If you pour any granular material (for example sand) onto a flat surface it will begin to pile-up into a conical shape. As you continue to increase the pile, the cone will grow higher and its sides will get steeper until some point where the frictional forces that provide cohesion for the material cannot continue to hold back the effect of gravity and the side of the slope gives way with material tumbling down and the pile getting wider and flatter again. This maximal angle is known as the critical angle of repose and is nature’s way of saying that the slope is too steep. I was thinking of this in the context of snow recently while skiing in Utah with my kids. They were fascinated by the abundant avalanche warning signs on the mountain. It turns out that for snow, there are many factors at play and depending on conditions this angle can be between 30% and 60% with the most frequent angle for an avalanche being 38%.
Leaving the ski slopes and returning to the reality of the bond market, we have our own steep slopes to analyze. The big question going into 2014 is “where are interest rates headed?” In particular, the first question investors tend to ask in any economic discussion is “what will the yield on the 10yr US Treasury bond be at year-end?”
A good place to start this analysis is to look at the US Federal Reserve (Fed) Funds rate which is currently zero. If you believe, as we do, that the Fed will keep the funds rate anchored at zero through 2014 (and likely through much of 2015), then forecasting the yield on the 10yr amounts to forecasting the slope of the yield curve from funds to the 10yr point. That is to say, forecasting how market expectations of future short rates will evolve over the next 12 months. To do this, it is helpful to look at the history. As they say, the past is just the present in funny clothing. With the Fed beginning to taper and signs that economic growth is improving, it is likely that rates in the intermediate to long end will start to rise as the market prices in this improvement but how high?
The current slope is right around 285bps. If an investor buys the 10yr UST today and holds it for one year, she will earn 2.85% carry and will then own a 9yr bond. This results in a break-even yield (forward) of approximately 3.20%. Therefore, relative to the current 9yr bond yield of 2.75%, our investor can take a 45bp increase from today’s yield before losing money. Now imagine the slope from Funds to 10yr was 400bps. Using the same math, the breakeven increase would be more like 65bps.
This seems to be a level where the roll and carry conspire to make shorting the bond seem unattractive given the extremely high implied forward expectations. In fact, as the chart below shows, somewhere around 400bps seems to be the level where the slope starts to give way and either the short rate needs to rise or the long rate needs to fall.
Historic 10yr-Federal Funds Spread
So where does that leave us? Given that growth in the US does appear to be improving and the Fed has begun to taper, we expect intermediate to long-term rates to rates to rise over the course of the year but for the reasons given above that rise should be capped with the 10yr ultimately caught in a range of 3.25% to 3.75% later in the year. A yield curve steeper than that should carry the sign “warning avalanche danger”.
Notes: Special thanks to the US Rates team for their analysis.