Michael Purves July 7, 2018 Chief Global Strategist Head of Derivatives Strategy mpurves@weedenco.com (203) 861-7725 The Failed Normalization of the Term Premium (or, How the ECB Can Export Volatility) Summary As inflation, economic growth, and the Fed s hiking cycle have all helped to push longer term Treasury yields to multi year highs, the term premium associated with 10 year Treasuries still negative and trading close to record lows a striking condition given the dramatic increase in Treasury supply after the tax reform and spending deal passed this winter. 1 This failed normalization of the tem premium is a key reason why Treasury volatility both prospective and realized has remained close to life time lows despite the strong rise in nominal yields and the potential end of the 40 year Treasury bull market. If the term premium normalizes, we should not only see increases in yields, we should also see a much more robust volatility environment across asset classes. In turn, this will likely suppress earnings multiples and widen credit spreads, and also mark a decisive step forward in the normalization of macro conditions. We also argue that the low term premium in the U.S. Treasury curve is primarily a derivative of the ECB s balance sheet trajectory. In this respect, if the ECB moves to a decidedly more hawkish position, especially with regards to its balance sheet, it will not only like raise longer term Bund yields, it will also raise the term premium in the U.S. Treasury market effectively exporting a key volatility catalyst for U.S. assets. 1 The term premium can be defined as the excess yield investors require to hold a longer dated debt securities relative to shorter dated debt. The San Francisco Fed s definition of the term premium: Briefly stated, the term premium is the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds. For example, suppose that the interest rate on the 10-year U.S. Treasury note is about 5.5%, and suppose that the interest rate on the 1-year U.S. Treasury bill is expected to average about 5% over the next 10 years ( note and bill are the customary names for U.S. Treasury securities of these maturities). Then the term premium on the 10-year U.S. Treasury note would be about 0.5%, or 50 basis points. See: https://www.frbsf.org/economic-research/publications/economic-letter/2007/july/term-premium/#subhead1 1
Key Points Term Premium Has Failed To Normalize. Although nominal yields have increased substantially across the curve, the Fed s hiking cycle is in full gear, and actual and expected inflation have increased substantially since their lows last September, the term premium remains close to life time extreme lows. A Normalizing Term Premium Will Re-Steepen the Treasury Curve. The low term premium explains in part why the yield curve has been flattening; if the yield curve were to normalize to its average levels from 2000 through 2007 we would easily see the 2-10 curve steepen by more than 100 points (all other things being equal). QE Is Responsible for the Persistently Low Term Premium. In the aftermath of the financial crisis, the suppression of the term premium was a deliberate goal of the Fed s QE program. While the Fed s balance sheet reached a peak in Q3 2014 and started its steady decline (QT) last fall, the BOJ and the ECB s QE programs have, thus far, kept the upward trend of global liquidity intact and the term premium low. The ECB Pivot Point Is Key. The tax bill and budget deal have meaningfully aggravated Treasury supply/demand dynamics (essentially magnifying the impact of the Fed s QT by over 50%). One would expect that this would have resulted in a higher, not lower, term premium given the dramatically increased supply and the view that prospective fiscal discipline may be harder to find in Washington regardless of which party is in power. We believe this conundrum can be explained in large part by the ECB which is, for all practical purposes, the marginal provider of global liquidity. While the BOJ and Fed s balance sheet path are relatively predictable (and, on an incremental basis, effectively offset each other), the ECB has emerged as the key swing factor and explains why the term premium has been correlating with Bunds much more so than Treasuries. The Term Premium is a Key Volatility Factor. The low term premium explains in part why Treasury volatility has been low, despite the hiking trajectory, higher inflation, and the surge in yields through key resistance levels. As the term premium normalizes, we expect Treasury volatility to normalize. As this happens, this should put in a higher floor in the VIX, weigh on equity valuation and widen credit spreads. Foreign exchange volatility will increase as well. 2
