.8 1.8 1.3 Chart 2: Long-run Fed Expectations Driven by Near-term Economic Activity % Index 0.8 2013 2014 2015 2016 2017 2018 Source: TD Economics, Bloomberg L.P. Fed Funds in 10-years (LHS) ISM Manufacturing Index (RHS) 66 61 56 51 46 3.5 3.0 1.5 1.0 0.5-0.5 Chart 3: Stimulus Measures are the Real Boost to Growth Contribution to Real GDP Growth, Q4/Q4 % Change 3.1 2017 2018F 2019F F Government TCJA Rest of the economy GDP Source: Bureau of Economic Analysis, TD Economics i.e. the rate that balances the economy when we are in steady state. This long-term anchor is determined by the potential growth rate of the economy. In spite of a recent run of strong growth, largely pushed higher by fiscal policy, the determinants of potential growth have not been meaningfully altered. Aging demographics is not being sufficiently countered by immigration of skilled workers. The end result is an ongoing, and rapid, erosion in the growth of the core-aged labor force. On the flip side, productivity growth is firming, but the uptrend is necessary just to maintain the neutral rate at the lower end of the Fed s range. Recent developments with productivity are consistent with our prior baseline assumptions for an ongoing acceleration relative to the past decade. But, in order to support a neutral rate closer to the upper end of the Fed s longer term range, productivity growth would have to return to levels not seen since the 1960s in order to offset the heavy downdraft coming from demographic forces. However, the structural underpinnings of today s economy look little like that of prior decades. Interestingly, the recent upward shift in market pricing for the neutral rate is very much paralleling the recent cyclical upturn in economic momentum, rather than the fundamental longer term drivers of potential growth (Chart 2). This leaves the markets susceptible to a reality check. Take a look at Chart 3. Although the media has credited tax cuts for propelling economic growth higher, the larger impulse has actually been coming from direct government expenditures (i.e. budgetary spending at the federal and state/local levels). Growth 1.8

3 within the rest of the economy remains anchored by its fundamentals. In fact, the picture is very similar to that of 2017, which did not have the benefit of fiscal stimulus via greater budgetary spending or tax cuts. Inevitably, the thrust of fiscal policy will wear off, which should become apparent in late 2019. Likewise, economic growth will ease from current high levels. If the correlation between current economic activity and market pricing for long-run Fed policy holds, the recent driver of the UST 10-year could be vulnerable to a set-back. However, that would not alter the ultimate path for yields when looking past near-term noise. The rapid repricing of the long-end of Fed expectations a couple weeks ago ultimately caused the UST 10-year to move higher earlier than we thought, but did not breach the levels we think are attainable by the economic fundamentals. This harkens back to the old adage, you can get the forecast timing or level right, but rarely both! Regardless of any batting around of yields based on near-term surprises in the economic data, longer term yields should ultimately hue towards our target level of 3.35%. However, nothing is static. Should a breach occur, the gut-check is to ask whether there has been a fundamental change in the outlook based on data developments, or whether the market is merely having a knee-jerk reaction to a short-lived surprise in the data. When it comes to the former, we would look for confirmation in the data through specific paths. One such development could come from inflation data. With the 2.4 2.2 2.1 Chart 4: Inflation Expectations and Yields Have Room to Move Up % % 0.1 1.9 Aug-17 Dec-17 Apr-18 Aug-18 Source: TD Economics, FRB Inflation expectations - 10y (LHS) Term premium - 10Y (RHS) economy pushing on capacity limits, inflation looks set to marginally overshoot its 2% target in early 2019. Current expectations for inflation 5-10 years from now have remained stable (Chart 4). We believe core measures of inflation will move up in early 2019 and this could lift market expectations by 20-40 bps. In turn, higher inflation risk adds to the interest rate risk the premium for locking in for 10 years. In this event, yields on the long end could find a resting place closer to the 3.5% to 4.0% range, but would have a difficult time sustaining these levels because the Fed would respond and tap down expectations, as per its mandate. Fundamental economic drivers would eventually rule the day. -0.1-0.2-0.3-0.4-0.5-0.6

