INFOCUS M A R K E T S N A PS H OT APRIL 018 Where might long US yields settle? DISCIPLINED BY NATURE. FLEXIBLE BY DESIGN. The icons alongside represent our investment process. Through a disciplined provision of investment policy and security selection at the global level, regional portfolio management teams have the flexiblility to construct portfolios to meet the specific requirements of our clients. HIGHLIGHTED IN THIS PUBLICATION: GLOBAL STRATEGIC ASSET ALLOCATION GLOBAL SECURITY SELECTION REGIONAL ASSET ALLOCATION REGIONAL PORTFOLIO CONSTRUCTION
When monetary policy is normalised in the US, where might long yields settle? As Stefan Gerlach points out, it may be necessary to look outside the confines of recent history for answers. A central question facing investors is at what level long US yields will plateau after the Fed has finished normalising monetary policy. A common view is that long bond yields are likely to be much lower than in the past because inflation and the neutral real interest rate are both likely to be unusually low in the next decade or two. However, what qualifies as an abnormally low level of interest rates depends on the point of comparison. Interest rates were very high around 1980 but subsequently declined to the current low levels gradually over a 35-year period. It is easy to forget that interest rates were also very low between the early 1930s and early 1950s. This note looks at a century of data on the yields on threemonth treasury bills and ten-year treasury bonds to see what can be learned about the level at which long yields might plateau. A century of data Figure 1 shows the data. Treasury bill yields were exceptionally low after the financial crisis that started in 008 with the collapse of Lehman Brothers, and after the Great Depression which started with the stock market crash in 199. During both periods, treasury bond yields also declined to very low levels. The figure also shows that the last 35 years have been atypical: interest rates rose to exceptionally high levels during the 1970s in response to extremely high inflation resulting from the combination of oil price shocks and too stimulatory fiscal and monetary policies. Since then interest rates have gradually declined to levels broadly in line with the earlier historical experience. What do these data tell us about the likely steady state level of long yields in the future? One way to answer that question is to summarise the behaviour of three-month interest rates 1. Three-month and ten-year treasury yields, January 190 January 018 % 18 16 1 1 10 8 6 0 190 1930 190 1950 1960 1970 1980 1990 000 010 Short (3 months) Long (10 years) Source: FRED. Data as at 18 April 018. and ten-year bond yields using a simple statistical model. 1 Estimating the model it becomes clear (on statistical grounds) that the data can be divided into four episodes: the first ends in December 1955, the second ends in August 198, third in January 000 and the final period ending in January 018. Table 1 shows the average short and long rate in the full sample and in the four sub-periods. The first period is characterised by low and stable rates. The second corresponds to the period of gradually rising rates and ends when they peak in the early 1980s. The third corresponds to the period of declining rates following Fed Chairman Volker s decision to use tight monetary policy to break the dynamics of inflation. The fourth period starts as the dot-com bubble collapsed, in the aftermath of which three-month treasury bill yields fell below 1%. Where might long bond yields settle? Since the level at which ten-year bond yields will settle after the Fed has normalised monetary policy depends at what Table 1. Average short and long interest rates 190: -018:1 190: -1955:1 1956:1-198:8 198:9-000:1 000:-018:1 Average short rate 3.3% 1.59% 5.5% 5.96% 1.57% Average long rate 5.10% 3.5% 6.39% 7.95% 3.51% Source: EFG calculations. Data as at 18 April 018. 1 An ECM model is fitted on monthly data from April 190 to January 018 for the monthly change in the long bond yield, using as regressors two lags of the change in the long and in the short interest rates, the lagged levels of the two interest rates and a constant. A Bai-Perron test for structural breaks at unknown points in time is used to detect these episodes. Infocus April 018