Deconstructing the 10 Year Yield Chart 1 profiles the key components of the 10 year Treasury yield the Fed s hiking cycle measured by the aggregate number of Fed hikes in 2018-19 implied by the Fed funds futures markets, inflation (10 year break evens) and the term premium. 2 Forward inflation has been volatile, but has climbed 100 basis points since the record lows of Q1 2016 while CPI has increased over 200 basis points since the deflationary lows of 2015. The rate hike expectations contracted after the Trump inauguration, but have climbed steadily off the September, 2017 lows. The stand out here is the term premium which, despite brief rallies after the Trump election and then the tax/spending bill, has once again returned to record life time lows. The divergence of these metrics over a broader term is shown in Chart 2 which profiles the current level percentile rankings going back to 2000. 2 The term premium we focus on this note is the Adrian Crump & Moench 10 Year Treasury Note Term Premium which is used by (and developed by) the Federal Reserve Bank of New York. This term premium also has the benefit of the longest time series which starts in 1961. This metric shows some variability with other 10 year term premium calculations such as the Morgan Stanley Term Premium DTSM 10Y and the Kim and Wright Term Premium on a 10 Year Zero Coupon Bond (which the Fed also uses). While these three metrics show different levels, the direction is the same and consistent. See Chart 16 in Appendix. 3
Current Level Percentile Rank From 2000 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 10 Yr. Yld. Yield 10 Yr. B.E. Infl. 2 Yr. Yld. Term Premium 4
The Term Premium and Volatility As we can see in Chart 3, the MOVE index (a VIX for the Treasury curve) has moved in tandem with the term premium, especially when yields and the term premium are moving higher (less so when Treasury yields/term premium are moving lower). While both metrics spiked with the yield surge in February (concurrent with the passing of the spending bill), both have given back those gains despite the persistent rate hike trajectory (reflected in the rise in short term Treasury yields), and inflation metrics (both realized and anticipated). That Treasury volatility has remained low with Treasury yields piercing key resistance at the 2.64% and 3.0% levels raises several questions. Chart 4 illustrates the rolling correlations of the MOVE index with the 10 year yield, the hiking trajectory (measured by the total number of Fed hikes in 2018-19 implied by Fed fund futures), as well as the 10 year break even inflation rate and the 10 year nominal yield. We can see clearly here that the one correlation which has remained consistently strong (and positive) this year is the term premium correlation. Chart 3. 5
Chart 4. Rolling 90 Day Correlation 1.50 1.00 0.50 0.00-0.50-1.00 Move/Term Premium Move/BE Inflation Move/Rate Hikes MOVE/10 Yr. Yld. Connecting the Dots: Term Premium MOVE VIX. The lower term premium/lower MOVE condition has implications for other asset classes, including equities and high yield treasuries. As we can see in Chart 5, the MOVE index has a long standing relationship with the VIX (a correlation coefficient of.79 going back to 2000 based on daily values). Given the significance of the interest rates in the equity volatility surface, it should be no surprise that the further dated VIX contracts and MOVE index have moved closely over the past few years. Chart 6 highlights that during the February volatility spike both the MOVE index and the 5month VIX contract moved up, but modestly relative to the level of VIX spot (they reached a much lower high point than they did during the Q3 2015 volatility spike). In other words, despite the inflation/rates scare, the Treasury market and the back half of the VIX curve were not especially concerned. The red box in this chart highlights the subsequent divergence of these metrics when the VIX contract pushed higher not because of rate volatility but, in our view, because of the risks associated with the potential re-rating of the tech sector in the wake of the Facebook Cambridge Analytica scandal. In other words, while the VIX has been supported first by the VIX ETF squeeze, and then by the tech sector risks, the anticipated regime change associated with an aggressive bid expansion in Treasury rate volatility has yet to occur. This, in turn, brings the term premium into focus as a factor which would not so much drive a sudden VIX spike but push up the floor of the VIX on a sustained basis. Further, if bond volatility normalizes (let alone the potential for yields to go higher) this will decrease earnings visibility and 6
aggravate credit conditions at a time when companies are taking a less conservative stance with respect to their capital structures. Chart 5. Chart 6. 7
