Blue paper Why U.S. Interest Rates Will Rise IN BRIEF May 2013 10-year Treasury yields have become disconnected from economic fundamentals. We believe interest rates will gradually pull higher due to the strengthening U.S. economy, making duration risk in bond portfolios a serious concern for investors, but not to the extent of the Great Bond Bear Market of 1994.
Key Points Central banks have taken numerous measures to inject liquidity into their domestic economies. That has helped boost risk appetite and investor sentiment. Paresh Upadhyaya Senior Vice President Director of Currency Strategy, U.S. Investors are growing concerned that yields, which move inversely to prices, have bottomed for the 10-year Treasury and could surge, raising fears of a bond bear market along the lines of the Great Bond Bear Market of 1994. With debt-to-gdp skyrocketing from 36.3% in 2008 to 74.2% in March 2013, and 10-year yields near recent lows, there appears to be little debt risk premia priced into the Treasury market. Quantitatively, the 10-year s yield is out of sync with current fundamentals. Presently, both real GDP and inflation are growing around 2% in the U.S., which would equate to 10-year yields intuitively yielding around 4% more than double current levels. If the economy continues to maintain its current recovery, and perhaps gain some momentum with unemployment maintaining its gradual descent, and inflation expectations remain near 2%, we think 10-year yields can be expected to rise gradually over the next few years. Bond investors may face meaningful duration risk in their portfolios but not to the extent of 1994 and the Great Bond Bear Market. The views expressed in this memorandum regarding market and economic trends are those of 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 intent on behalf of any Pioneer investment product. There is no guarantee that market forecasts discussed will be realized or that that these trends will continue. The performance data quoted represents past performance, which is no guarantee of future results. Neither Pioneer, nor its representatives are legal or tax advisors. In addition, Pioneer does not provide advice or recommendations. The investments you choose should correspond to your financial needs, goals, and risk tolerance. For assistance in determining your financial situation, please consult an investment professional. Contributor Paresh Upadhyaya is Director of Currency Strategy, U.S. He leads Pioneer Investments currency research effort out of Boston and serves as an advisor to the firm s global fixedincome and equity investment staff on currency-related issues. In addition, he helps lead sovereign credit analysis and advises the investment team on sovereign bond investments. He is a member of Pioneer s 29-person U.S. fixed income team. Paresh has 18 years of experience in the investment industry. He joined Pioneer from Bank of America Merrill Lynch, where he was Director, Senior FX Strategist Head of North Americas G-10 FX. Prior to BofA Merrill Lynch, he was a Portfolio Manager and member of the currency team at Putnam Investments, where he participated in actively managing $20 billion in currency investments in currency overlay, fixed income, global asset allocation, and international equity portfolios. He has a B.S. in Economics and International Relations from Boston University and an M.B.A. in Finance from Boston College. 2
Investors are growing concerned that yields, which move inversely to prices, have bottomed for the 10- year Treasury and will surge, raising fears of a bond bear market along the lines of the Great Bond Bear Market of 1994. Why U.S. Interest Rates Will Rise Central banks have taken numerous measures to inject liquidity into their domestic economies. That has helped boost risk appetite and investor sentiment. The European Central Bank s stabilization programs have successfully reduced financial market and sovereign tail risk for banks. Global growth troughed in Q2 2012 but has been on an upward trend since. Market concerns over the U.S. debt situation are easing as the U.S. economy proved surprisingly resilient to many uncertainties. As a result, investors are growing concerned that yields, which move inversely to prices, have bottomed for the 10-year Treasury and will surge, raising fears of a bond bear market along the lines of the Great Bond Bear Market of 1994. We believe 10-year yields do not reflect current fundamentals and that the risk/reward ratio increasingly favors a gradual rising trend in yields. The key force behind a gradual pull higher in yields: the