Why Treasury Yields Are Projected to Remain Low in 2015 March 2015

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1 Why Treasury Yields Are Projected to Remain Low in 5 March 5 PERSPECTIVES Key Insights Monica Defend Head of Global Asset Allocation Research Gabriele Oriolo Analyst Global Asset Allocation Research While the US economy is growing at a healthy pace, governemnt bond yields are close to new historical lows. In order to better understand the reasons behind the current situation, traditional ways of assessing rates dynamics, predominately based on macrofundamentals, may be ineffective. Forecasting flows and supply-demand trends will be, in our view, essential to understanding the bond market in the coming months. Valuation factors such as expectations on short-term rates, inflation and GDP growth should play along with technical factors that include volatility of the Personal Consumption Expenditure (PCE) deflator, Central Bank asset expansion and foreign demand for USD denominated bonds. In the era of Quantitative Easing (QE), Central Banks should absorb most of the bond supply around the world. In our view, the shortage of bonds in the US, UK, Eurozone and Japan will be a global factor that will dominate 5, and will likely keep interest rates lower than pure economic fundamentals would justify. Finally, another important element to consider is the flow dynamics. Treasury purchases by foreigners, averaging 9% of US GDP, could drag almost.5% off the -year US government bond yield, according to our model. Connecting all the dots (fundamentals, flows, Central Bank actions) we believe that the US -year government bond yield is projected to remain low over the next months, at about.5%, even with the US economy reaching escape velocity. Where Is The Bond Market Going? Looking at financial markets in these first months of 5, one of the biggest surprises is core government bond yields that have reached new historical lows across the board. Government Bond Yields Reaching New Lows (995-5) 3 3,6 %,, average Y mar- mar-5 Source: Bloomberg, data as of March 6, 5. Yields are for -year Government Bonds of US, EU, Japan and UK.

2 Why Treasury Yields Are Projected to Remain Low March 5 At the time of this writing, the -year German Government Bond (Bund) is yielding in the.% range, and most of the Bund yield curve is in negative territory (up to 5 years). While the low level of Bund yields can be explained by the extended European Central Bank (ECB) Quantitative Easing, a poor economic outlook and deflationary fears in the Eurozone, it seems much harder to understand why -year Treasury bond yields are trading around % with the US economy growing above 3%. A possible increase in volatility of Personal Consumption Expenditure could push the -year government bond yield higher (+% from current figures). In seeking an explanation, let s consider two elements: ) Valuation factors such as expectations on short term rates, inflation and GDP growth. ) Technical factors such as volatility of the Personal Consumption Expenditure (PCE) deflator, Central Bank asset expansion and foreign demand for USD denominated bonds. These elements typically influence the shape of the US yield curve (known as the term premium ) and interest rate forecasts according to our in-house rates model. If we limit our analysis to valuation factors, consistent with our macroeconomic outlook for 5 (GDP growth +3.8%, fed funds rate at.75%), the -year US Treasury yield should be higher than current levels, between and.% in twelve months 3. However, extending the analysis to the technical factors in point two above, the conclusion appears to be significantly different. Let's start with considering what we see as the most relevant factors: inflation volatility, Central Bank balance sheet expansion and flows. Inflation volatility affects the formation of future expectations by consumers and investors. Since 3, the PCE has been stable around.5% with an extraordinarily low average volatility of.6 (a bottom of. was recorded last November). Given expectations for labor market conditions to continue to improve and for the free fall in commodities prices to stabilize, we can reasonably suppose that PCE volatility will rebound from the current bottom. We have assumed volatility of., which represents the peak since the end of the crisis (see chart). This would imply, according to our models, an increase in interest rates of about %. Please note this is the only technical factor to affect the term structure on the upside, in our scenario. Personal Consumption Index and its Volatility % ,5,5,5 PCE CYoY Index (LHS) Source: Pioneer Investments, as of March6 5. PCE Volatility (RHS) Source: Bloomberg, data as of March 5, 5. US GDP 3.6%, YoY change at 3//. View also US Economic Update March 5 on 3 Forecasts are based on our internal model for interest rate forecasts. Source: Bloomberg, elaboration Pioneer Investments, data as of March 6, 5.

