What is driving Treasury yields higher? " our programme for reducing our [Fed's] balance sheet, which began in October, is proceeding smoothly. Barring a very significant and unexpected weakening in the outlook, we do not intend to alter this programme." Jerome Powell, Chairman of the Federal Reserve, March 8. The global economy is decisively moving from the recovery phase of the economic cycle to the expansion phase. The transition occurs as most countries start to experience shortages in spare capacity, causing firms to bid-up input prices including wages, which in turn drive demand higher. As a result, inflation is typically higher, prompting central banks to tighten monetary policy. Bond yields tend to rise during this phase of the cycle as investors demand additional compensation not only for rising inflation, but also the higher potential returns on equities, driven by stronger economic growth. equity markets have struggled so far this year, partly due to fears of protectionism, but also due to rising bond yields Recent jitters in equity markets are partly explained by fears of protectionism, but also the recent rise in bond yields. As yields rise, so does the discount rate applied to forecasts of future income growth for equities, therefore reducing the present value and making equity valuations less attractive. Higher bond yields also increase the opportunity cost of owning risk-assets compared to holding a "risk-free" government bond. The S&P equity index is down almost 7. since its peak on 6 January, and is down overall year-to-date. Meanwhile, the yield to maturity on the benchmark -year Treasuries closed on February at.9 the highest level since January, and more than double the yield seen as recently as July 6. Yet, a nominal yield below is still very low compared to past cycles. However, the current economic cycle is arguably like no other seen before. The prolific use of quantitative easing has distorted asset prices, while the cycle itself may be is set to be one of the longest in history (see chart earlier). How far should yields rise going forward? What are the key drivers? The Schroders Real Yield Model To gain a better understanding of the rise in Treasury yields, we turn to the Schroders Real Yield Model. The model was originally developed in the 99s, but has evolved over time to incorporate new explanatory factors. We recently reestimated the model to bring our analysis up to date, and the rest of this note explores the results and conclusions. The Schroders Real Yield model helps us understand the key drivers of real yields Before we delve into the results, a brief description of how the model works is required. First, the real yield is taken as the yield to maturity on the benchmark -year Treasury minus year-on-year core CPI inflation. It is important to note that we use core inflation and not headline CPI inflation, as additional volatility in the latter caused by energy and food price inflation would generate too much noise. By not taking the headline rate of CPI inflation, the model's results are more stable, but the results are not comparable with inflation linked bonds. The model finds a fair value of the real yield using the following variables: Real Fed Funds rate (to capture the impact of rising short-term interest rates). Manufacturing ISM survey (as a proxy for GDP growth). The model is estimated using quarterly data, with an OLS regression, using a Cochrane Orcutt transformation to correct for serial correlation in the error terms. The model is estimated using data from Q 99 to Q 7. Economic and Strategy Viewpoint April 8 8
Overseas official holdings of Treasuries as of total issuance (important to capture the expansion of reserves in emerging markets, and their holdings of Treasuries). Fed purchases of Treasury bonds as of GDP (to estimate the impact of QE). Two VIX dummy variables (to capture safe haven demand during market panic). Chart 7 shows the model's estimate of the real yield versus the actual real yield as defined previously. The key feature of the model is that it allows the actual real yield to fluctuate around the model's estimate, which we deem as being the fair value. The light blue swath around "fair value" line is the 9 confidence interval of the model. This suggests that when the actual real yield (green line) moves outside of the swathe, the bond market is either too cheap or too expensive. Indeed, the model has a good track record of identifying these periods when bond yields move too far away from where they should be based on fundamentals. Chart 7: Estimating the real yield The model suggests that the current real yield is within fair value territory - - 9 confidence interval yr real yield () Fair value Forecast 9 9 9 97 99 7 9 7 9 Source: Schroders Economics Group. 