economy. Disconnect Between the 10-Year Treasury s Current Yield and Fundamentals Qualitatively, factors that drive long-term interest rate valuations include inflation expectations, growth expectations, and the debt/fiscal outlook. On a quantitative basis, consider Citigroup s fixed income research team, which uses a fairvalue model of the U.S. 10-year Treasury that covers a number of fundamental variables in 3 key categories: growth, inflation and asset markets. Based on these measurements, Citigroup projects the fair value for the U.S. 10-year yield to be 2.6, compared to 1.9964% currently (as of 3/15/13). After analyzing these key variables, it becomes clear that the 10-year s yield is out of sync with current fundamentals. Let s take a look at them one at a time. There has been a convergence between inflation expectations and 10-year yields. Remarkably, since 2012, 10-year yields have been trading through inflation expectations. Inflation Expectations and Yields The Fed s measure of inflation expectations, the five-year forward breakeven inflation rate, has been more or less stable between 2 and 3 percent since its inception in 1999. Following the Global Financial Crisis (GFC) beginning in 2007, there has been a convergence between inflation expectations and 10-year yields. Remarkably, since 2012, 10-year yields have been trading through inflation expectations. 10-Year Yield Trading Through Inflation Expectations 7% 6% 5% Percent 4% 3% 2.71% 2% 1% 1.85% Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 10-Year Treasury Yield Inflation Expectations (Fed 5-Year Breakeven Inflation Rate) Source: Bloomberg and Pioneer Investments. Last data point 3/29/2013. 3
Presently, both real GDP (GDP discounting inflation) and inflation (the Consumer Price Index or CPI) are growing around 2% in the U.S., which would equate to 10-year yields intuitively yielding around 4% more than double current levels. We think this condition is unsustainable. Investors will demand higher yields to compensate for higher inflation expectations and not see the value of owning Treasuries. This risk could rise measurably the longer the Fed maintains its excessively easy monetary policy. Where Should 10-year Yields be Trading? We sought to calculate a proxy measure of where 10-year yields should be trading in light of the current real GDP and inflation environment. Presently, both real GDP (GDP discounting inflation) and inflation (the Consumer Price Index or CPI) are growing around 2% in the U.S., which would equate to 10-year yields intuitively yielding around 4% more than double current levels. Current Growth and CPI Suggest Treasury Yields Should be Higher 8% 6% 4% 2% -2% -4% Jan-99 Jan-00 Jan-01 Jan-02 Index Value Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Proxy 10yr-based on GDP/CPI 10yr yield Source: Bloomberg and Pioneer Investments. Last data point 2/28/2013. Since the mid-1990s, debtto-gdp has been on a gradual rise while 10-year yields have moved in the other direction. Since the GFC, there has been a clear decoupling of these metrics. Debt-to-GDP and 10-year Yields There is a reasonably strong relationship between debt-to-gdp and 10-year yields. Since the mid-1990s, debt-to-gdp has been on a gradual rise while 10-year yields have moved in the other direction. Since the GFC, there has been a clear decoupling of these metrics. With debt-to-gdp skyrocketing from 36.3% in 2008 to 74.2% in 2013, and 10-year yields near recent lows, there appears to be little debt risk premia priced into the Treasury market. Yields have no place to go but up, unless you believe the status quo can persist. But the economy is growing, as I discuss below. 4
Debt-to-GDP and 10-year Yields since the Mid-1990s: Clear De-coupling Very Little Debt Risk Priced In 9% 8% 7% 6% 5% 4% 3% 2% 1% 8 7 6 5 4 3 2 1 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 10-year Yield (left scale) Debt-to-GDP (right scale) Source: Bloomberg and Pioneer Investments. Last data point 2/28/2013. The Pressure on Yields to Rise Comes From... the Economy Gathering momentum in the economy will put persistent pressure on 10-year yields to rise rather than decline. The Fed maintains a fairly cautious view of the U.S. economy. We believe the economy is stronger than many believe. If you strip out government consumption, the U.S. economy has been growing at a relatively robust rate between 3.0-3.5% year-over-year similar to the mid-2000s. During the last few years, there has been a good deal of uncertainty over the U.S. economic outlook, especially public consumption, as the government focuses on cutting