US Treasury Curve and Outright Rates Trade Strategy Analysis
US Treasury Curve and Outright Trade Strategy Analysis
[Using a Fisher Rate Understanding of NGDP: Spot and Forward Expected]
This report is for market close immediately preceding:
##  "April 03 2017"
This analysis justifies or dismisses the use of long duration US Treasurys for a rebalanced equity and fixed income portfolio, with the fixed income weights almost always long duration US Treasurys and with that weight constantly or dynamically reweighted.
The only “hedge” or offset for equity risk available to the American investor is a position in long duration US Treasurys. However, the following will show that the Federal Reserve is significantly behind the market and long duration US Treasurys have large jump risk in rates, with long US Treasurys potentially reaching 5% or higher yield.
Therefore long US Treasurys are currently unusable in a dynamically balanced equity portfolio strategy.
1. US Treasury rates are unusually low given intense pressure from the US Federal Reserve. This pressure comes from maintaining an “emergency policy” large Quantatative Easing potfolio, still approaching $4 trillion, and by keeping rates extraprdinarily low. The US Federal Reserve is likely well over 2 years “late” in normalizing rates and reducing the large QE position. Currently the Taylor Rule solves for a 4% Federal Funds rate. The Fed Board also seems to be in direct opposition to Trump, inexplicably raising rates when conditions are the same as when they insisted on keeping rates near “zero” under Obama. US Treasury 5 years are likely to jump towards 4% and the US Treasury 20 year will jump towards 5%. The expected NGDP, the core tool used in this analysis, derived from market rates,are about 1/2 the rate level that would align with US Treasurys curve rate levels and about 1/3 a reasonable studied view of US potential GDP. There are similarities between the Japanese economy from 1992 to date and the US economy now.
2. The curve will steepen - 5 years to 20 years - by 120 basis points or more, likely in a sudden jump.
3. Volatility for US Treasury yield is extraordinarily low so that all trades should be long vega and long convexity.
This analysis uses a Fisher Rate spot and forward derivation. James Bullard of the St Louis Fed provides the relationship of the Fisher Rate with a rules based FOMC policy. And we believe significant errors by the Fed (either by political commission or happenstance) have been made such that great inefficiencies are now in UST pricing as well as the USTC. The recent work on developing the “Neo Fisherism”" thesis correctly identifies why and to what degree UST have been distorted. The once in a 1/2 a century problem of QE distortion has large inefficiencies in UST and the curve, with flattening the yield curve out of proportion to how, indicated by via the Fisher Rate, to the normal relationship to the US economy. The long intermediate US Treasurys rate is approximate of NGDP expected over time adjusted for the risk premium per year, and the yield curve for longer intermediate US Treasurys to long duration US Treasurys is the growth of the NGDP. These inefficiencies allow good opportunity in trading UST for at least another two years or more. If the stress and use of FR is misplaced, then positions are established at levels which are, in fact, efficient so while inordinate return will not occur, inordinate loss will not occur either.
The Fisher Rate, spot being Fed Funds, for every 3 month forward out to 7 years is plotted.
The process is unique. Most US Treasury and curve traders or portfolio managers use an approach like what Yellen applies where the monetary policy Fed Funds rate is set to a level in relationship to a Wicksell “natural rate”. The Wicksell natural rate is set by intuition as it cannot be observed. This “natural rate” approach does not consider Fed Funds in terms of the relationship of the Fed Funds to Fisher Rate to NGDP; with the Fisher Rate being the equivalent, in the end, to inflation + GDP, or NGDP. Furthermore, the use pf a Wicksell “natural rate” can easily allow the Fed to pursue a political agenda as it is cloaked under the unobservable nature of the Wicksell rate.
The following analysis is based on the spot and future NGDP/Fisher Rate/Fed Funds rate which in the end syncs with the spot pricing of US Treasurys rate and the yield curve - the relationship between the curve and spot US Treasury prices is co-dependent where if the Fed strives to a certain curve and certain US Treasury yield, that will for the short and intermediate run define NGDP based on the power of the Federal Reserve, which if course is considerable, and thereby the curve and rates, the NGDP will in turn define the curve and US Treasurys as the two are o to the limits of the Fed power - cp-dependents. This is the “Neo Fisherism” effect of the Fed Funds defining NGDP and NGDP in the end defining Fed Funds, and thereby having managed rates defining on NGDP or if the Fed is truly “rules based” the Fed Funds rate is defined by NGDP.
