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It's a 3% World With 3% Growth and a 3% Yield Curve Because Three Is a Magic Number

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Stimulus or not, it is likely that this 3% growth rate represents the new structural growth potential of the US economy.

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Many participants misinterpret the impact of QE on bond yields. Ironically, QE lowers nominal yields via raising inflation expectations and thus lowering real yields of which nominal yields have followed. The reverse is also true. The entire back-up in nominal yields has been a function of real yields rising as the inflation premium falls. Tapering should continue that trend as the inflation premium is reduced; ultimately, nominal yields are going to settle in near the discount for growth plus this inflation premium.

In reality, QE became irrelevant about as soon as it got started when the Fed backed off their full commitment to their inflation target. Upon the release of the January FOMC minutes in February, we found out about the Fed's ex-post QE cost/benefit analysis, which clearly indicated that the committee was no longer comfortable with the side effects of the program. Since then, the long end of the curve has essentially been free to trade, and this entire year has been about finding equilibrium. First, the long end will set the price, and then the Fed will follow suit.

What is the equilibrium Fed funds rate?

Kevin Ferry's Fed Funds Model


Based on Kevin Ferry's model (the go-to guy for money market interpretation), the current Fed funds rate at ~10 bps (0.10%) is already neutral. The benchmark for which he measures this equilibrium is the spread between FF and 12-month LIBOR, which at 66 bps has not even budged since the rest of the Eurodollar curve for 3-month LIBOR futures exploded in May and June. If the market was responding to an increase in the demand for money, these spot LIBOR rates would be increasing with the futures curve. They are not. The Fed thinks that it can go to 4% when at 10 bps, it's already at equilibrium? I don't think so.

The Fed may well hike FF to 4%, but it will massively invert the curve. If the Fed even gets to 2.5% by the end of 2016, I think we could see a scenario where the whole curve flattens to zero, converging at 3%, which looks to be the new structural nominal growth rate for the economy. Think it can't happen?

5-Year/10-Year Vs. 10-Year/30-Year


It wasn't that long ago that the 5-year/10-year spread and the 10-year/30-year spread were both flat at 5%. In 2006, when the Fed pushed the Fed funds rate to 5% with nominal GDP decelerating due to the credit bubble unwind, the whole curve went to zero. Similarly, in 2000, when the Fed pushed the FF rate above 6% in line with NGDP, the whole curve inverted. This is not random. This is what happens when the cost of funds exceeds the growth rate.

In this cycle, as the Fed tightens into what I posited last week was potentially an already-tight monetary condition with decelerating growth, I think curve convergence is going to happen again. As the Fed shifts from ultra-easy policy to neutral, we are going to begin to see the yield curve reflect this uneasy reality by normalizing rates in the front while taking the term premium out of back, flattening the curve.

Last week, with little fanfare, the spread between the 10-year and 30-year flattened to 91 bps, the lowest level since the 2011 stock market crash prompted a massive flight to quality bid in the long end. This is where the inflation premium beta gets the most action, and if the market is reversing the QE steepening bias that has ruled the bond market since 2008, we are in the midst of a cyclical shift.

There is no greater consensus market view right now than "rates are going higher." Everyone wants to be short the long end of the curve because the Fed is set to taper and soon will embark on a tightening cycle. It may happen in the short run, but in the long run, the curve doesn't work that way. The bond market is not waiting on the Fed to tell it where to go. The long end of the curve is an inflation premium discounting mechanism, the QE inflation discount is in the rearview mirror, and the quest for equilibrium is now governing the term structure.

Where is the curve's equilibrium?

As I said a couple of weeks ago in Interest Rates Are Normalizing, interest rates shot straight to their respective 5-year means:
With the bond market open to trade the 10-year, it immediately reverted to the 5-year mean. Not only did the 10-year revert to the mean, but the 5-year went to 1.60% versus a 5-year mean of 1.65%, and the 30-year went to 3.75% versus a 5-year mean of 3.75%.

By my math, the long end of the curve is pretty close to fair value, and arguably, the 30-year at 3.75% is cheap relative to what could be a much slower structural growth rate of NGDP. The initial move of the tightening cycle was a normalization of the long end. Once the Fed begins to actually tighten, we shall see a normalization in the short end.

In my view, it's a 3% world we live in. The scenario I see playing out is one where growth rates remain at 3% the FOMC raises FF to 3% over the next three years, and the 5-year, 10-year, and 30-year all converge toward 3% as the bond market discounts tight monetary conditions and virtually zero inflation premium. That's because... "Three is a magic number. Yes it is, it's a magic number."

Twitter: @exantefactor
No positions in stocks mentioned.
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