US Rates Outlook. Presenter(s): Anshul Pradhan

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1 Sponsored by and US Rates Outlook Presenter(s): Anshul Pradhan

2 Research Anshul Pradhan US Rates Outlook 10 th Annual Equity Based Insurance Guarantees Conference (Chicago) 18 November 2014: hours PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 31

3 Macro environment in 2014 Consensus view that yields will rise following the taper has been proven wrong. Relentless flattening of the yield curve, as the long end has been well supported data but the start of the hiking cycle has been pegged Volatility has declined across asset classes globally; e.g. US 3m10y at 70abpv (pre-crisis low : 57apbv). Both FX and Equity vol are also close to historical This lows economic backdrop has kept the front end pegged, but longer dated yields have rallied relentlessly Mixed data amid steady message from the Fed, has kept volatility low across asset classes % Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 5Y5Y swap yields, % 5s30s Treasury Curve, %, rhs 70% % % 40% % 20% 50 10% 0 0% Ju l - 04 Ju l - 06 Ju l- 08 Ju l- 10 Ju l - 12 Ju l - 14 USD 10y, lhs S&P, rhs FX, rhs Source: Bloomberg, Barclays Research 2

4 Why have long dated yields declined this year? 3

5 Decomposition of long dated yields into expectations and term premium Driven by a decline in expectations of real neutral rate and term premium 2.5% % 1.8% 2.3% 2.1% y5y swap yields have declined significantly since the beginning of the year 1.5% % 0.5% 1.3% 0.6% Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec % -0.5% 0.0% -0.1% -0.2% -0.3% Expecte Real Policy Rate Expected Inflation Dec-13 Nov % Term Premium 0.0% 5y5y swap rates, % -0.4% -0.5% -0.5% -0.6% Source: Federal Reserve, Barclays Research -0.7% Expecte Real Policy Rate Expected Inflation -0.6% Term Premium 4

6 Growth forecasts have again turned out to be too optimistic Growth forecasts have been pared back in the US Not just in the US but globally as well US GDP Forecasts World GDP Forecasts Source: Bloomberg, Barclays Research 5

7 Underlying GDP growth hasn t shown any signs of acceleration Underlying GDP in the 2-2.5% range Q3 15 print was not as strong as suggested by the headline number Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Domestic Private Final Sales, 4Q MA Contribution to real GDP Q3 14 Q2 14 Q Personal Consumption Non Residential FI Residential FI Government Defense Government Other Net Exports Change in inventories Total Final sales Domestic Final sales Domestic Pvt. Final Sales Source: CBO, Haver Analytics, Barclays research. 6

8 Central banks globally are missing their inflation targets Inflation is expected to remain below CB targets Long term inflation expectations in DM have been falling over the past year Inflation (%) 3.5 Current vs 1 yr ago and next year Inflation expectation 3.5 % UK BE (RPI):2.73 US BE EU US Japan UK Canada Switzerland Sweden Denmark New Zealand Sep-13 Sep-14 Q3-15* Inflation Target Australia UK BE 10y Eur BE 10y France BE 10y US BE 10y France BE: 1.18 Germany BE: 1.13 Q2-15* is yoy quarterly average inflation forecasts (Core PCE for the US, CPI for all other countries) Realized inflation forecasts are yoy core PCE for the US, core CPI for EU,UK and CPI for others Source: Bloomberg, Barclays Research 7

9 Global term premia has compressed to unprecedented lows Long dated yields have declined globally Term Premium has compressed to historical lows 1.5 % Jan - 99 Jan - 01 Jan - 03 Jan - 05 Jan - 07 Jan - 09 Jan - 11 Jan - 13 Recession Term Premium Source: Bloomberg, Barclays Research 8

10 Rate volatility has declined to historical lows Global rate vol close to pre recession lows Dispersion of economic forecasts has declined Nov-02 Nov-04 Nov-06 Nov-08 Nov-10 Nov-12 Nov-14 PC1 of US, UK, Eur rate vol Dec-66 Dec-74 Dec-82 Dec-90 Dec-98 Dec-06 Dec D Realized Vol, 10y Tsy, % 1y10y swaption vol, % Dispersion of real GDP growth forecasts (75/ 25%ile), 4Q MA Source: Barclays Research 9

11 Negative correlation with equities has increased the perceived diversification benefit in owning Treasuries Stock-bond Return correlation has recently been negative Correlation in close to the historical lows Daily Tsy Index Price Return, % Daily S&P Price Return, % Sep-94 Sep-98 Sep-02 Sep-06 Sep-10 Sep-14 Stock-Bond Correlation, % Source: Barclays Research 10