7 March 8. Please note the forecast warning at the back of the document. The last observation of the actual real yield (Q 7) is below the model's fair value estimate, but within the 9 confidence interval. However, what the model allows us to do is to forecast where the real yield is heading. Using our baseline forecast for the economy (featured in last month's viewpoint), we forecast the path of our estimated fair value real yield, as shown in the above chart. The real yield is estimated to rise by basis points by the end of 9 to.9. Structural versus cyclical factors To better understand the recent rise in yields, we can look at how much of the change in yields is attributed to each independent variable by the model. Over the past year, the model's fair value estimate has risen by 9 basis points (bps) (chart 8). 6bps of which was caused by the rise in the manufacturing ISM survey. This was the most important factor, followed by the rise in the real Fed funds rate (+7bps) and the reduction in quantitative easing (QE) as a share of GDP (+9bps). The VIX volatility index remained subdued and therefore had no impact; however, the overseas official holdings of Treasuries as reserves made a small negative contribution. The first VIX dummy variable is triggered when the VIX index rises more than one standard deviation above its long-run average. However, VIX is triggered when the rise is more than two standard deviations. Economic and Strategy Viewpoint April 8 9
Chart 8: Drivers of the Schroders Real Yield Model The recent rise in yields has been driven by stronger growth and rising real interest rates point contribution to q change in real yield estimate - - - 6 7 8 9 6 7 8 9 Real Fed Funds rate ISM Reserves QE VIX VIX Source: Schroders Economics Group. 7 March 8. Please note the forecast warning at the back of the document. however going forward, our forecast suggests that the unwind of QE will become the dominant factor Given that growth (as captured by the ISM survey) and the Fed funds rate are estimated to have had the largest impact, we conclude that cyclical factors have so far been the key drivers of the rise in yields. Looking ahead, our forecast assumes that growth, and therefore the ISM survey, will peak in 8 and begin to moderate over most of 9. While nominal interest rates are forecast to rise further, the real rate is only forecast to rise a little further in 9 given our forecast of rising inflation. The main driver of higher yields over 8 and 9 is forecast to be the reduction of the Fed's balance sheet, which is set to accelerate over 9. In our view, the Fed's policy of unwinding QE is likely to be more of a structural headwind for the bond market in the coming years, rather than policy driven by cyclical factors. The Fed has communicated a path for the policy, which the new chair is happy to stick to (see quote earlier). Balance sheet deduction is set to accelerate from $bn per month to $bn per month by the end of the year. Unless there is a significant downturn in the economy, the Fed is unlikely to waver from its path of allowing its balance sheet to shrink. What about inflation? As mentioned earlier, the rise in inflation during the expansion phase of the economic cycle is a critical factor behind tighter monetary policy. The model presented above is estimated in real terms using core inflation, but in order to make its output comparable with the market, we need to return to nominal yields. Chart 9 (on next page) takes the real yield model as presented in Chart 7, but adds historic core inflation and our baseline forecast for core inflation. In doing this, the estimated fair value of the -year nominal yield is forecast to rise by 66bps to.9. This is made up of the bps increase in the real yield and bps rise in core CPI inflation. A forecast of a rise to.9 for the nominal -year Treasury yield would be considered as aggressive today, despite historic yields being much higher in the past. Compared to market pricing, taken from forward contracts of the -year, we see that the market barely expects the -year yield to breakthrough the level by the end of 9. Moreover, the profile priced by markets is well below the lower confidence interval of.78 at the end of 9. This suggests that not only is there considerable upside risk to Treasury yields over the forecast horizon, but also to market pricing of the future path of yields. Economic and Strategy Viewpoint April 8