Table. Responses of ten-year bond yields to 100 bps increase in three-month t-bill rate 190: -018:1 190: -1955:1 1956:1-198:8 198:9-000:1 000:-018:1 Immediate response 31 bps 3 bps 35bps 70 bps 37 bps Long-run response 91 bps 78 bps 13 bps 71 bps 7 bps Source: EFG calculations. Data as at 18 April 018. level three-month yields will stabilise, it is of interest to review what the model says about the reaction of long bond yields to changes in short interest rates. In doing so, it must be recognised that long rates respond gradually and that the impact (or within-the-month) effect is likely to be much smaller than the long run effect. Table shows the results for the full century of data, and for the four subperiods identified above. On average, a hypothetical 100 basis points rise in short interest rates is associated with a 31 basis points increase in long yields in the same month. However, in the long run the increase is about 91 basis points or three times as large. One consequence of the large difference between the immediate and long run responses to a tightening of monetary policy is that the Fed cannot easily control the interest rate spread. If the three-month treasury bill rate were to rise by 100 bps, the spread will immediately shrink by 69 basis points, but over time it will widen again as the long rates rises. But that process is slow and spread over several years. What do these data tell us about the level at which ten-year yields will stabilise after the Fed has normalised monetary policy? That is of course a hypothetical question as new shocks will always occur, leading the Fed to move short-term interest rates temporarily, although perhaps in a protracted way, away from their normal level. One answer is suggested by the average level of the long rate in this century of data, which is 5.1%. 3 However, the average inflation rate, as measured by the CPI, in this sample is.7% and the average three-month treasury bill rate is 3.%. Since the Fed has in recent years adopted a % inflation objective, inflation rates in the future are likely to be lower than on average over the past century. This implies that short- and long-run interest rates are also likely to be below their historical averages. The statistical model discussed above can be used to estimate the normal level of ten-year bond yields for different assumptions regarding the normal level of threemonth treasury bill rates. Figure shows this relationship, which is estimated using the full sample period. Since the estimate is uncertain, a 95% confidence band has been included. At the March 018 FOMC meeting, the median member took the view that in the long run the federal funds rate needs to settle at.9% for the FOMC to reach its statutory objectives. Supposing that implies that three-month treasury bill yields settle at 3%, Figure shows that, if so, the last century of data suggests the ten-year yield will settle at.6%; the confidence band, which spans the range.30% to.98% indicate that the exact effect is uncertain.. Estimated steady state level for long rate as a function of short rate Ten-year yield (%) 1 10 8 6 95% confidence band; January 190 January 018 0 0 1 3 5 6 7 8 Source: EFG calculations. Data as at 18 April 018. Three-month rate (%) Since the relation is likely to have shifted across the four sub-periods identified above, Table 3 shows the predicted long-run level of ten-year bond yields for the full sample, as well as for the four subperiods, under the assumption that the normal three-month treasury bill yield is 3%. 3 Interestingly, since there are a few episodes when interest rates are much above their averages but few in which they are much below, the median value of the short rate is 3.1% and the median value of the long rate is.5%. That confidence band is narrowest at the average short interest rate in the sample (3.%) and becomes wider away from that average since less is known about what the relationships looks at other levels of the short interest rate. Infocus April 018 3
Table 3. Predicted level of long yields, assuming short rates settle at 3% 190: -018:1 190: -1955:1 1956:1-198:8 198:9-000:1 000:-018:1 Point estimate.6%.3%.% 5.50% 3.9% 95% Confidence band.30% -.98% 3.31% - 5.1% 3.6% -.81% 3.78% - 7.3% 3.% -.6% SSource: EFG calculations. Data as at 18 April 018. Interestingly, the predicted level is much the highest in the 198-000 subperiod, which suggests the long bond yield will settle at 5.5% if the treasury bill yield settles at 3%. By contrast, the predicted level is.% in the first and second subperiods. The most recent subperiod, covering the years 000-018, suggests that long rates will settle at 3.9%. Conclusions The above analysis leads to two important conclusions. First, while the immediate impact of higher short interest rates on long bond yields is about 1/3 of the increase in short rates, the long-run impact, which is reached only after several years, is around unity. While rapid interest rate increases by the Fed can lead to an inverted term structure of interest rates, over time long rates will rise about three times as much as they do immediately, reducing or offsetting the inversion of the term structure. Second, if, at the end of the Federal Reserve s normalisation process, three-month treasury yields stabilise at 3%, long bond yields would stabilise somewhere around %. While data for the 198-000 period suggests that long yields might stabilise at around 5.5%, data for the period 190-1980 suggests a much lower steady state level of around.% and the data for the most recent period 000-018 points to a steady state level of 3.9%. Taking the uncertainty of the estimates into account, a steady-state level below % is certainly possible. Infocus April 018
