Daily Themes - 20 December 2010

US yields rise with growth optimism, low inflation provides an anchor

The sharp drop in Treasury prices over the past few days, pushing yields dramatically higher, has been triggered by improvement in the US growth outlook. Momentum turned particularly negative following news of new fiscal stimulus plans, but we see this as the result of increased hopes for a strengthening recovery rather than concern that the US fiscal position was becoming unsustainable. We have increased our forecast for 2011 US GDP growth from 2.5% to 3-4% on the back of the stimulus package, and similar revisions to consensus estimates are likely. We therefore believe yields are currently moving up for ‘good’ economic reasons, and this supports our positive view on risk assets.

The much stronger growth outlook has led us to revise higher our estimate of the range of ten-year Treasury yields that would represent fair value to 2.8-3.6%. What’s more, the likelihood of further positive economic data over the next few months increases the chances that yields move somewhat above this fair value.

However, the ultra-low level of the official Fed Funds target rate will act as an anchor on 10-year yields, preventing them from rising too far. Stronger growth reduces, but does not eliminate, deflationary pressures, which we think will keep inflation low for some time.

Stimulus plans accelerate the rise in yields

Ten-year Treasury yields have risen about 0.70 percentage point (pp) in December, with roughly half of this advance coming over two days with the news of President Obama’s plans for a two-year extension of all Bush-era tax cuts and various additional measures. While the measures will boost short-term growth, they will also put the long-term public finances on shakier ground.

The ratio of gross debt to GDP will be around 5 pp higher in two years time, according to our estimates. At some point this could lead to investors demanding a much higher risk premium, or additional yield for the added risk, for US debt. The IMF estimates that an increase of 10 pp in the debt to GDP ratio adds around 0.50 pp to the risk premium on that debt.

The spike in yields after the announcement of new stimulus measures led to some speculation that bond vigilantes were selling Treasuries on concerns about long-term US government-debt dynamics, as they have done to euro-zone periphery bonds. However, as noted above, we believe yields have reacted to improvement in the US growth outlook, given the close relationship between the two.

The outlook for inflation is also a key determinant of long-term bond yields, and we think it will continue to act as a downward force on US Treasury yields in the coming months. Downward pressure on core inflation from the large amount of spare capacity opened up during the credit crisis and recession remains substantial. Core US inflation, excluding volatile food and energy prices, is already close to record lows (0.8%), and we expect it to fall further in the months ahead, possibly to below zero by mid to late 2011.

Where is fair value now?

Allowing for a range of outcomes for core inflation and GDP growth by the end of 2011 gives us our fair-value range of 2.8-3.6% for US 10-year yields (see table). This does not mean that 10-year yields won’t rise above this range over the next few months. Indeed, given the upward momentum in yields and the possibility of further positive economic surprises, yields are likely to climb further over the next few months unless a significant escalation of the euro-zone debt crisis leads to a bout of risk aversion.

Limit to how far bond yields can rise

However, we think low and falling core inflation and low policy rates will prevent 10-year Treasury yields from rising much beyond 4% in the first half of 2011. The yield curve is already close to record levels of steepness, measured as the difference between 10-year yields and the policy rate. A spread of 3.8-4% between the two has historically acted as a ceiling on how far the yield curve can steepen.

There is also a self-correcting mechanism inherent in US bond-yield dynamics – a rise in 10-year yields beyond 4-4.5% is likely to crimp growth. The US housing market remains fragile, and would be affected by further increase in mortgage rates, which are based on Treasury yields.

Key risks to our view of a limited yield rise

The key upside risk to yields are even stronger growth than we expect or increased concerns over US fiscal sustainability. The key factor that could potentially push yields lower would be an escalation in the euro-zone crisis that leads to another bout of risk aversion. This risk is concentrated around the first few months of 2011, when euro-zone governments and banks will need to refinance a large amount of maturing debt.

In summary, we believe yields will rise further over the next few months, but at some point low inflation and low policy rates will act as an anchor on yields.

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