expenditures to reduce the fiscal deficit. If you strip out government consumption, the U.S. economy has been growing at a relatively robust rate between 3.0-3.5% year-over-year similar to the mid-2000s. If We Strip Out Government Spending, the Economy is Expanding 8% 6% 4% 2% -2% -4% -6% -8% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 GDP Ex-Gov't Spending Gov't Spending Source: Bloomberg and Pioneer Investments. Last data point 11/15/2012. A relatively weak USD and a pickup in global growth are the main factors boosting net exports. Nonfarm payrolls have been averaging around 160k/month, not too far from previous peaks over the last 40 years. The housing market has been on a nice upswing with housing starts up 86% from the trough in 2009. The external environment is contributing to U.S. growth with net exports rising 8 out of the last 9 quarters. A relatively weak USD and a pickup in global growth are the main factors boosting net exports. 5
We believe if the trend continues and the employment-to-population ratio declines slightly, it would not be surprising to see the unemployment rate fall below 7% by Q4. Despite a dour view of the U.S. economy by the Fed, the markets will increasingly look past government consumption and focus more on the other sectors of the economy. We do not believe the recent softening in U.S. economic data is sustainable and expect yields to move higher on stronger macro-economic data. The Sustainability of Rates Rising As mentioned, investors are growing concerned, with good reason, that yields have bottomed for the 10-year Treasury and will surge as the economy gains strength. The question is whether that could trigger a bond bear market along the lines of the Great Bond Bear Market of 1994? We don t think so. Treasury Yields Probably on Their Way Up We ve discussed how 10-year Treasury yields remain at historically low levels and don t reflect current economic fundamentals. We believe rates will rise and numerous factors are helping support that case. But what about the sustainability of that trend? In order to determine the future direction of long-term interest rates, we ve looked at the following guideposts, taking to heart the Fed s forward guidance: Employment: Focusing on weekly jobless claims and monthly nonfarm payrolls, jobless claims have been consistently below 400k since Q4 2011 a level that is in line with monthly nonfarm payroll gains of 160k/month or more. That is what we have been averaging during the last 12 months. We believe if the trend continues and the employment-to-population ratio declines slightly, it would not be surprising to see the unemployment rate fall below 7% by Q4. Inflation: Monitoring the output gap, unemployment, capacity utilization, and scrutinizing any signs that the Fed s balance sheet may be generating inflation pressures, we are also keeping an eye out for any notable increase in money supply and money multiplier growth. While there remains enough spare capacity in the economy to keep a lid on inflation, inflation expectations can be fairly arbitrary. Strong asset price performance like equity and house prices, and better-thanexpected economic growth, could feed into inflation expectations. Why Now is Not Like 1994 The Fed tightened monetary policy in February 1994, triggering one of the worst bear markets in recent history, and investor concerns are that this might occur again. We do not foresee a repeat of 1994. Strong asset price performance like equity and house prices, and betterthan-expected economic growth, could feed into inflation expectations. Following the recession in 1991-92, the U.S. economy finally gathered momentum. There were signs of emerging inflationary pressures with the output gap closing rapidly, the unemployment rate approaching the non-accelerating inflation rate of unemployment (NAIRU) and capacity utilization at levels that generally led to bottlenecks. Given this economic and inflation backdrop, the Fed tightened monetary policy by 25 basis points (bps) in February. (Basis points are 1/100th of a percent.) The markets were caught off guard by the unexpected rate action and the severity of the rate hikes. In that year, the Fed tightened by 50bp twice and once, late in the cycle, hiked by 75bp. This sent 10-year yields surging higher by 239bp to 8.03% by Q4 1994. The results are also referred to as the Great Bond Market Massacre. 6