4 INTEREST RATE & FOREIGN EXCHANGE RATE OUTLOOK Spot Rate 2018 2019 Oct-16 Q1 Q2 Q3 Q4F Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F Interest Rates Fed Funds Target Rate 2.25 1.75 0 2.25 0 2.75 3.00 3.25 3.25 3.25 3.25 3.25 3.25 3-mth T-Bill Rate 2.26 1.73 1.93 2.19 2.48 2.78 3.03 3.15 3.15 3.15 3.15 3.15 3.03 2-yr Govt. Bond Yield 2.86 2.27 2 2.81 2.85 3.00 3.10 3.15 3.15 3.15 3.15 3.15 3.05 5-yr Govt. Bond Yield 3.02 6 2.73 2.94 2.95 3.10 3.15 3.20 3.20 3.20 3.20 3.20 3.10 10-yr Govt. Bond Yield 3.16 2.74 2.85 3.05 3.10 3.20 3.30 3.35 3.35 3.35 3.35 3.30 3.20 30-yr Govt. Bond Yield 3.33 2.97 2.98 3.19 3.25 3.35 3.45 3.50 3.50 3.50 3.50 3.45 3.35 10-yr-2-yr Govt Spread 0.30 0.47 0.33 0.24 0.25 0.20 0.20 0.20 0.20 0.20 0.20 0.15 0.15 Exchange rate to U.S. dollar Chinese Yuan CNY per USD 6.91 6.27 6.62 6.87 6.90 6.90 6.90 6.80 6.80 6.80 6.80 6.80 6.80 Japanese yen JPY per USD 112 106 111 113 110 108 107 106 105 104 103 103 102 Euro USD per EUR 1.16 1.23 1.17 1.16 1.17 1.18 1.19 1.20 1.21 1.22 1.23 1.24 1.25 U.K. pound USD per GBP 1.32 1.40 1.32 1.31 1.32 1.32 1.33 1.34 1.35 1.36 1.37 1.38 1.39 Swiss franc CHF per USD 0.99 0.95 0.99 0.98 0.97 0.97 0.97 0.97 0.97 0.97 0.97 0.97 0.97 Canadian dollar CAD per USD 1.29 1.29 1.31 1.29 1.28 1.27 1.27 1.26 1.26 1.26 1.26 1.26 1.25 Australian dollar USD per AUD 0.71 0.77 0.74 0.72 0.72 0.73 0.73 0.74 0.75 0.76 0.77 0.78 0.79 NZ dollar USD per NZD 0.66 0.72 0.68 0.66 0.66 0.67 0.68 0.69 0.70 0.71 0.72 0.73 0.74 Exchange rate to Euro U.S. dollar USD per EUR 1.16 1.23 1.17 1.16 1.17 1.18 1.19 1.20 1.21 1.22 1.23 1.24 1.25 Japanese yen JPY per EUR 130 130.8 129.3 131.9 128.7 127.4 127.3 127.2 127.1 126.9 126.7 127.1 127.5 U.K. pound GBP per EUR 0.88 0.88 0.89 0.89 0.89 0.89 0.90 0.90 0.90 0.90 0.90 0.90 0.90 Swiss franc CHF per EUR 1.15 1.17 1.16 1.13 1.14 1.14 1.15 1.16 1.17 1.18 1.19 1.20 1.21 Canadian dollar CAD per EUR 1.50 1.59 1.53 1.50 1.50 1.50 1.51 1.52 1.53 1.54 1.55 1.56 1.57 Australian dollar AUD per EUR 1.62 1.60 1.58 1.61 1.63 1.62 1.63 1.62 1.61 1.61 1.60 1.59 1.58 NZ dollar NZD per EUR 1.76 1.70 1.72 1.75 1.77 1.76 1.75 1.74 1.73 1.72 1.71 1.70 1.69 Exchange rate to Japanese yen U.S. dollar JPY per USD 112 106 111 113 110 108 107 106 105 104 103 103 102 Euro JPY per EUR 130 131 129 132 129 127 127 127 127 127 127 127 128 U.K. pound JPY per GBP 148 149 146 148 145 143 142 142 142 141 141 141 142 Swiss franc JPY per CHF 113.3 111.4 111.6 116.3 113.3 111.8 110.8 109.8 108.7 107.7 106.6 106.1 105.6 Canadian dollar JPY per CAD 86.8 82.4 84.3 87.8 85.9 85.0 84.5 83.8 83.2 82.6 81.9 81.6 81.3 Australian dollar JPY per AUD 80.2 81.7 81.9 82.1 79.2 78.8 78.1 78.4 78.8 79.0 79.3 8 80.6 NZ dollar JPY per NZD 74.0 76.9 75.0 75.3 72.6 72.4 72.8 73.1 73.5 73.8 74.2 74.8 75.5 F: Forecast by TD Economics, October 2018; Forecasts are end-of-period; Source: Federal Reserve, Bloomberg. COMMODITY PRICE OUTLOOK Price 52-Week 52-Week 2018 2019 Oct-16 High Low Q1 Q2 Q3 Q4F Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F Crude Oil (WTI, $US/bbl) 72 76 51 63 68 70 67 66 65 65 65 65 66 66 66 Natural Gas ($US/MMBtu) 3.29 5.46 2 3.10 2.82 2.90 3.10 3.04 2.98 3.02 3.08 3.04 3.03 3.03 3.02 Gold ($US/troy oz.) 1225 1358 1174 1329 1306 1213 1225 1240 1275 1300 1325 1350 1375 1370 1355 Silver (US$/troy oz.) 14.66 17.55 14.06 16.74 16.56 15.02 14.75 15.25 16.00 16.50 17.00 17.50 18.20 18.10 17.75 Copper (cents/lb) 286 333 261 316 312 277 284 293 300 308 311 313 315 318 319 Nickel (US$/lb) 5.72 7.14 4.90 6.01 6.56 6.02 6.17 6.26 6.40 6.53 6.58 6.58 6.75 6.75 6.70 Aluminum (Cents/lb) 92 115 90 98 102 93 100 100 98 99 101 101 101 100 99 Wheat ($US/bu) 6.89 8.08 6.15 7.42 7.46 6.70 6.80 6.83 6.87 6.90 6.94 6.97 7.01 7.04 7.08 F: Forecast by TD Economics, October 2018; Forecasts are period averages; E: Estimate. Source: Bloomberg, USDA (Haver).

