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Lukas Daalder

Graph of the week

Rates are still far too low

13-01-2017 | Lukas Daalder Yields on US 10-year Treasuries have risen a full percentage point in less than six months to 2.5%, rounded off. That is ten times as much as yields on German government bonds over the same period. The yield differential between US and German bonds is now greater than it has been since 1989. But even government bonds of debt-laden Italy have lower yields than in the US. And yet even US yields are still much too low.

graph-of-the-week-01.jpg

At least that is what the graph above tries to tell us. In the graph we find the actual 10-year yields in the US versus a model estimate based on three factors: the 3-month rates, core inflation and the ISM Index for new orders. The first factor reflects the current Fed interest-rate policy. In terms of inflation, the higher it is, the higher the rates increase. The ISM Index for new orders is a somewhat better reflection of economic conditions than the ISM Index itself. And here too, the maxim applies: the higher it is, the higher the rates increase. The picture clearly shows that this simple model usually provides a reasonable estimate of the level of 10-year yields.

Nobody is surprised that 3-month rates are currently very low. After all, the Fed has only just started lifting its policy rate from zero. But this does not apply at all to the other two. Core inflation currently stands at 2.1%, above the long-term average. And the ISM Index for new orders this week reached its highest point since November 2014. The US economy seems to be doing okay. Conclusion: based on these numbers, US 10-year yields should be – wait for it – 4.21%! So that's almost – exaggerating slightly for effect – another two percentage points higher than presently.

However, the graph also shows that the two lines have diverged greatly over the last few years. And that's not because the model is broken. There is one clear explanation that has arisen for that gap – quantitative easing. The model simply doesn't cover this extreme instrument from the central banker's toolkit.

But surely the Fed halted its QE program long ago, I hear you thinking. You aren’t the only one who thinks that. And that's not surprising as Janet Yellen tells us one moment that rates really must rise substantially this year, while Draghi's bazooka on the other hand takes more ground and extends the ECB buying program ‘just’ for nine more months. The reality is that QE in the US too continues stubbornly, albeit with less fanfare. The Fed aims to maintain its balance sheet at the current inflated levels. That means that for each bond that matures, a new one is obediently bought. The result of this is that liquidity in the system remains vast and rates artificially low.

graph-of-the-week-02.jpg

Yep, that's the Fed alright – ‘a bull in a china shop’. Although Yellen and her Fed colleagues express very little about their balance sheet, the official goal is still to reduce it at any moment. From that point on, rates will rise rapidly. But the question remains whether this will happen soon. The limited information we have indicates that the Fed has absolutely no idea how to guide this process safely. And honestly it looks like one hell of a task to me too. There are Fed watchers who suggest that, owing to changes in the banking world and the Fed's unique status as ‘lender of last resort’, the central bank will never be rid of its balance sheet. I'm not yet convinced of this. With the first graph in the back of my head, my conclusion is ‘yes’: US yields are high versus those in Europe, but once things have normalized, they should be much higher.

A complete overview of all previous editions of Best of the Web can be found here http://lukasdaalder.com/. All links provided are collected from public websites, unless otherwise specified. I have not checked the data or information for accuracy used, and therefore do not guarantee that all data provided will be 100% correct. The links provided do not necessarily reflect my personal opinion and should be seen as general interest: oftentimes I do not agree with arguments presented, but nevertheless think it is worthwhile to read them. It is up to the reader to make up their own mind. Suggestions or discussions are more than welcome. Do not quote unless specifically checked beforehand!


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Lukas Daalder
CIO Investment Solutions