Bond Yields Not Inflated Yet

Bond Yields Not Inflated Yet
July 17, 2008

By Manoj Pradhan | London


Notwithstanding the current financial turmoil, there is a disconnect in bond markets, and we think that bond yields are too low. Either bond markets are too bearish on growth or too sanguine about the inflation threat, or both. According to MS-FAYRE (our fundamental fair value model for US 10-year yields), and after accounting for the sizeable flight-to-quality bid for bonds, US bond markets seem to be pricing in either a very bullish outlook for the fed funds rate or an all-too-sanguine outlook for inflation. Even after a balanced testimony from Fed Chairman Bernanke, money markets are still pricing in 36bp of hikes by March 2009. Thus, we think that investors are not being compensated for the inflation risk. We have addressed this issue in the past (see “The Inflation Conundrum”, The Global Monetary Analyst, Joachim Fels and Manoj Pradhan, April 30, 2008), and our rates strategy team has long highlighted the fact that TIPS have not been a good inflation hedge. In this note, we quantify the extent of the mis-pricing.

First, what inflation risks should investors care about? Although we agree that the structural case for higher inflation (see “A New Inflation Regime”, The Global Monetary Analyst, Joachim Fels and Manoj Pradhan, March 5, 2008) is not a done deal, the uncertainty over the inflation outlook and the non-zero risk of inflation staying higher for longer mean that markets should be compensating investors for the risk of higher inflation and the higher inflation volatility that comes with it. Rising term premiums on both sides of the Atlantic underscore higher risks going forward. Our US teams expects growth of 1.5% in 2008 and 0.7% in 2009, but for headline inflation to stay at 4.6% and 3.5%, respectively, keeping the Fed on hold through 2Q09. Given the significant risks to growth, we believe that an on-hold Fed will not be able to actively tackle the inflation problem for a while now, strengthening the fundamental case for higher inflation risk compensation. However, the fundamental case for higher yields can be derailed by a worsening of systemic risks that would increase the flight-to-quality bid and lead yields lower.

MS-FAYRE puts fair value about 100bp above the current bond yield. Bond yields have risen smartly since mid-March, pulling breakeven inflation rates higher. At 3.8%, they are still well below our estimate of fair value. MS-FAYRE delivers a fundamental fair value estimate based on the long-run relationship between bond yields and three fundamental drivers – the level of the real fed funds rate (using year-on-year core PCE inflation as a deflator), one-year ahead CPI inflation expectations (from the Survey of Professional Forecasters) and inflation volatility (the 5-year rolling standard deviation of core PCE inflation). With the fed funds rate currently at 2%, core PCE inflation at 2.1% (which puts the real fed funds rate at -0.14%), 1-year ahead expected inflation at 2.7% and inflation volatility at 0.5%, fair value of 10-year yields is 4.9%, some 100bp above the current bond yield.

New kid in town – the flight-to-quality bid. MS-FAYRE does not account for the flight-to-quality bid but it does provide clues as to how large it might be. This is a crucial factor in the analysis of bond yields over the last year, given the price and volatility action in risky assets. Since the onset of the crisis, investors have flocked to safe securities in a bid to preserve capital, willingly giving up higher returns available on more risky assets. To get an estimate of the flight-to-quality bid, we look at the wedge between actual bond yields and our fundamental fair value from MS-FAYRE. Bond yields have been about an average of 100bp below our fair value estimate since the onset of the crisis. However, about half of this deviation is probably due to factors such as central bank purchases of Treasury securities and/or demand for duration from pension funds. These factors helped to keep bond yields below their fair value by an average of 54bp since 2004 – a situation famously dubbed as the bond yield ‘conundrum’ by Alan Greenspan. Thus, our rough estimate of the flight-to-quality bid for Treasuries is about 50bp.

