The Wall Street consensus is that economic growth in the United States will firm in the second half of 2013 and finally reach “escape velocity” in 2014 following years of slow growth in the wake of the financial crisis.
This economic resurgence is expected to usher in a secular bull market for the U.S. dollar while continuing to propel the stock market to new all-time highs.
Meanwhile, bond yields are expected to rise as the Federal Reserve normalizes monetary policy in response to an improving economy, removing a large source of demand from the bond market.
Already, U.S. Treasuries have sold off substantially in response to the prospect that the Fed may begin to reduce the amount of bonds it purchases every month under its quantitative easing (QE) program as soon as its next FOMC meeting in mid-September, leaving the yield on the 10-year Treasury note at current levels around 2.87%.
Deutsche Bank strategist Makoto Yamashita departs from the consensus today in a note to clients, saying the sell-off that has gripped the Treasury market is likely over for now, the economy could go into cyclical decline after the Fed begins to taper back QE, and a further rise in stocks seems distant.
U.S. and European long-term yields are on an uptrend, with the curve steepening. However, we do not expect the [10-year U.S. Treasury] yield to sustain a rise above 3% because this would mean the market has factored in a normalization of the US economy. The [five-year/five-year] forward rate has already exceeded 4%, but a move beyond 5% would return it to levels before the financial crisis in 2008.
However, the world has changed since that time. Take inflation rates for example. The U.S. core PCE deflator, with a growth rate of below 1.5% [year over year], is unlikely to move sharply above growth of 2% necessary for monetary tightening.
Financial institutions’ balance sheets are also growing slowly, although this partly due to the low level of inflation. Growth in total assets held by U.S. commercial banks has recovered to 6% [year-over-year], but had risen to above 10% at times before the financial crisis. In addition, lending by European banks to the private sector continues to fall [year over year]. Regulatory officials worldwide have taken a stricter stance on risk taking by banks since the crisis. We do not believe inflation can be triggered in the current environment even if liquidity and balance sheet expansion by central banks leads to increased lending.
Investors are concerned about upcoming monetary tightening as the worldwide economy moves to a recovery. However, economic recoveries are partly cyclical in nature, so we see no guarantee that the economic recovery (tightening supply/demand gap) will be sustained at a level which necessitates a rate hike.
In other words, the Fed’s forward guidance for a rate hike when the unemployment rate reaches 6.5% will still be a long way off even if QE3 is tapered from September. We see the risk that the economy could enter a cyclical decline over that period. We believe a rise in both yields and stocks is distant.
The Treasury market got hit hard yesterday on the release of the minutes from the July FOMC meeting, which suggested that the Fed may be on track to announce a tapering of QE at the conclusion of the next FOMC meeting on September 19.
Selling overnight in Asia, sending the yield on the 10-year note to fresh new multi-year highs of 2.94%.
However, the bonds are rallying this morning, and the yield on the 10-year is now trading at 2.87%, down 2 basis points from yesterday’s close.