Historical Context For The Term Premium The story of the term premium is, on one hand, much like the 10 year Treasury yield rising from very low levels in the 1960 s to life time extremes in the 1980 s, and in structural decline since then. Chart 7 shows the life time history of the Adrian Crump & Moench 10 Year Treasury Premium ( TP ), a metric developed and used by the Federal Reserve (and offers the longest time series available starting in 1961). We can see that the only other time the term premium reached extremely low levels was back in the early/mid 1960 s a period which, like the post Great Financial Crisis ( GFC ) period was defined by low stable inflation, tight credit spreads, high late cycle P/E s, and very low Treasury and equity volatility. The term premium started rising in 1966 when inflation, yields and asset volatility all started moving steadily higher and did not look back until the Treasury bull market began in early 1980 s. Chart 7. Adrian Crump & Moench 10 Yr. Treasury Premium A key difference between the post GFC period and the early/mid 1960 s is of course the aggressive central banking, and in particular the advent of large scale asset building focused on longer term debt securities. It is obvious that the negative term premium today owes much to this central banking; Bernanke explicitly addressed this as a key rationale for QE in 2012. 3 The decision of the Fed to have targeted the term premium is logical and intuitive; it is the facet of the longer term Treasury valuation which can be most directly impacted by the Fed s QE programs through the 3 See Brookings Why are interest rates so low, part 4 : Term Premiums by Ben Bernanke. https://www.brookings.edu/blog/ben-bernanke/2015/04/13/why-are-interest-rates-so-low-part-4-term-premiums/ 8
purchase of longer dated Treasuries. With the persistent purchase of longer dated Treasuries (and mortgages) amidst a period recovering from a severe deflationary shock, the Treasury effectively de-risked the asset class for private investors. The Fed, and its peers in Japan and Europe, can not only be big buyers, they, unlike other types of investors, can hold indefinitely and perhaps more importantly, telegraph their long term strategies well in advance. Term Premium and the Monetary-Fiscal Transition. If we take a more detailed look at the term premium in the last few years, we can see that while it soared after the Trump election, it subsequently gave back those gains (Chart 8). This makes sense given that with the Trump election came the expectation of a loose fiscal agenda which would increase interest rates, GDP and inflation but also increase the term risk associated with Treasuries. When the implementation of this agenda was stalled in the first 10 months of 2017, it was logical for the term premium to give back its gains. When the tax deal was passed in December, the term premium started climbing and accelerated with the spending bill in early February again, an intuitive market reaction given the higher inflation and long term incremental deficits in the Federal Budget. As the U.S. economic/macro back drop was normalizing, so too should the term premium. Chart 8. The mystery at hand, however, is why did the term premium contract so much since the February spike, and why is it still negative this late in the U.S. cycle? The budget deficits not only mitigate U.S. credit quality and provide a key structural weakening factor for the dollar, they also drive up supply at a time when the Fed is reducing its balance sheet. 9
The Congressional Budget Office ( CBO ) report released in April shows an incremental budget deficit over their previous budget analysis (from June, 2017) of nearly $1.3 Trillion for the 2019-2023 fiscal years and over $1.7 Trillion for the following 10 years. 4 Chart 9 shows on a calendar year basis that the incremental monthly supply from tax/spending is about $15 bn/month this calendar year and then pushes into a $27 to $32 bn/month range for the following four years. CBO estimates are just one estimate which are highly assumption dependent and prone to change. None the less, when we consider that the arrival of these large incremental deficits will be in concurrence with the acceleration in the QT program (which has shifted from $20 bn/month to $30 bn/month in May and is scheduled to increase to $40 bn/month in August then $50bn/month in November), the scale of these incremental budget deficits effectively magnify the QT impact by over 50%. Chart 9. 5 Incremental Deficit Post Tax/Spending Bill ($ Bn.) 35.0 30.0 25.0 20.0 15.0 10.0 5.0 Incremental Treasury Supply/Month - 2018 2019 2020 2021 2022 2023 4 The government fiscal year ends 9/30. 5 Derived from annual CBO budget deficits from June, 2017 report to April, 2018 report. Estimates are adjusted to calendar year end from 9/30 government fiscal year end and divided by 12 to arrive at monthly estimates. 10
