US 10-Year (CMT) Treasury yields have been declining (on trend) since November 1st. Pundits' recent call for high interest rates for longer appears disconnected with the reality of market pricing and macroeconomic fundamentals. These calls implicitly assume the continuation of improvements in future real economic growth prospects will lead to persistently high inflation. While plausible, this scenario for growth and inflation seems unlikely, according to our models, principally because it ignores the impact of growth uncertainty. By contrast, in our models' most likely scenario, increased certainty about slow long-term growth and benign long-term inflation expectations imply lower interest rates ... for longer.
We start our analysis by examining the long-term drivers of real (TIPS) yields. According to our models, these drivers are the long-term real economic growth expectations and long-term growth uncertainty. As portrayed by Exhibit 1, and as discussed in our previous note, in the US, markets and macro fundamentals point to more certainty (i.e. receding uncertainty) about improved but still slow long-term real growth. While growth expectations have recovered (to about 2%) since the pandemic lows, they remain significantly lower compared to the pre-2008 Global Financial Crisis (GFC) average trend of about 3%. It is worth noting that our macro uncertainty index - a measure of long-term growth uncertainty - has now declined to 111, a level below the pre-GFC average of about 170. Going forward, the most likely scenario , according to our models, is that of a continuation of low long-term real growth and a moderate increase in uncertainty back to its (benign) pre-GFC average level. The question is how long it will take for this reversion of uncertainty to materialize.
In turn, our models indicate that these real economic growth and growth uncertainty trends have implications for real (inflation-linked) bond yields. Exhibit 2 depicts the evolution since 2003 of the 10-Year Constant Maturity TIPS yield, along with its long-term expectations, and contributions from long-term growth expectations and growth uncertainty, as implied by our models. As shown in the Exhibit, long-term growth expectations contribute positively to real government bond yields, while growth uncertainty contributes negatively. Indeed, investors view real government bonds as safe, insurance assets against negative shocks to real economic growth. The sheer decline in real yields during the pandemic was driven by the sizeable decline in real growth expectations and a corresponding increase in growth uncertainty. Conversely, the rise in real yields in the past two years was driven by the continued recovery in real growth expectations and the decline in uncertainty.
What about nominal yields? According to our models, nominal yields are driven by expectations of long-term real growth, growth uncertainty and long-term inflation. As discussed in our previous note and as portrayed by Exhibit 3, our models point to more certainty (i.e. receding uncertainty) about well-anchored, benign inflation expectations.
Exhibit 4 depicts the evolution since 2003 of the 10-Year Constant Maturity Treasury yield, along with its long-term expectations, and contributions from long-term growth expectations, growth uncertainty, and long-term inflation expectations, as implied by our models. As was the case for real yields, long-term growth expectations contribute positively to (nominal) government bond yields, while growth uncertainty contributes negatively. In addition, long-term inflation expectations also contribute positively. Interestingly, Exhibit 4 shows that the increase in nominal yields through 2022 and November 2023 was driven, as in the case of real yields, by the recovery in long-term growth expectations and the decline in growth uncertainty - and not by (unchanged and rather benign) long-term inflation expectations.
Going forward, according to our models, the path for real and nominal bond yields depend on the path for future real economic growth expectations, growth uncertainty, and long-term inflation expectations. For example, should long-term real growth expectations remain at current (relatively low by historical standard) levels and should uncertainty increase back to its benign (pre-GFC average) level (consistent with our most likely scenario) our models imply that the 10-Year (CMT) TIPS yield could well decline from its current level of 171bps to about 90bps. Moreover, should inflation expectations remain well-anchored and benign at about 2.1% (as discussed in our previous note), the 10-Year (CMT) Treasury yield could decline from the current level of 390bps to about 300bps.
What next for investors? One key takeaway is that investors should refrain from relying on pundits' and market commentators' views based on single (often uninformed and potentially biased) point estimates. Instead, they are better served by focusing on the sources of long-term growth and inflation expectations and uncertainty, and evaluating the impact of alternative scenarios (including those of pundits) of long-term growth and inflation expectations (and uncertainty) on bond markets. One other takeaway is that via their impact on interest (discount) rates and dividend growth, long-term growth and inflation expectations also drive equity valuations and returns. We will explore these implications for equity markets in subsequent notes.
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