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Vince Foster: Why Long-Term Interest Rates Are Falling and May Continue to Drop


As the Fed removes stimulus, the market is reducing the inflation premium embedded in the yield curve.

On April 11, the 30-year Treasury bond closed at 3.48% -- the lowest level since June and over 50bps below where it traded when the Fed commenced tapering of its purchases at the beginning of the year. This move has been completely counterintuitive to participants who believed the Fed's flow of purchases was responsible for pushing interest rates lower and who have been positioned for higher interest rates. This week I want to address why long-term interest rates are falling and why they may continue to fall as the Fed exits the market and begins to raise the Fed funds rate.

There is a pervasive misunderstanding among economists, Wall Street strategists, and the financial media of what influences long-term interest rates -- namely, the role of the Fed on pricing interest rates. There are three main variables that influence prices in the long end of the curve: the structural growth rate in nominal aggregate demand, the inflation premium embedded in the term structure of the yield curve, and the participant positioning bias with regard to the future direction of the previous two variables.

You often hear the media refer to movements in the bond market as they relate to what's happening in the stock market. If rates are lower and stocks are higher, money is moving out of bonds and into stocks. This is an elementary explanation of what's going on. The truth is that most of the big money in the bond market does not have a material exposure to the stock market. Most bond investors have to own bonds because they are matching a liability. These investors are leveraged and have a cost of funds. 

While stock investors will express their exposure bias by a percent allocated to stocks and the balance in cash, bond investors express their exposure bias by their weighted average duration. Thus bond investors can be thought of as fully invested, and they express their directional bias by being long or short duration or against their benchmark duration.

If bond investors think rates will rise then they will shorten their duration with the idea of "rolling" up the curve as rates rise. If bond investors think rates will fall then they will lengthen their duration with the idea or "rolling" down the curve as rates fall. Therefore the slope of the yield curve can tell you a lot about the positioning bias among bond market participants and thus their belief about the future direction of interest rates. There is no more important market metric than the slope of the yield curve.

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

The massive steepness in the yield curve since the financial crisis has been a function of an extremely high premium for inflation risk and the short-duration positioning bias among participants that rates must eventually rise from the zero bound, and will thus force long-term interest rates higher. The third variable, though, is still in play. The growth rate in aggregate demand during this recovery has been lower, averaging close to 3%, and it's quite possible that for the foreseeable future the structural growth rate is going to be around this 3% level. If this is the case then the long end of the curve that straddles this 3% level could be fairly priced.

As QE was implemented the market focused on the growth in the asset side of the Fed's balance sheet in terms of the securities purchased. As the Fed exits I believe the focus will shift to the liability side of the balance sheet in the size of the reserves it issued to buy these assets. Historically the growth rate in reserves has been positively correlated with the slope of the yield curve. This makes sense. As the Fed creates reserves in excess of demand inflation, risk grows and the market raises the inflation premium by steepening the yield curve. As reserve growth slows, inflation risk falls and the slope of the yield curve flattens.

Reserve Balances Vs. 5-Year/10-Year Spread

This correlation held up perfectly during QE as the curve steepened when reserve growth rose and flattened when reserve growth fell. And it should have been no surprise that the massive reserve growth coincided with the steepest yield curve in history. Conversely, as this reserve growth peaks, so too should the slope of the curve. I wrote the following this time last year on April 15 in Contrary to Consensus: Why Tapering QE Is Bullish For Treasuries:

Due to the unprecedented nature of this easing cycle, the curve remains historically very steep. At 100bps the 5-year/10-year spread still rivals record steepness in previous cycles and is 70bps wider than the average spread going back 50 years. If the FOMC decides to taper purchases, the reduction in accommodation should lower the inflation premium and lead to curve flattening. When it does finally decide to exit, as in previous cycles the curve will likely have already reflected the tightening cycle by flattening from the front end. Net/net, aside from a surge in the size of the Fed's balance sheet, which seems to be off the table, the future bias of the curve should be flattening. 

The consensus wants to be short the long end of the curve when the Fed tapers or exits altogether because that is where the purchases have been focused. However the yield curve is responding more to the level of accommodation, and any reduction should produce a flattening bias and a headwind for the shorts.

I believe this is what is happening. As the Fed removes stimulus, the market is reducing the inflation premium embedded in the yield curve. I don't think there is any question that the growth rate in reserves has peaked, and thus the future bias of the curve should be flatter. The positioning bias is overwhelmingly short duration, and as this inflation premium is reduced, long-term interest rates are anchoring around the structural growth rate in aggregate demand.  The key going forward will be the trade-off between the discount for aggregate demand and the positioning duration bias.

On March 24, Bloomberg First Word quoted me about why I thought the long end of the curve was rallying: "I smell a pain trade... as those sitting in the front waiting on rates to rise; long bond has been best performer." The pain trade is in play but can be averted if the market begins to discount a higher growth rate in aggregate demand. However this will require a big change in the current trajectory. If this doesn't materialize, the pressure on those short duration will be to extend duration exposure. As long as the 30-year yield remains below 3.50%, the pressure will intensify. With economic storm clouds on the horizon, I'd say the forecast calls for pain.
Twitter: @exantefactor
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