3 Why Treasury Yields Are Projected to Remain Low March 5 The shortage of bonds in the US, UK, Eurozone and Japan will be a global factor that will dominate 5 and will likely keep rates lower than pure economic fundamentals would justify. The second element that we believe will have a material impact on rates is the evolution in Central Bank balance sheet expansion. Although we believe that the Federal Reserve (Fed) and the Bank of England (BoE) will be on hold in 5, the Bank of Japan (BoJ) and the ECB will be expanding their total assets, detracting from the global supply of core rates. According to our calculations, Central Banks should absorb most of the bond supply around the world. The shortage of bonds in the US, UK, Eurozone and Japan will be a global factor that will dominate 5, and will likely keep rates lower than pure economic fundamentals would justify. We believe the US will face its lowest fiscal deficit in the last years, and this will more than compensate for the absence of positive net purchases by the Fed, which is going to leave its balance sheet dimension unchanged. Net issuance (net of the Fed) will shrink from $538B to $57B. (See chart below). We expect Japan s net issuance to stay roughly unchanged with respect to, but the BoJ with its 8T yen expansion (according to our calculations) will absorb % of net issuance. This should apply downward pressure to domestic rates and eventually result in private flows moving abroad. The UK will hold political elections at mid-year. We expect that the fiscal deficit will stay strictly under control; the Ministry of Finance projects + 7B of net issuance. BoE balance sheet expansion is on hold, as with the Fed. The Eurozone should experience the largest impact. The ECB has declared plans to expand its balance sheet by 6B monthly up to September 6 (of which 8B per month will be government bond purchases). Germany, which is supposed to have no fiscal deficit, will have a net issuance around - 8B. In addition, the periphery will experience a shortage of newly issued paper: according to our elaboration on Central Bank data, net of the ECB and National Central Banks, Italy s issuance will be - 9B, Spain s - 5B. According to our calculations, Central Bank Balance sheet expansion and the consequent shortage of bond supply should be responsible for a drag of about % on the year Treasury bond yield. In sum, 5 G net issuance should shrink to -$58B from +$75B in, an impressive number largely driven by the Eurozone and Japan. According to our calculations, Central Bank Balance sheet expansion and the consequent shortage of bond supply should be responsible for a drag of about % on the -year Treasury bond yield. Negative Net Issuance in 5 5 /bln -5 USA JAPAN UK EURO TOTAL 5 Source: Pioneer Investments elaborations on Central Banks data and Ministry of Finance of G countries, data as of March 5, 5. 3

4 Why Treasury Yields Are Projected to Remain Low March 5 Finally, another important element to consider is flow dynamics. Treasury purchases by foreigners, according to the Fed, are material with respect to overall flows. Foreigners hold about 5% of the total debt outstanding and their purchases have been more volatile than domestic investors, such as US Pension funds and Insurance companies. Since the financial crisis, quarterly purchases by foreigners have averaged 9% of US GDP (min 7%, max %). Given the shortage of bonds in Japan, the UK and Eurozone already described, the positive spreads Treasuries currently offer versus other core government bonds, and finally the record current account surpluses in the Eurozone, we can conservatively project an 8% quarterly average of foreign purchases as percentage of GDP in 5, dragging almost.5% off bond yields. Who Holds Treasury Bonds 5 Forecasting flows and supply-demand trends will be essential to understanding the bond market in the coming months. Usd/bln Source: Federal Reserve, data as of March, 5.Others includes non-financial corporate institutions, nonfinancial non-corporate institutions, government-sponsored enterprises, ABS issuers. 6 Foreigners Fed Insurance & Pension Funds Mutual Funds Household Com. Banks Others State & Local Governments In conclusion, in a market environment driven by Central Bank money manipulation, the traditional way of assessing rates dynamics based principally on macro-fundamentals may be ineffective. Forecasting flows and supply-demand trends will be, in our view, essential to understanding the bond market in the coming months. Connecting all the dots (fundamentals, flows, Central Bank actions) we project the US -yield government bond yield to remain low in 5, at about.5%, even with a US economy that is reaching escape velocity.

5 Why Treasury Yields Are Projected to Remain Low March 5 Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of March 5, 5. The views expressed regarding market and economic trends are those of the author and not necessarily Pioneer Investments, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Pioneer Investment product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any service. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: March 6, 5. Follow us on: 5