Chart 9: Taking inflation into account Factoring in core inflation, the model suggests the nominal yr yield is heading to.9 by end 9 9 7-9 confidence interval yr nominal yield () Fair value Forecast Market pricing 9 9 9 97 99 7 9 7 9 Source: Bloomberg, Schroders Economics Group. 7 March 8. Please note the forecast warning at the back of the document. Conclusions The Schroders Real Yield Model suggests that the real yield in the is within fair value, and the recent rise has largely been driven by stronger growth, and the rise in real Fed funds rate. However, combining the model with our baseline forecast to look ahead, we conclude that these cyclical factors are likely to moderate, though structural factors in the form of the unwind of QE will drive real yields higher. Once higher inflation is also factored in, the model's 9 confidence interval suggests that the nominal -year Treasury yield could rise to between.78 and.8 by the end of 9. Meanwhile, markets expect the -year yield to barely breakthrough over the same time horizon. If yields do rise in line with the Real Yield Model's forecast, or even by more, then equities could struggle to make gains, especially where earnings growth is weak or hard to identify. Economic and Strategy Viewpoint April 8
Schroders Baseline Forecast Real GDP y/y Wt () 7 8 Prev. Consensus 9 Prev. Consensus World.. (.).. (.). Advanced* 6.8..6 (.).. (.). 7... (.).8.9 (.).6 7...6 (.).. (.9).9 Germany...8 (.6).. (.).9.8.7.7 (.6).6. (.). 7..6. (.8).. (.). Total Emerging** 7... (.9).. (.8).9 BRICs..7 6. (.8).8.9 (.7).7 China 6. 6.9 6.6 (6.) 6. 6. (6.) 6. Inflation CPI y/y Wt () 7 8 Prev. Consensus 9 Prev. Consensus World.. (.)..6 (.). Advanced* 6.8.7.9 (.7).9. (.9).8 7... (.)..6 (.). 7... (.).. (.).6 Germany..7. (.7).7.8 (.8).8.8.7. (.).6. (.). 7... (.9)..6 (.6). Total Emerging** 7... (.).. (.). BRICs...8 (.).7. (.9). China 6... (.).. (.). Interest rates (Month of Dec) Current 7 8 Prev. Market 9 Prev. Market... (.).8. (.).78...7 (.).7. (.). (Refi)... (.).7 (.) -. (Depo) -. -. -. (-.). (.). -. -. -. (-.).8 -. (-.). China... (.) -. (.) - Other monetary policy (Over year or by Dec) Current 7 8 Prev. Y/Y() 9 Prev. Y/Y() QE ($Bn) 9 9 9 (6) -9. 9 (6) -.9 EZ QE ( Bn) (). (). QE ( Bn) (). (). JP QE ( Tn) (6).7 67 (8).9 China RRR () 7. 7. 6. 6. - 6.. - Key variables FX (Month of Dec) Current 7 8 Prev. Y/Y() 9 Prev. Y/Y() D/GBP... (.8) 7.7.6 (.) -.9 D/EUR...8 (.).. (.) -. JPY/D 6.. () -8.7 ().8 GBP/EUR.88.88.9 (.9)..9 (.). RMB/D 6.9 6.6 6. (6.) -6. 6.7 (6.).7 Commodities (over year) Brent Crude 7..6 6. (6.). 9.7 (8.7) -6.7 Source: Schroders, Thomson Datastream, Consensus Economics, February 8 Consensus inflation numbers for Emerging Markets is for end of period, and is not directly comparable. Market and consensus data as at 8//8 Previous forecast refers to November 7 * Advanced markets: Australia, Canada, Denmark, Euro area, Israel,, New Zealand, Singapore, Sweden, Switzerland, United Kingdom, United States. ** Emerging markets: Argentina, Brazil, Chile, Colombia, Mexico, Peru, China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand, South Africa, Russia, Czech Rep., Hungary, Poland, Romania, Turkey, Ukraine, Bulgaria, Croatia, Latvia, Lithuania. Economic and Strategy Viewpoint April 8 6
Updated forecast charts Consensus Economics For the, and Pacific ex, growth and inflation forecasts are GDP weighted and calculated using Consensus Economics forecasts of individual countries. Chart A: GDP consensus forecasts 8 9 7 7 6 6 J F M A M J J A S O N D J F M 7 8 J F M A M J J A S O N D 8 Chart B: Inflation consensus forecasts 8 9 J F M A M J J A S O N D J F M J F M A M J J A S O N D 7 8 8 Source: Consensus Economics (March 8), Schroders. Pacific ex. : Australia, Hong Kong, New Zealand, Singapore. Emerging Asia: China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand. Emerging markets: China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand, Argentina, Brazil, Colombia, Chile, Mexico, Peru, South Africa, Czech Republic, Hungary, Poland, Romania, Russia, Turkey, Ukraine, Bulgaria, Croatia, Estonia, Latvia, Lithuania. The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors. The views and opinions contained herein are those of Schroder Investments Management s Economics team, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document does not constitute an offer to sell or any solicitation of any offer to buy securities or any other instrument described in this document. The information and opinions contained in this document have been obtained from sources we consider to be reliable. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. For your security, communications may be taped or monitored. Economic and Strategy Viewpoint April 8 7