Recap 6-21-13: Have Treasury Yields Moved Enough?

Commentary:

To answer that question, we need to first answer two other questions. First, what does the Fed expect and second, how is the market likely to price that in? Note that we will attempt to do this exercise only on the front end of the treasury yield curve. Longer term yields are subject to a slew of other factors which are beyond the scope of this piece.

We can get an answer to the first question from the weighted FOMC survey which includes the level various voters expect Fed Funds to be at the end of the next several years.

If we make the assumption that the Fed is likely to hike only 25bps at each meeting, and since there are 8 meetings a year, we can get an estimate for the exact meeting that the various voters expect to first hike. For example, 1 participant expected the Fed Funds rate to be at 2% by the end of 2015. That is 175bps of hikes, which means, if split evenly and done at 25bps per meeting, implies the first hike in March 2015. (There is a Fed meeting in January but not in February) It turns out that, if we throw out the 3 most hawkish and 3 most dovish votes, the weighted average is the 5th meeting, which is in August of 2015. This is comparable to the median rate of 1.0%, which coincides with a Sept hike.

Now, let’s take a look at what treasury yields have done before the start of the past two substantial hiking cycles. (I excluded the late 90’s cycle because the Fed did not ease significantly in the years before) In the most recent cycle, the 2y treasury traded between 50-100bps above the Fed funds rate for about 9 months until the Fed signaled that it was ready to tighten, at which point the spread promptly moved to 200bps:

And in the early 90’s, 2y yields traded between 75-125bps above Fed Funds for almost 12 months, all the way through the first Fed hike.

So in aggregate, it is probably reasonable to assume that 2y yields are likely to trade at least 75bps over Fed Funds about a year before the first Fed hike. With Fed Funds at 25bps, this implies a yield of 1.0%. (Incidentally, that was roughly where 2y yields traded for most of 2009 and early 2010 when the market thought the Fed was going to normalize rates quickly. Note that I’m also ignoring the difference between Fed Funds target and Effective Fed Funds rate, which is lower) So with the FOMC forecast for the first hike around Sept 2015, 2y yields in Sept 2014 should be around that 1.0% level.

Ok. Now with that very rough guide, we can compare it against what the market is pricing in to get a rough gauge of whether yields have moved enough. Currently, the on the run 2y treasury note is yielding just 35bps, but the implied forward 2y yield in Sept 15th, 2014 is higher, at ~1.17%. In aggregate, this suggests that yields are roughly fair, IF the market takes the Fed forecast at face value.

Now, there are lots of caveats here, of course. The Fed has been overly optimistic in the recent past, so perhaps the market will discount that, and expect an actual first hike date sometime later. The tightening that has just occurred may have a larger impact on the economy than expected, which may also delay the first hike. But on the other hand, given the highly unusual nature of current Fed policy, and the uncertainties involved, maybe the market will demand a higher yield premium as compensation. Furthermore, because we are at the zero bound, the payoff profiles are asymmetric, which suggests the need for a higher term premium. I.e. a holder of 2y notes would lose more if the Fed hiked earlier than they would make if the Fed hiked later, which may prompt them to seek a higher yield to compensate for this asymmetry. And another argument for an overshoot is the simple fact that global carry trade unwinds, like all deleveraging events, tends to drive prices well past ‘fair value’ before stabilizing. 2y yields in 2009 – mid 2010 jumped above 1.25% several times, for example. In aggregate, there’s probably reason to believe that we have not seen the end of this move in yields just yet, although we are probably also not too far away. Technicals and the calendar suggest we could get the near term yield highs by next week.

Notable:

  • Canada Core CPI was stable at 1.1% vs 1.2% exp
  • Canada Retail Sales ex Autos declined -0.3% MoM in Apr vs 0.0% exp
  • Some managers of EM ETFs (Citi was specifically mentioned) are now refusing to honor orders to redeem ETF units.

Upcoming Data:

  • Mon: German IFO, Mexico Unemployment,
  • Tue: US Durable Goods Unemployment, Consumer Confidence, New Home Sales, South Korea Business Survey
  • Wed: Mexico Trade Balance, US Oil Inventories,
  • Thu: German Unemployment, EU money supply, US Personal Income, Jobless Claims, Pending Home Sales, Japan CPI, IP
  • Fri: Italy Business Confidence
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