12 Key Takeaways Long dated yields have declined sharply, not just in the US but globally Neutral rate expectations have declined along with growth forecasts Inflation continues to remain stubbornly below Central Bank Targets Term Premia has compressed to unprecedented lows Volatility is close to historical lows given low dispersion in growth forecasts Negative correlation with equities has increased the diversification benefit 11

13 What is the outlook for monetary policy? 12

14 Monetary policy has been extremely accommodative by historical standards Fed funds rate has been stuck at the ZLB since 2008 Fed s Balance Sheet has expanded significantly Dec-89 Dec-94 Dec-99 Dec-04 Dec-09 Dec-14 Fed Funds Forecast, % 5,000 Current 4,000 3,000 2,000 1, Tsys held in SOMA, $bn MBS+Agency Debt, $bn Total Securities in SOMA, % of GDP, RHS 30% 25% 20% 15% 10% 5% 0% Source: Federal Reserve, Barclays Research 13

15 Labor market slack has declined significantly Labor market slack is steadily falling. Broader measures of unemployment may fall to 2004 levels by late Jun-92 Jun-94 Jun-96 Jun-98 Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Jun-14 Jun-16 U3 Unemp (>27wks) U6 Latest Average Q Distance Pace of Decline, 1yr Time to H104 Levels, yrs Date when hit Dec-14 Sep-15 Sep-15 Source: Federal Reserve, Barclays Research Broad Slack Measure to decline 0.5% by Q3 15 Unemp - NAIRU Labor Market Indicators (first factor) Q2-04 Levels 14

16 Broad range of labor market indicators have shown improvement Temporary help services employment Initial Claims Unemployment Rate, >27 weeks Nonfarm employees Job Op en i n gs Hirings Quits Underemp. (U6-U3) NFIB Hiring Plans Unemployment Rate Difficult to fill (NFIB) Labor market differential Latest 1y ago Q104 Q4 06 Q4 09 Source: Haver Analytics, Atlanta Fed, Barclays research. 15

17 Discouragement has only marginally contributed to the decline in the overall labor force participation rate Decline in LFPR over last few years, not due to discouragement Only a small fraction of the decline in LFPR over the last decade attributable to those who want a job Cumulative Decline in LFPR since End of Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Retirement Want a Job Don't Want - Not in School Disability Don't Want - In School Decline in LFPR, % population, Q407 to Q413 Total Want a Job Retired Disabled or Ill In School Others Wants a Job/Total 16-24y -0.6% -0.1% 0.0% -0.1% -0.5% 0.1% 11% 25-50y -0.3% -0.2% -0.1% 0.0% -0.2% 0.1% 53% 51-60y -0.4% -0.1% 0.1% -0.4% 0.0% 0.0% 22% 61y+ -1.9% -0.1% -1.4% -0.3% 0.0% 0.0% 6% Total -3.2% -0.5% -1.4% -0.9% -0.7% 0.2% 14% Source: Haver Analytics, Philadelphia Fed, Atlanta Fed, Barclays Research 16

18 Maximum Employment Mandate: Wage inflation is key All measures of wage inflation have risen from the lows Wage inflation should accelerate going forward Source: Haver Analytics, Barclays research 17

19 Inflation has risen from the lows but remains below target 5% 4% 5% 4% 3% 2% 1% 0% -1% Core inflation has stagnated at current levels 3% 2% 1% 0% -1% -2% -3% -4% Jan - 01 Jan - 03 Jan - 05 Jan - 07 Jan - 09 Jan - 11 Jan - 13 Core Services Core Goods 8 7-2% Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Headline PCE PCE excluding Food and Energy Source: Haver Analytics, Barclays research Mar-83 Mar-89 Mar-95 Mar-01 Mar-07 Mar-13 Core PCE Services ECI AHE 18

20 Goods inflation to become more of a drag in the near term 5% Housing inflation has risen from the lows and should accelerate further 1 Trade weighted USD has strengthened from the lows % % % 1% % -1% Mar-01 Mar-04 Mar-07 Mar-10 Mar-13 Non-housing service inflation lower than pre-crisis levels Recent drop in healthcare due to Sequester 5.0% 4.0% 3.0% % % 0.0% Housing Inflation, %, lhs -% Jan - 01 Jan - 03 Jan - 05 Jan - 07 Jan - 09 Jan - 11 Jan - 13 Core Services ex-housing ex- heathcare Rental Vacancy Rates, %, rhs Health Care Medicare Sequester 80 May-94 May-99 May-04 May-09 May-14 Nominal Broad Trade-Weighted Exchange Value of the US$ (Jan- 97=100) Pickup in core Goods inflation to be reversed 20% 15% 10% 5% 0% -5% -10% -15% Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 yoy change in Trade Weighted USD yoy change in Core Import Prices, 3M Lagged, rhs Source: Haver Analytics, Barclays research 10% 5% 0% -5% -10% 19