A Federal Reserve managed and insisting upon low Fed Funds rate can over time end with a low NGDP well below potential NGDP. Japan has shown this ability or power of the central bank for the last 16 years, and this NGDP below potential was the Japanese experience from 2000 to date.
The process to derive the forward Fisher Rate is to first derive the risk premium, how much more yield is required to extend a year in UST maturity.
To do this is counter- intuitive but simply put: 1) the curve is monitored over the 7 years term structure to get a read - 7 years being a point in time when a business cycle will occur, this is to get past the immediate trading of anticipating a business cycle; 2) the curve is deconvexed by calculating what the positive convexity of the curve is worth using bond volatility; 3) then a one year 6 years forward read is taken of the forward deconvexed curve. That is the risk premium. The risk premium, considering the riskiness of normalization and the risk pricing as to the effect of the new POTUS on fiscal policy, is abnormally low, moving below 10 basis points. We feel this indicates how behind the market the FOMC is, how it is leaning in to maintain low rates. The risk premium should be around 20 basis points, not the current sub 10 basis points. And the Fed continues to pressure rates down such the risk premium is decreasing. The additional 10 to 14 basis points in risk premia if the Fed had or was normalizing would result in curve 100 to 150 basis points steeper than the current curve. We feel this will occur in jumps and not discreetly as Yellen is now stating.
The risk premium above is then used to build a term structure of the instantaneous Fed Funds rate in the future, or the Fisher Rate, which in turn is considered to be equivalent to NGDP. In this case a 7 years forward instantaneous NGDP. Keep in mind this is not a forward forward but the instantaneous NGDP (Fed Funds) expected in market prices. NOte the risk premia and expected NGDP are moving in opposite directions. The risk risk premium and expected NGDP should move in the same direction. The ethusiasm for Trump’s expected economic policy is opposite to the risk premum. Large jumps in the curve and in rates should materialize. Note as well that as soon as the Yellen Fed started, the RP fell from 30 basis points to now about 7 basis points, despite a brief rise towards 20 basis points foe the first Fed Fund raise in December 2015. But as it became clear that Yellen would not normlize - the RP reversed and fell to current lows.
The above shows forward NGDP expectation in 7 years over time. We now derive the forward Fisher Rate, the NGDP, in quarterly periods up to 7 years, a term structure, and look at this term structure of expected NGDP at certain times and consider how it is changing.
Trump potential policy is raising expected NGDP, though now at a dimishing rate of increase versus what occured during the first 2 months after the election . This seems to have peaked at 2 1/2%. The Trump raise in expected NGDP combined with the Federal Reserve refusal to deal with this potential by the “go slow”Fed Funds raise also explains the drop in risk premium (above) which is making for unprecedented explosive pressure on the yield curve and US Treasury 20 year rate as the curve flattens and the 20 year rate stays at low rates. The curve and the 20 year US Treasury will jump by about 100 basis points in a short time frame - week or months - when the correct risk premium and a forward NGDP matches the Trump realized NGDP.
The slope of the term structure of expected NGDP will over time be in synch with the US Treasury curve.
If it is not, that it is a trade opportunity.
This is like the FOMC “dots”, but the dots are not derived, but a “best guess” of the FOMC which is is assumed has better information than.
NGDP expected should make sense in terms of the schedule for NGDP change, and the level of NGDP at any time. The yellow dotted line ins NGDP before the crisis, indicating that after A Fed tightening was digested, the US NGDP would be consistently over 4%. The blue line shows that the nadir of the crisis as far as US Treasurys and Fed policy goes was not in 2009, but in 2012, Then the expectations indicated expectations for a Japanese like slow burn depression. The red line is the current terms structure of expected NGDP which still shows an abnormal low expectation for NGDP, though higher since the time when pre election polls showed most thought HRC would win the election; not in sync with a 4% plus regular NGDP and certainly not at all in sync with a Trump strong fiscal stimulus plan.
The current pricing of expected NGDP shows that long duration US Treasurys are unusually low and though already backing about 50 to 75 basis points. And the 2% level of expected NGDP is not in sync with record high SP500 as it indicates sub-par Japanese “lost decade” GDP is expected. This will resolve moving to the long term levels of March 2007 (yellow dotted), in a series of large sudden jumps.