What fundamental values will generate today’s bond yield? A natural benchmark for headline CPI inflation over 10-years is the median forecast from the Survey of Professional Forecasters of the Philadelphia Fed. This forecast has been quite steady at 2.5% throughout the last few years, including the crisis period since last July. In the long run, core inflation can’t be meaningfully different from headline inflation, and we set both equal to the 2.5% benchmark. Setting inflation volatility to 0.5% (its average since 2000) and the flight-to-quality bid to 50bp, the fed funds rate that deliver’s today’s bond yield is an astonishing 1.25% – 75bp below its current value and 110bp below the level money markets are pricing in for the Fed by March 2009. The mis-pricing clearly lies at the inflation end of things.

Another way to view the mis-pricing is to see what level of inflation would generate today’s bond yields if the fed funds rate were to go to neutral territory. Our latest estimate of the nominal neutral rate of interest is around 3.6%. To justify today’s bond yields, inflation would then have to come significantly lower to 2% with inflation variability equal to its average since 2000. Our US team expects the fed funds rate to reach this level only in 4Q09, which means that real rates are likely to spend most of the interim period in negative territory as the Fed focuses on getting the US out of the clutches of the crisis-induced slowdown. Given expansionary monetary policy both in the US and globally, global inflation risks (see “Emerging Inflation?” The Global Monetary Analyst, Global Economics Team, July 9, 2008) and our view that inflation may be structurally higher going ahead, bond markets seem to us to be too sanguine about inflation risks.

Macro fundamentals thus point to higher nominal yields and breakeven inflation. At present, nominal yields and therefore breakeven inflation (the difference between yields on nominal and inflation-protected bonds) are not reflecting the inflation risk. At 2.5%, 10-year breakevens are equal to the 10-year median forecast for headline CPI inflation – the index to which inflation-protected coupons and principal payments are tied. Breakeven inflation is supposed to compensate investors for not just expected inflation but also the volatility of inflation. A rise in nominal yields would lead breakeven inflation wider, providing fairer compensation for at least the risk of a higher and more volatile inflation regime.

Term premiums on the rise. Additional support for our thesis comes from rising term premiums on both sides of the Atlantic. That term premiums are rising when bond yields are below fair value underscores the mis-pricing in bond markets. The flight-to-quality bid has kept term premiums from asserting themselves, but a further ratcheting up of risk premiums to match both higher and more volatile inflation as well as the uncertain macro environment is on the cards. Bond yields will be supported from below on this measure. A similar story applies to European rates, though to a lesser extent than in the US, we suspect. With the ECB expected to hike its policy rate to 4.5% by year-end, and inflation above the ECB’s target and expected to stay elevated for the foreseeable future, rising term premiums should mean higher bond yields.

There are two risks to our story and macro outlook for bond yields. The flight-to-quality bid could actually be much higher than we estimate. The more obvious risk is that systemic risk intensifies and pushes bond yields lower on the back of an even stronger flight-to-quality bid. Given the historical performance of our fair value model, we are quite confident about the average size of the flight-to-quality bid, but it could indeed be higher if the factors that depressed bond yields since 2004 are now no longer as powerful. However, with the misery in risky assets spreading to emerging markets since January, it is unlikely that Treasury securities are being shunned. Finally, there have been other ‘conundrum’ periods in the past where bond yields have stayed below the fair value measured by MS-FAYRE. These deviations were corrected in past episodes by bond yields moving towards our fair value estimate – a pattern that we expect to be repeated.

It would be premature, to put it mildly, to say that the financial crisis cannot deepen. The events of last week surrounding the GSEs demonstrated this all too clearly. At least on that front, the rescue package put together by the Treasury and the Fed has alleviated systemic risks for the financial system (see The GSEs, Financial Conditions and the Fed, Dick Berner and David Greenlaw, July 14, 2008). The impact of this episode on the Treasury market is likely to be weaker than most assume, with financial conditions the most likely to suffer. Any significant worsening of market sentiment and/or systemic risk would be enough to overturn the macro story, however compelling it may be.