21 Weak recovery suggests neutral rate is much lower today According to an estimate, short run real neutral rate has declined to around 0% Jun-92 Jun-95 Jun-98 Jun-01 Jun-04 Jun-07 Jun-10 Jun-13 Estimate of short run real neutral rate Well below pre-crisis levels due to slower trend growth and headwinds -4.0 Jun-92 Jun-95 Jun-98 Jun-01 Jun-04 Jun-07 Jun-10 Jun-13 Trend Growth Headwinds The Taylor Rule assumes an equilibrium real rate of interest of 2 percent. This seems much too high in the current economic environment in which headwinds persist, and somewhat too high even when these headwinds fully dissipate NY Fed Dudley - June 14 Source: Federal Reserve, Barclays Research 20

22 Fed s estimate of long term neutral rate may be too high Fed s long term fed funds forecast has declined Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Fed's mean estimate of longer run nominal funds rate Median Trend growth may be lower than the Fed is assuming Potential Output Potential Labor Force Potential Labor Productivity Source: Federal Reserve, Barclays Research 21

23 Key Takeaways Monetary policy has been extremely accommodative post-crisis Labor market slack has fallen significantly from post-crisis highs Wage inflation has risen from the lows but remains muted Inflation has risen from the lows, but downside risks have emerged Neutral Rates are significantly lower than pre-crisis averages Patience in unwinding monetary policy accommodation is warranted. A pickup in Inflation could cause the Fed to tighten at a faster pace 22

24 What does it mean for the markets? 23

25 Yields are lower than can be justified by the economic outlook Benign hiking cycle given the econ outlook Market is trading well through even this benign cycle Dec-14 Dec-16 Dec-18 Dec-20 Dec-22 Dec-24 Base Case Market OIS Rates, % s 3s 5s 7s 10s 30s Term Premium, bp Source: Barclays Research 24

26 Low term premium leads to low/negative excess returns Term premium is negative in the intermediate sector Ju n - 03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 5y term premium, % 10y term premium, % Low term premium is associated with subsequent low excess returns Tsy Index Excess Returns, Subsequent 1 year R² = y term premium, % Source: Federal Reserve, Barclays Research 25

27 Net Supply of Treasuries has been steadily falling Net Coupon Issuance Foreign Sector Federal Reserve Pension Funds /Ins Mutual funds Banking Sector Others , , , E E Source: Haver Analytics, Barclays Research 26

28 Demand from foreign investors remains high FX Reserve balances stand at $12trillion. Even modest growth will result in significant demand for US FI $bn 13,000 12,000 11,000 10,000 9,000 8,000 7,000-5% Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Level of FX Reserves, $bn, lhs Currency adjusted, 12M growth of key countries, %, rhs 20% 15% 10% 5% 0% 100% 80% 60% 40% 20% 0% 2005 Foreign Investors have been buying further out the curve at Treasury auctions YTD % of purchase in 2y/ 3y/ 5y % of purchase in 7y/ 10y % of purchase in 30y Duration Est (yrs), RHS Source: Treasury, Bloomberg, Barclays Research 27

29 Real yields in the US are high in a global context! 10y real yields in the US are low in a historical context but high relative to Europe and Japan Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 10y real rates, USD EUR JPY Source: Barclays Research 28

30 Domestic bank demand has accelerated given new regulation Bank demand for securities has picked up Mutual fund demand has picked up but not to the levels prior to the last year selloff Jan - 04 Jan Jan - 08 Jan - 10 Jan Jan - 14 Net increase in security holdings, 6m annualized -400 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Taxable Bond funds, $bn, 13 weeks, annualized Equity Inflows,$bn, 13 weeks, annualized Source: Haver Analytics, Barclays Research 29

31 What could be the big surprise next year? Higher Inflation Market s are very sanguine about the inflation outlook Pickup in inflation could trigger faster normalization % UK BE (RPI):2.73 US BE 1.92 France BE: 1.18 Germany BE: Mar-87 Mar-91 Mar-95 Mar-99 Mar-03 Mar-07 Mar-11 Real FF Rates, % Real Neutral Rate Deviation from Neutral, % UK BE 10y Eur BE 10y France BE 10y US BE 10y Source: Treasury, Bloomberg, Barclays Research 30

32 Key Takeaways: Inflation is key for higher yields Yields in the US look too low even given the moderate economic outlook Term Premium is unusually low Negative Term Premium is associated with low/negative subsequent returns Global Supply-Demand Factors argue for term premia to unwind gradually A pickup in Wage/Price Inflation is key for yields to rise Higher inflation should accelerate the process of policy normalization Higher inflation should also lead to higher term premia 31

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