Insight on the political expectations before the election, that the largest change in the structure of term NGDP expected came about from the time Clinton was expected to win the election then rising Trump odds until he won the election and then to date. The point in time that Hillary Clinton was at her highest polling was also a time of very low expected term structure of expected NGDP. And the most recent read shows how Trump raised the schedule for expected NGDP. This amount of change is graphed to show the positive effective of Trump in a great rise in expected NGDP short term forwards and NGDP long term forwards. The Trump election win has resulted in well over a trillion in expected NGDP to be added to the economy for the next 7 years. This explains the jump in rates. after Trump won the election.
Plotting the expected NGDP in 7 years over time versus long duration UST shows whether the UST is currently rich or cheap versus the expected NGDP. While US Treasury rates have risen since the election, they will rise another 150 basis points, assuming NGDP expected in 7 years does not rise. Since we feel expected NGDP will rise by 150 basis points to 200 basis points, that will be an additional 100 basis points in the US Treasury 20-year yield to 4%
By locating certain key dates, the effect of Neo Fisherism and how out of whack UST has been since the Yellen Fed began are obvious. The recent jump in rates with the Trump election victory rise in NGDP expectations is obvious, as is the distance the 20 year UST has still to go as NGDP (monetary rate policy) normalizes. There is significant return in various short US Treasury rate trades until the UST 20 year is 4% or higher.
The relationship of long term expected NGDP to the UST 20 year is regressed and a rich/cheap pricing of the 20 year US Treasury is arrived at, graphed in terms of the 20 year US Treasury given expected NGDP compared to the current trading of the US Treasury 20 year. Currently, if expected NGDP stays at this level or goes higher - as it will - the US Treasury 20 year is about 75 basis points rich. However the current procing has backed and filled now for about 2 months around a 3% expected 20 Year US Treasury versus the current 2 3/4% market level.
Taking a closer look (smaller rainge in “x” axis - or US Treasury 20 year yield) shows the US Treasury 20 year was retracing the path from the beginning of the Yellen Fed to the Dec 2015 rate rise. however the 20 Year has staled out at current levels. It is likely therefore that the US Treasy 20 year, if it continues this patern, will jump soon by 50 to 100 basis points to where the US Treasury 20 year traded when the Yellen Fed began.
The same regression of expected NGDP to the UST 5 year is done using both NGDP expected in 7 years and NGDP expected in 4 years.
If NGDP stays at the current level or drops, the UST 5 year is about 30 basis points cheap. Our read is that expected NGDP is lagging the US Treasury 5 year prices and NGDP expected will jump 100 basis points as a 2% Fed Funds is reached quickly.
Where the size of the current Fed “error” distortion shows most clearly is when the anlaysis for 5 years and 20 years above are joined to consider the curve between 5s and 20s.
The curve from intermediates to long duration in UST is can be considered the forward pricing of NGDP growth.
Just as for UST 20 years and UST 5 years, we regress the curve to expected NGDP over time and compare that to the 20 to 5 curve.
Given the analysis for 20 year and 5 year above, and considering the curve graphed to expected NGDP, the curve is flat now versus where it has been for the last 50 years. A rise in expected NGDP will remove some of this very large cheapness in the curve (i.e. it is too flat and will steepen), but even then the curve will steepen by at least 50 basis points. A technical effect from QE is also capping long rates, not from supply and demand but from the “lack of safe assets” repo.
The 5:20 curve will steepen in a jump by at least 80 basis points.
Spot curve versus the 5 year is graphed, starting with 5 year and 20 year yield and the curve over time.
The curve from 5 years and 20 years can be considered the forward expectations of NGDP growth. The UST 5 years is a good forward expectation of expected NGDP.
Current levels show that the UST 5 year may jump suddenly by 150 to 200 basis points to be in sync with both a normalized NGDP expectations and in terms of the level in 5 years being in sync with forward views of “normal”" growth.
The SP500 is plotted against the forward expected NGDP.
The SP500 is reflected in the forward expected NGDP and the forward growth of NGDP. Or to sustain current levels of SP500 the NGDP expected must achieve certain levels. Currently the NGDP of around 2% will not sustain SP500 over 1800 level.
The curve 5:20 year UST is graphed versus expected NGDP. It is obvious the curve will steepen dramatically unless the US enters a serious recession if not depression of secular stagnation.