The overwhelming majority of the U.S. Treasury market is held by non-market sensitive investors, such as the Fed and global central banks, who are acutely aware that selling these U.S. Treasuries could have broad consequences. Investors are becoming concerned about a repeat of 1994, especially if 10-year yields remain at or sub-2% real yield. There are 3 key factors why we do not see a repeat of 1994. 1. Fed s Forward Guidance Unlike 1994, the Fed has emphasized more transparency and more clear communication. It believes that increased transparency makes monetary policy more effective. Following the December 2012 Federal Open Market Committee meeting, the Fed unveiled its forward guidance that stated the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee s 2 percent longer-run goal and longer-term inflation expectations continue to be well anchored. Though admittedly a mouthful, this should ensure that financial markets are not surprised when the Fed begins to tighten policy. Therefore, we believe 10-year yields should move higher in an orderly fashion. 2. Key Stakeholders The overwhelming majority of the U.S. Treasury market is held by non-market sensitive investors, such as the Fed and global central banks, who are acutely aware that selling these U.S. Treasuries could have broad consequences. These entities will be concerned that unloading their Treasury holdings could destabilize the global financial markets. Selling their Treasury assets could affect the bottom line and overall foreign exchange (FX) reserve management. In December 1993, the Fed and foreign central banks owned 3 of the Treasury market, but that figure has now ballooned to 64% as of September 2012 (the following table). As the holdings by these key stakeholders remain large, this should help cushion any potential selling of Treasuries by market sensitive investors. 3. Regulation The banking system came under immense pressure and scrutiny following the Great Financial Crisis in 2008. Policymakers implemented regulation to de-lever the banking sector. Most of the regulations forced banks to hold higher quality assets and that led to a growing share of their balance sheets in sovereign bonds. For many global banks, that led to Treasuries. According to a BiS survey (Bank for International Settlements), the Top 30 largest banks have increased their share of Treasuries as a percent of overall exposure from 12% in 2008, to 19% in 2012. This regulatory environment is not likely to change for the foreseeable future. In December 1993, the Fed and foreign central banks owned 3 of the Treasury market, but that figure has now ballooned to 64% as of September 2012. A Majority of The Treasury Market Is Held By Non-Market Sensitive Investors December 1993 September 2012 Foreign Investors 19% 49% Federal Reserve 11% 3 15% 64% Insurance companies & pensions 18% 1 Households 17% 7% Money market funds 2% 4% Mutual funds 5% 4% Banks 12% 3% Others 16% 8% Total 10 10 Source: Pioneer Investments, BofA Global Research 7
Beware Duration Risk If the economy continues to maintain its current recovery, and perhaps gain some momentum with unemployment maintaining its gradual descent, and inflation expectations remain near 2%, we think 10-year yields can be expected to rise gradually over the next few years. Bloomberg consensus expects the 10-year yield to rise to 2.64% by Q2 2014 (see chart). The Projected Gradual Ascent of Interest Rates 4.5% 4. 3.5% 3. 2.5% 2. 1.5% 1. 0.5% 0. Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 10-Year Treasury Yield 10-Year Treasury Yield (Forecast) Source: Bloomberg and Pioneer Investments. Last actual data point 3/29/2012. While we don t anticipate a bond bear market like 1994, we would caution investors to beware of duration risk. In a landmark speech on long-term rates, Fed Chairman Bernanke stated, long-term interest rates are expected to rise gradually over the next few years, rising to around 3% at the end of 2014. However, we do not expect a dramatic and destabilizing rise in long-term interest rates in 2013. As a result, we continue to expect continued strong performance in equities, high yield, and multi-sector bond funds. While we don t anticipate a bond bear market like 1994, we would caution investors to beware of duration risk. As we ve described, we foresee the mis-evaluation of long-term interest rates, and fundamentals are coming together to push yields higher. Interest rates do not have to back up much to create significant losses. To receive automatic notification of updates to this and other Pioneer thought leadership pieces, sign up at us.pioneerinvestments.com/enotify, or look for this icon on our website. Pioneer Investments 60 State Street, Boston, Massachusetts 2013 Pioneer Investments us.pioneerinvestments.com 26657-00-0413