Treasury bond yields jump: a recovery jump toward normal, but what is normal?
The 110 basis point (bp) jump in 10-year yields to 1.7% since late August 2020 is among the largest since a 150bps jump in early 2009, as the financial crisis stabilized. Similar sized jumps to now occurred in late 2010 to early 2011, as the European-Central-Bank (ECB) actions eased Europe's periphery crisis, and in mid-2013, as the U.S. expansion gained traction despite fiscal tightening. Treasury yields also made a late cycle high by climbing 100bps to 3.2% after Trump's election on extended cycle views from pro-supply-side policies. Larger yield jumps within six months are found before 2000, such as the 1994 bond bear market, when the U.S. Federal Reserve (Fed) hiked aggressively to take insurance against inflation risk.
Still negative real yields suggest it is early cycle, but inflation breakeven more mid to late
Less than half the jump in 10-year Treasury yields since late August is from real yields rising from roughly -1% to -0.5%. Whereas the increase in Treasury vs. Treasury Inflation Protected Securities (TIPS) inflation breakeven accounted for a little more than half, climbing from about 1.7% to 2.3%. The balance in the pieces of the recent Treasury-yield jump differs from the inflation expectation dominated jumps in the recovery years of the last cycle, in early 2009 and late 2010 to early 2011, and also from the real interest rate dominated yield jump in mid-2013. But more importantly, the recent climb in real yields is from all-time lows and the recent climb in the inflation expectation is to the highest level since 2013. Hence, we now have the inflation expectation of an entrenched expansion as during 2013, but still the long-term real interest rate of a slowly recovering global financial crisis as in 2009-2012. The bond market’s behavior suggests we have yet to enter mid-cycle real interest rates, but entered mid-cycle inflation.
Normal yield equals target inflation plus neutral real overnight rate plus term risk premium
The Fed to a large extent controls inflation, but cannot control real yields; at least not for long if it wants stable inflation. The Fed's inflation target is 2% with a preference for modestly above that for some time. When inflation is below target, the Fed can cut overnight rates to below the neutral real rate (r*) or take other actions to boost inflation. But once inflation trends at target, the Fed cannot keep policy loose without risking inflation over target. Normal inflation should be target inflation when a central bank sticks to its inflation target and uses its tools effectively to achieve it. The Fed's heavy machinery includes large scale asset purchase to affect interest rates beyond the short-term and to fund extraordinary fiscal deficits in emergencies.
What is the normal or neutral real overnight interest rate (r*)? Probably 0%
What should the real federal funds rate be when inflation trends at target? A big question that raises many others. The average real federal funds rate since 1960 is 1.2%, but inflation did not trend at a consistent rate through past decades and the target was not clear or consistent. For years with inflation below 4%, the real federal funds rate averaged 0.8% since 1960. Some concepts to interpret history and answer: What is the real overnight rate that neither accelerates nor slows inflation (r*)?. We think of r* as the fair real return for taking no risk. So perhaps this fair return is nothing. But, classic theory argues a positive risk-free interest rate must be paid to savers to forgo consumption today for greater consumption tomorrow. Yet, perhaps saving is of little sacrifice in affluent economies with many peak earnings age households. It is uncertain, but we think r* at about 0% is a decent medium-term estimate.
What is the normal steepness of the yield curve? Probably well below history
Since 1934, the average difference between 10-year yields less the federal funds rate is 1.2%. The main driver of yield-curve steepness, yields over normal overnight rates, is inflation uncertainty. Thus, the inflation risk premium is usually the main part of the term premium. If the Fed keeps its inflation target credible, the term premium should stay low, perhaps at under 50bps. Other forces also influence the term premium. Consider risk asset hedge value of Treasury bonds, which helps portfolios diversify systematic equity risk. Treasury bond returns have a negative beta to equities in recent years, this can reduce the term premium. The value of this risk hedge might be falling, just as inflation uncertainty might be rising. Because TIPS pay ex post Consumer Price Index (CPI) inflation, the yield does not include an inflation risk premium. TIPS protect against inflation, Treasury bonds protect against risk.
How high is too high? Our S&P 500 and sector target P/Es assume 0% 10-year TIPS
Our S&P 500 real cost of equity estimate is 4.5%= 0% real long-term risk-free rate + 4.5% ERP. An equity-risk-premium (ERP) assumption of 450bp, provides some target price-to-earnings ratio (P/E) protection against TIPS yields over 0%, as this higher than history ERP reflects real rate uncertainty, provided the climb is slow with favorable economic and earnings growth trends.