The Term Premium and the Global Central Bank Balance Sheet The mystery of the shrinking term premium in the aftermath of the incremental fiscal deficits needs to be understood in the context of the global central bank balance sheet. As is well understood, since the BOJ and ECB have adopted the balance sheet expansion strategies of the FED and BOE, bond yields have been suppressed globally with sovereign rates going to record lows across the curve, and frequently into negative territory. We can see in Chart 10 that the term premium (shown on a reverse axis) has co-moved with the collective balance of the big 4 central banks; as the central bank balance contracts, the term premium goes higher, and vice versa. Over the past five years a period which encompasses the arrival of BOJ QE and then ECB QE, the term premium carries a correlation coefficient of - 0.73 (R2 of.54). 6 Chart 10. We can see in Chart 11 that even with the announced QT (scaling to $50bn/month in Q4 of 2018) the collective balance continues to grow, even when we assumes the ECB balance sheet additions go to zero after September. 6 Note that the combined balance sheet is in USD so includes FX exchange rates at the given point in time. We would suggest that given the global liquidity dynamic driving down the term premium for Treasuries needs to accommodate exchange rates; if a foreign central bank is building their balance sheet but their currency is weak, the impact on global liquidity will be diminished. 11
9/1/2009 2/1/2010 7/1/2010 12/1/2010 5/1/2011 10/1/2011 3/1/2012 8/1/2012 1/1/2013 6/1/2013 11/1/2013 4/1/2014 9/1/2014 2/1/2015 7/1/2015 12/1/2015 5/1/2016 10/1/2016 3/1/2017 8/1/2017 1/1/2018 6/1/2018 11/1/2018 MARKET AND DERIVATIVES STRATEGY Chart 11. 7 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 - Cumulative Big 4 B/S in USD Fed BOE ECB BOJ Chart 12 illustrates the historic and projected year over year growth rate in the collective balance sheet.in the projections we assume the Fed QT stays in place, the ECB tapers to zero after September, and the BOJ continues apace (projected additions or subtractions to the respective balance sheets are translated at current FX valuations). This chart highlights that, essentially for the first time since post GFC QE began, the growth in the balance sheet will become neutral. In other words, if the ECB stops adding (but does not reduce their balance sheet), the BOJ s addition each month of about $65 to $70 bn/month is likely largely offset by the Fed s balance sheet reduction program. The QT program specifies a $50 bn/month reduction through early 2019; we would consider it unlikely that the Fed would reduce that amount unless the economic picture was decidedly weaker than it is currently. We have seen growth in this balance sheet hit the zero level back in 2013 and again in 2015 but in those instances the balance sheet growth was rescued by the BOJ s program and then the ECB program. Thus, if we assume that the BOJ and the Fed will both continue apace a year from now they willeffectively be neutralizing each other. If the BOJ is offsetting the Fed, the ECB emerges as the key swing factor in the global liquidity discussion. In other words, if the ECB decides to contract their balance sheet in 2019, that will put the collective balance sheet into a decisive negative growth position, which means the ECB is an incredibly important part of the U.S. Treasury discussion. 7 Sources: Federal Reserve, Bank of England, ECB, Bank of Japan, Bloomberg, L.P. 12
Chart 12. 8 The ECB Pivot Point and the Term Premium. The criticality of the ECB in the global liquidity premium discussion helps explain the mysteriously low term premium for U.S. Treasuries. Chart 13 shows the term premium went negative (and remained largely in negative territory) once European QE began. In a similar manner, Chart 14 shows the term premium, 10 year Bund and 10 year Treasury yield all move in tandem but over the past several months the term premium has de-coupled from Treasuries and followed the Bund. 8 Sources: Federal Reserve, Bank of England, ECB, Bank of Japan, Bloomberg, L.P, Weeden & Co. L.P. All values used in calculations translated at then current exchange rates; prospective values translated at current spot rates. 13
Chart 13. Chart 14. 14
8/12/2015 10/12/2015 12/12/2015 2/12/2016 4/12/2016 6/12/2016 8/12/2016 10/12/2016 12/12/2016 2/12/2017 4/12/2017 6/12/2017 8/12/2017 10/12/2017 12/12/2017 2/12/2018 4/12/2018 MARKET AND DERIVATIVES STRATEGY Yet another display of this unusual co-relationship of the U.S. term premium with German Bunds is shown in Chart 15. We can see here that over the ECB QE period the term premium has demonstrated a higher correlation with Bunds than it has with Treasuries. What is especially striking is that this correlation divergence has become more apparent after the tax bill was passed in December and the spending deal was completed in early February. The slow down in European growth in Q1 and bid for Bunds raised questions about the ECB pivot point, and effectively suppressed the term premium in the United States. Chart 15. Term Premium 90 Day Correlation 1.20 1.00 0.80 0.60 0.40 0.20 0.00-0.20-0.40 10 Yr Bund/Term Premium 10 Yr. Treasury/Term Premium 15
APPENDIX Chart 16 16
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