How to be a US Rates Analyst

One of the expectations of a US interest rate analyst is to forecast Treasury yields. Forecasting can be complex and involve a large number of assumptions. But when examining this task from a bird’s eye view, the many dozens of factors considered ultimately boil down to two elements:

1. What is the investor’s expectation for short-term interest rates over the maturity horizon?
2. What additional compensation or extra yield does the investor demand for committing to tie up their money in a longer term investment (rather than a series of short-term ones)? This concept is called term premium^[1] .

Let’s look at these two elements in practice to take a view on where the 10-year Treasury should trade.

Short-Term Rate Expectations:

The shortest of short term interest rates in the United States is the Federal Funds Rate, the rate at which banks borrow reserves from one another on an overnight basis^[2] . Surveys of economists and forecasters can provide a fairly comprehensive view for what markets expect over the next handful of years. For instance, the FOMC currently sees the Federal Funds rate around 3% by 2019 while investors in the Fed Funds futures market see the rate in 2019 at 1.5 – 2%.

But what about the average short-term rate over the next 10 years? If inflation and unemployment both reach the Fed’s mandated targets, the Federal Funds rate should be set at a level which encompasses two parts: a real component and an inflation component. We will set the inflation component at 2%, which is the Fed’s target.

Next is the real component. Looking empirically, the average Real Federal Funds rate over the past 50 years has been right around 2%. This average ties in nicely with the FOMC’s pre-2015 SEP forecast of a long-run “dot” of 4% (2% Real + 2% Inflation).

The path in which we get to a level of 4% on the Federal Funds rate will impact the average short-term rate over the 10-year period in which we are forecasting. There are an infinite number of possible paths. I have modeled a few below and calculated the 10-year average short-term rate for these paths.

Term Premium:

The second part of this forecast is perhaps more controversial. When we think of term premium, we think of the excess yield provided to a longer-term investor for taking a risk and locking up their money.

Term premium is ultimately difficult to measure in real time because it is the residual of one observable and one less observable factor. The current 10-year interest rate is known but expectations of short-term interest rates far into the future are hard to extract accurately from market participants. We have chosen one measure for the purposes of this blog that happens to be popular, easily assessable and updated daily called the ACM (Adrian, Crump, and Moench) model published by the NY Fed^[3] .

Nothing says that term premium has to be positive even though historically it has been. Term premium is ultimately a demand versus supply story. When demand outstrips supply, the term premium can be driven very low, even negative like it was in the summer of 2016. We have identified four major sources of demand which have been influencing the dynamics in term premium. These sources of demand are all to some extent “price indiscriminate” market participants. This means that these purchases are less sensitive to the level of prices/yields compared to other objectives.

1. The Federal Reserve’s Quantitative Easing program has been an important factor driving term premium. Although this program has ended, the Fed continues to reinvest principal payments for the time being but they have indicated a willingness to stop reinvestments as the tightening cycle continues.
2. Overseas investor demand is another important factor. Foreign investors were drawn to higher nominal yields despite sometimes uneconomic foreign exchange hedging costs. This demand also includes the building of US dollar reserves which sovereign governments and central banks have been stockpiling since 2000. However, foreign holdings of Treasuries started to stabilize and turn downward in 2016.
3. LDI (Liability Driven Investor) demand has been a secondary factor impacting the market. These investors are required (by regulation) to match the duration of their liabilities and assets. As rates fell, the duration of their liabilities extended, increasing their overall demand for duration, and further compressing term premiums.
4. Fourth is the “Flight to Quality” phenomenon. Treasuries are a perceived safe haven asset and in times of financial stress they are seen by investors as a store of value rather than a traditional return generating investment.

These forces, although powerful, ebb and flow during cycles and are unlikely to put downward pressure on yields indefinitely. Therefore, this argues for normalization in term premium over time. From a historical perspective, term premium has ranged from -75bps to 500bps and the average term premium has been around 100 – 200bps. The long term average since 1961 is around 160bps.

Yield Forecast:

We’ve looked at the two components of a simple 10-year Treasury Rate forecast:

1. Average short-term rate over the next 10 years: 1.5 – 3%
2. Average term premium: 1% – 2%

This brings us to a conservative estimate of 3.25% (2.25% average short-term rate + 1% term premium) with a range of 2.5% to 5%. This is consistent with GFICC’s year-end 10-year yield forecast of 3 – 3.5%. Today, the term premium is 20bps and the 10-year Treasury is around 2.4%.

We discussed that the forces of demand that have depressed term premium over time are not static and may slowly diminish. If the US economy and financial markets were to evolve back to a more “normal” state, we should be able to look historically in order to draw conclusions about what the normal levels of term structure and term premium should be.

Historically, the Federal Funds rate has spent about 25% of its time around 4% and the 10-year term premium was on average around 130bps. During these same periods, the average 10-year Treasury yield was 5.5% (see table below).

To those who have only been watching the markets in the post-financial crisis world, a forecast of 5% Treasury yields may seem outlandish. But these estimates are well within the ranges of historical experiences and can be forecasted using the simple methodology described above.

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^[1] Term premium has been a topic of discussion on this blog before. Portfolio Manager Andrew Norelli has published a number of informative blogs to further put this in context.

http://blog.jpmorganinstitutional.com/2015/10/just-how-low-is-low/

http://blog.jpmorganinstitutional.com/2013/06/evolution-of-the-short-rate/

^[2] Investors generally use the 3-month T-Bill Rate as a proxy for an investable short term interest rate. In this scenario, we will focus on the Fed Funds rate for simplicity.

^[3] https://www.newyorkfed.org/research/data_indicators/term_premia.html