Bond Yields, Inflation, and More

It all seems so reasonable. 
US Treasury yields have fallen around 50 bp since the March rate hike.  Market-based measures of inflation, like the
10-year breakeven and the five-year/five years
forward, have fallen around 35 bp over the same period.  That is to say
that the decline in market-based measures of inflation expectations can account
for nearly three-quarters of the decline
in nominal yields. 

It begs the question, why these inflation expectations have fallen. 
Commodity prices in general, and oil prices, in
particular,
have fallen, and this coincides with a decline in inflation
expectations. 

While this is clearly part of the
story, many narratives are stopping at this point. 
  It is
fundamentally incomplete. 

Let’s begin with the basics.  The nominal yield is a function of
a real yield and a premium.  In many high
income countries, that premium is thought to be inflation.  The
conventional narrative uses market-based measures of inflation expectations.
There are some problems with the market-based measures.

One widely recognized problem is that there is a difference in liquidity
between conventional bonds and inflation-protected securities. 
This lends itself to breakevens falling an
environment when bonds are rallying, increasing breakevens when bonds are being sold

There are survey-based measures of inflation as well.  These are
considerably more stable than market-based measures.
  There are two
surveys that have been cited by officials.  The first, and arguably the
more important, is the survey the Fed conducts itself, the Survey of
Professional Forecasters.  In May 2016, the average (2016-2020) was 2.1%
and the 2.3% for a longer period (2016-2025).  Last month’s survey
resulted in an average of 2.35% and 2.30% (2017-2021 and 2017-2026
respectively. 

The other survey is the University of Michigan’s consumer sentiment
survey. 
The 5-10 year expectation was at 2.6% in June 2016.  The
preliminary estimate for June 2017 was reported
last week.  It was also at 2.6%.  The final estimate will be reported next week (June 30). Taken together and individually, the surveys
suggest inflation expectations are considerably more stable than the
market-based measures. 

The surveys encourage us not to be completely satisfied with the
conventional narrative.  It is missing something:  Demand.

 There are at least five sources of demand that a robust explanation
would address. 
First, the post-crisis regulatory environment
(national as well as international) requires large financial institutions to
bolster their core capital.  Government bonds meet the need.  Second,
the central bank continues to buy bonds as it recycles the proceeds from
maturing issues. 

We reckon that in September, provided there are no new shocks, the Fed
will announce that starting in October, it will begin refraining from fully
recycling the maturing funds, but this will be a very gradual process. 

The Fed has not announced the size of the balance sheet it will target. 
Many suspect it something closer to half its current size may be
appropriate. 

Third, there is a demand for US debt instruments by foreign investors
trying to escape the negative or low yields available in their domestic
market.  
In the middle of the noughts, as the Fed under
Greenspan was raising the Fed funds target, long-term rates fell.  This was dubbed the Greenspan Conundrum.  It was not such an outlier as commonly claimed. 
In any event, a Governor at the time, none other than Bernanke, provided what
arguably was the most robust explanation of the time. 

He suggested that developing Asian countries, many of whom began running
current account surpluses after the 1997-1998 financial crisis.
  Their
capital markets were underdeveloped and
could not absorb the local savings.  Instead,
the savings were exported to the
US.  Bernanke’s explanation had a role for OPEC
and recognized a demographic function.    Bernanke’s broad
narrative still seems to be intact, but the players have changed. 

Fourth, although the Federal Reserve has raised interest rates four times
since late 2015, and three times since the US election last November, the
higher rates have not been passed to consumers
.   In order to secure a better return, it appears
that retail investors have moved into high-quality
bond funds as an alternative to cash. 

The fifth factor is not operational yet, but it is something that is
another potential source of demand. 
Earlier this month, the US Treasury
recommended revisions to financial regulation including some adjustment to the
supplemental leverage ratio (SLR), which is one of the metric regulators look
at in the US (and the UK).  In
particular, the recommendation is that holdings of US Treasuries, cash being
held by the central bank, and the initial
margin requirements for centrally cleared derivatives should be excluded from
the calculation of the SLR. 

The Bank of England has taken similar measures but have not excluded
Gilts from its SLR calculation.
  This
would be a US innovation.  It effectively cuts the cost of funding US
Treasuries significantly and would
increase the capacity of bank balance sheets.    The lower cost
funding would make US Treasuries more appealing for US financial institutions. 

Sometimes lowering funding costs can offset other constraints of to make
an asset look attractive.  Remember in Q4 last year; the cross currency swap basis made it very cheap for dollar
holders to swap for yen and buy a short-term Japanese debt instrument.
 
By securing very cheap funding, they were able to buy negative yielding
instruments and earn a better return that was available in the Treasury market
itself. 

In broad strokes, we have painted a picture that builds on what we argue
is an incomplete conventional narrative that seeks to explain the drop in
nominal yields as a decline in inflation expectations. 
We suggest
that the market-based measures of inflation
expectations may be compromised by liquidity differentials

Survey-based measures are considerably more stable.  The conventional
narrative does not integrate the strong demand for US Treasuries from both
domestic and international sources.  It stems from regulatory issues,
competitive considerations, the lack of pass-through of Fed rate hikes to
higher interest rates on household savings.

Disclaimer

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