Quo Vadis Long Term Rates?
Dimitri Triantafyllides, CFA
(704)968-9074
October 3, 2023
The US Federal Reserve’s potential for one more rate increase before yearend appears to be on most investors’ current focus. The market seems fairly evenly split, depending on the day of the week, on whether the Fed will increase its target Federal Funds rate by 25 bps to a range of 5.50% to 5.75% or it will hold at its current 5.25% to 5.50%. Either way, the majority of market participants believe after this year, future rate moves are likely to be downward – with some debate on how long we stay at whatever level is reached by yearend. This is evident by the shape of the yield curve, which has been inverted (short term rates higher than long term rates) for almost a year.
While these short-term rates get the brunt of attention, we are more interested in long term rates and their implication on the valuation of other financial assets, primarily stocks. As the previous chart shows, not only have short term rates increased in the last year, but so have long term rates, leading to a rising rate environment across the maturity spectrum. Prior to the post 2008 Financial Crisis and Quantitative Easing (money printing through the purchase of longterm bonds with money created out of thin air), the long end of the yield curve had traditionally been viewed as a central bank’s report card. In other words, the Fed’s use of short-term rates to control inflation and inflation expectations would get priced into longer term rate expectations, which in turn drove long term yields. If a central bank was successful through its monetary policy to contain inflation, the invisible hand of the market would price long term rates, finding a balance between inflation expectations and economic growth.
The advent of Quantitative Easing in 2009 until the beginning of its sunset mid-last year was a period in which the market’s ability to issue the Fed a “report card” was dulled by the Fed’s own purchases or longer dated securities. Since then, as the roll-off of it Fed portfolio has begun, long term rates have been allowed to find their own, market-based level. So now that for the first time in 15 years we have a chance to experience a functioning yield curve, what should longer terms rate be? This is a pertinent question, especially given the recent and rapid raise in rates.
The US 10 year bond yield has moved from 0.7% in April of 2020 and 3.31% yield as recently as early April of this year to more than 4.75% currently. This is a relatively massive increase in yields over a short period of time, reminiscent of the beginning of stratospheric yield increases witnessed starting in April of 1977 which did not abate until October of 1981 (see chart at top of article). Even the somewhat infamous yield increase in early 1987 that precipitated the October 1987 stock market crash, paled by comparison.
While most of us on a daily basis focus on the outlook for economic growth measured by real GDP, as well as inflation expectations, over the long run, the sum of these two values, namely nominal GDP, is most helpful when thinking of long-term risk-free yields. Conventional wisdom calls for long term interest rates to reflect nominal GDP growth expectations. This makes intuitive sense. In a rapid notional GPD growth environment, for example, whether the growth is coming from inflation or real growth (or both), fixed income investors are either spooked by the eroding purchasing power of their principal (due to inflation) or attracted by the appreciation potential of non-fixed income assets tied to real GDP growth (stocks etc.). Either way, bond investors demand a higher return in periods of high nominal GDP growth. Alternatively, in periods of low nominal GDP growth (such as the 2010-2020 decade), investors are willing to chase yields lower, given the lack of investment alternatives, and/or stability of purchasing power due to low inflation. By our calculations, since the early 1960s, actual nominal GDP growth in the US has lagged 10-year Treasury bond yields by an average of 60 bps (with a median of 63 bps, implying a fairly normal distribution).
On the chart at the beginning of this article we show annualized nominal GDP growth versus the 10 Year bond yield, as well as the excess of bond yield to nominal GDP growth measured in bps (the bar chart). What is interesting to us from this overlay, is that in periods of expanding nominal GDP, bond yield increases lag and fall short of matching nominal GDP growth (roughly 1961-1979 and 2011-2019), whereas in periods of decreasing nominal GDP growth (roughly 1980- 2003), bond yields exceed nominal GDP. In either scenario, it appears that the bond yields follow nominal GDP trends. With this in mind, as long as investors expect nominal GDP to remain elevated, as compared to the 2010-2020 period we believe long term rates may have more room to increase. Although not a “price target” current nominal GDP of 6.4% would put the historical fair value yield for the US 10 year bond at around 5.6%.
Disclosure Statements This report is for your information only and is not an offer to sell or a recommendation to buy the securities or instruments named or described in this report. Additional information is available upon request. The information in this report has been obtained or derived from sources believed by Sixty Guilders, LLC (Sixty Guilders) to be reliable, but Sixty Guilders does not represent that this information is accurate or complete. Any opinions or estimates contained in this report are current as of the date of the report and are subject to change without notice. Copyright © 2023 Sixty Guilders, LLC. Conflicts of Interest. Sixty Guilders, its employees and its affiliates may from time to time hold securities mentioned in this report, either long or short, whether relying or not on information provided in this report. Sources of Information. The information in this report has been obtained or derived from sources believed by Sixty Guilders to be reliable, but Sixty Guilders does not represent that this information is accurate or complete. Estimates for revenue and cash flow (EBITDA) are derived from street expectations as of the date of publication, therefore changes following the publication of the report are not reflected in the report. Other estimates in the report are provided by Sixty Guilders and may similarly be changed following the publication of the report. Ratings. Sixty Guilders does not provide buy, hold or sell recommendations on the debt and equity securities profiled in its reports. Instead, Sixty Guilders force-ranks securities under coverage on a percentile scale, ranging from 100% (highest possible percentile) to 0% (lowest possible percentile). As a result, Sixty Guilders’s rankings are evenly distributed across the percentile spectrum of 100% to 0%. In its reports, Sixty Guilders discloses rankings for a company’s equity appeal and credit quality in 10 percentile increments rounded to the lowest 10 percentile increment. This format is also followed for a company’s peer group (“industry sector”). Industry sector rankings similarly rank sector fundamentals against the broader Sixty Guilders coverage index. In order to preserve the ranking relevance on our index data, company credit and equity percentile rankings are not rounded when displayed on the index. Furthermore, rankings on company reports are only current as of the publication date of a report, and may change as a company’s credit or equity relative appeal may improve or deteriorate following the publication of a report. Since our index data are updated daily, credit and equity rankings on the index are more current than those published in reports whose publication date may have been several days or weeks prior to the most recent current ratings.