Important Information This document does not constitute and shall not be construed as a prospectus, advertisement, public offering or placement of, nor a recommendation to buy, sell, hold or solicit, any investment, security, other financial instrument or other product or service. It is not intended to be a final representation of the terms and conditions of any investment, security, other financial instrument or other product or service. This document is for general information only and is not intended as investment advice or any other specific recommendation as to any particular course of action or inaction. The information in this document does not take into account the specific investment objectives, financial situation or particular needs of the recipient. You should seek your own professional advice suitable to your particular circumstances prior to making any investment or if you are in doubt as to the information in this document. Although information in this document has been obtained from sources believed to be reliable, no member of the EFG group represents or warrants its accuracy, and such information may be incomplete or condensed. Any opinions in this document are subject to change without notice. This document may contain personal opinions which do not necessarily reflect the position of any member of the EFG group. To the fullest extent permissible by law, no member of the EFG group shall be responsible for the consequences of any errors or omissions herein, or reliance upon any opinion or statement contained herein, and each member of the EFG group expressly disclaims any liability, including (without limitation) liability for incidental or consequential damages, arising from the same or resulting from any action or inaction on the part of the recipient in reliance on this document. The value of investments and the income derived from them can fall as well as rise, and past performance is no indicator of future performance. Investment products may be subject to investment risks involving, but not limited to, possible loss of all or part of the principal invested. The availability of this document in any jurisdiction or country may be contrary to local law or regulation and persons who come into possession of this document should inform themselves of and observe any restrictions. This document may not be reproduced, disclosed or distributed (in whole or in part) to any other person without prior written permission from an authorised member of the EFG group. This document has been produced by EFG Asset Management (UK) Limited for use by the EFG group and the worldwide subsidiaries and affiliates within the EFG group. EFG Asset Management (UK) Limited is authorised and regulated by the UK Financial Conduct Authority, registered no. 738976. Registered address: EFG Asset Management (UK) Limited, Leconfield House, Curzon Street, London W1J 5JB, United Kingdom, telephone + (0)0 791 9111. If you have received this document from any affiliate or branch referred to below, please note the following: Bahamas: EFG Bank & Trust (Bahamas) Ltd. is licensed by the Securities Commission of The Bahamas pursuant to the Securities Industry Act, 011 and Securities Industry Regulations, 01 and is authorized to conduct securities business in and from The Bahamas including dealing in securities, arranging deals in securities, managing securities and advising on securities. EFG Bank & Trust (Bahamas) Ltd. is also licensed by the Central Bank of The Bahamas pursuant to the Banks and Trust Companies Regulation Act, 000 as a Bank and Trust company. Bermuda: EFG Wealth Management (Bermuda) Ltd. is an exempted company incorporated in Bermuda with limited liability. Registered address: Thistle House, nd Floor, Burnaby Street, Hamilton HM 11, Bermuda. Cayman Islands: EFG Bank is licensed by the Cayman Islands Monetary Authority for the conduct of banking business pursuant to the Banks and Trust Companies Law of the Cayman Islands. EFG Wealth Management (Cayman) Ltd. is licensed by the Cayman Islands Monetary Authority for the conduct of trust business pursuant to the Banks and Trust Companies Law of the Cayman Islands, and for the conduct of securities investment business pursuant to the Securities Investment Business Law of the Cayman Islands. Guernsey: EFG Private Bank (Channel Islands) Limited is licensed by the Guernsey Financial Services Commission. Hong Kong: EFG Bank AG is authorized as a licensed bank by the Hong Kong Monetary Authority pursuant to the Banking Ordinance (Cap. 155, Laws of Hong Kong) and is authorized to carry out Type 1 (dealing in securities) and Type 9 (asset management) regulated activity in Hong Kong. Jersey: EFG Wealth Solutions (Jersey) Limited is regulated by the Jersey Financial Services Commission in the conduct of investment business under the Financial Services (Jersey) Law 1998. Liechtenstein: EFG Bank von Ernst AG is regulated by the Financial Market Authority Liechtenstein, Landstrasse 109, P.O. Box 79, 990 Vaduz, Liechtenstein. Luxembourg: EFG Bank (Luxembourg) S.A. is listed on the official list of banks established in Luxembourg in accordance with the Luxembourg law of 5 April 1993 on the financial sector (as amended) (the Law of 1993 ), held by the Luxembourg supervisory authority (Commission de surveillance du secteur financier), as a public limited company under Luxembourg law (société anonyme) authorised to carry on its activities pursuant to Article of the Law of 1993. Luxembourg residents should exclusively contact EFG Bank (Luxembourg) S.A., 56 Grand Rue, Luxembourg 013 Luxembourg, telephone +35 651, for any information regarding the services of EFG Bank (Luxembourg) S.A. Monaco: EFG Bank (Monaco) SAM is a Monegasque Public Limited Company with a company registration no. 90 S 067 (Registre du Commerce et de l Industrie de la Principauté de Monaco). EFG Bank (Monaco) SAM is a bank with financial activities authorized and regulated by the French Prudential Supervision and Resolution Authority and by the Monegasque Commission for the Control of Financial Activities. Registered address: EFG Bank (Monaco) SAM, Villa les Aigles, 15, avenue d Ostende BP 37 98001 Monaco (Principauté de Monaco), telephone: +377 93 15 11 11. The recipient of this document is perfectly fluent in English and waives the possibility to obtain a French version of this publication. People s Republic of China ( PRC ): EFG Bank AG Shanghai Representative Office is approved by China Banking Regulatory Commission and registered with the Shanghai Administration for Industry and Commerce in accordance with the Regulations of the People s Republic of China for the Administration of Foreign-invested Banks and the related implementing rules. Registration No: 310000500509. Registered address: Room 65T10, 65 F, Shanghai World Financial Center, No. 100, Century Avenue, Pudong New Area, Shanghai. The business scope of EFG Bank AG Shanghai Representative Office is limited to non profit making activities only including liaison, market research and consultancy. Singapore: The Singapore branch of EFG Bank AG (UEN No. T03FC6371J) is licensed by the Monetary Authority of Singapore as a wholesale bank to conduct banking business and additionally carries on the regulated activities of dealing in securities, fund management and securities financing. Switzerland: EFG Bank AG, Zurich, including its Geneva and Lugano branches, is authorized and regulated by the Swiss Financial Market Supervisory Authority ( FINMA ). Registered Office: EFG Bank AG, Bleicherweg 8, 80 Zurich, Switzerland. Registered Branches: EFG Bank SA, quai du Seujet, 111 Geneva, Switzerland and EFG Bank SA, Via Magatti, 6900 Lugano, Switzerland. Taiwan: EFG Securities Investment Consulting Co. Ltd, Suite A-1, 1th Floor, Hung Tai Center, No. 168 Tun Hwa North Road Taipei, +886 8175 0066, SICE License No. BO86. United Kingdom: EFG Private Bank Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, registered no. 1036. EFG Private Bank Limited is a member of the London Stock Exchange. Registered company no. 3180. Registered address: EFG Private Bank Limited, Leconfield House, Curzon Street, London W1J 5JB, United Kingdom, telephone + (0)0 791 9111. In relation to EFG Asset Management (UK) Limited please note the status disclosure appearing above. United States: EFG Asset Management (UK) Limited is an affiliate of EFG Capital, a U.S. Securities and Exchange Commission ( SEC ) registered broker-dealer and member of the Financial Industry Regulatory Authority ( FINRA ) and the Securities Investor Protection Corporation ( SIPC ). None of the SEC, FINRA or SIPC, have endorsed this document or the services and products provided by EFG Capital or its U.S. based affiliates, EFGAM Americas and EFG Capital Advisors (EFGCA). Both EFGAM Americas and EFGCA are registered with the SEC as investment advisers. Securities products and brokerage services are provided by EFG Capital, and asset management services are provided by EFGAM Americas and EFGCA. EFG Capital, EFGAM Americas and EFGCA are affiliated by common ownership and may maintain mutually associated personnel. This document is not intended for distribution in the United States or for the account of U.S. persons (as defined in Regulation S under the United States Securities Act of 1933, as amended (the Securities Act )) except to persons who are qualified purchasers (as defined in the United States Investment Company Act of 190, as amended (the Investment Company Act )) and accredited investors (as defined in Rule 501(a) under the Securities Act). Any securities referred to in this document will not be registered under the Securities Act or qualified under any applicable state securities statutes. Any funds referred to in this document will not be registered as investment companies under the Investment Company Act. Infocus April 018 5