5 INTERNATIONAL INTEREST RATE OUTLOOK Spot Rate 2018 2019 Oct-16 Q1 Q2 Q3 Q4F Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F Germany ECB Deposit Rate -0.40-0.40-0.40-0.40-0.40-0.40-0.40-0.25 0 0 0.25 0.25 0.50 3-mth T-Bill Rate -0.68-0.79-0.65-0.58-0.65-0.55-0.45-0.35-0.25-0.10 0.15 0.15 0.40 2-yr Govt. Bond Yield -0.56-0.62-0.67-0.53-0.56-0.43-0.31-0.17-4 0.20 0.46 0.71 0.95 5-yr Govt. Bond Yield -0.11-0.11-0.30-9 -6 0.17 0.39 0.61 0.82 1.03 1.23 1.41 1.60 10-yr Govt. Bond Yield 0.49 0.49 0.30 0.47 0.54 0.76 0.97 1.18 1.38 1.56 1.75 1.93 0 30-yr Govt. Bond Yield 1.12 1.15 1.02 1.08 1.12 1.33 1.53 1.71 1.90 8 2.15 2.21 2.28 10-yr-2-yr Govt Spread 1.05 1.11 0.97 1.00 1.09 1.18 1.27 1.34 1.42 1.36 1.29 1.21 1.05 United Kingdom Bank Rate 0.75 0.50 0.50 0.50 0.75 0.75 1.00 1.00 1.25 1.25 1.25 1.50 1.50 3-mth T-Bill Rate 0.75 0.51 0.58 0.58 0.65 0.78 0.90 1.03 1.15 1.15 1.28 1.40 1.65 2-yr Govt. Bond Yield 0.82 0.81 0.72 0.72 0.84 1.07 1.31 1.50 1.64 1.78 1.93 8 2.20 5-yr Govt. Bond Yield 1.17 1.11 1.02 1.02 1.26 1.44 1.63 1.80 1.97 2.13 2.29 2.45 0 10-yr Govt. Bond Yield 1.61 1.35 1.28 1.28 1.59 1.78 1.95 2.12 2.28 2.44 2.60 2.65 2.69 30-yr Govt. Bond Yield 0 1.71 1.73 1.73 1.93 2.10 2.27 2.43 9 2.75 2.80 2.84 2.86 10-yr-2-yr Govt Spread 0.79 0.54 0.56 0.56 0.75 0.71 0.64 0.62 0.64 0.67 0.67 0.58 0.49 F: Forecasts by TD Bank Group, October 2018; Forecasts are end-of-period; Source: Bloomberg. GLOBAL STOCK MARKETS Price 30-Day YTD 52-Week 52-Week Oct-16 % Chg. % Chg. High Low S&P 500 2,810-3.3 5.1 2,931 2,557 DAX 11,777-2.9-8.8 13,560 11,524 FTSE 100 7,059-3.3-8.2 7,877 6,889 Nikkei 22,549-2.4-0.9 24,271 20,618 MSCI AC World Index* 493-5.2-4.0 550 489 *Weighted equity index including both developing and emerging markets. Source: Bloomberg, TD Economics. Disclaimer This report is provided by TD Economics. It is for informational and educational purposes only as of the date of writing, and may not be appropriate for other purposes. The views and opinions expressed may change at any time based on market or other conditions and may not come to pass. This material is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The report does not provide material information about the business and affairs of TD Bank Group and the members of TD Economics are not spokespersons for TD Bank Group with respect to its business and affairs. The information contained in this report has been drawn from sources believed to be reliable, but is not guaranteed to be accurate or complete. This report contains economic analysis and views, including about future economic and financial markets performance. These are based on certain assumptions and other factors, and are subject to inherent risks and uncertainties. The actual outcome may be materially different. The Toronto-Dominion Bank and its affiliates and related entities that comprise the TD Bank Group are not liable for any errors or omissions in the information, analysis or views contained in this report, or for any loss or damage suffered.