- US real rates are negative all the way out to 10 years. Without deflation this is not a sustainable situation.
- QE will not continue forever and the US economy is turning a corner for the better
- Fed policy is transparent and guidelines have been give when QE will be reduced or eliminated - it is the additional purchases that matter not just the stock of money supply
- Equities are increasingly a more attractive investment opportunity with higher yields and returns. Expect 10-year rates to be 2.5% by end of year and to rise further afterwards
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Due to massive amounts of QE the yields in the USA have been suppressed to their current levels with 10-year yields trading at 1.82% and 30 year yields trading at 3.06%. This is, in our opinion, unsustainable, as current inflation rates in the USA are around 2% and current GDP growth around 2-2.5%. With these statistics based on historic norms we should be seeing yields trading at around 4.5% in the 10-year region and even higher further out. As a rule of thumb we see 10 year yields in high credit worthy countries at roughly inflation plus the economic growth rate.
Looking at some historical charts of the long term interest rates back to 1790 we only see one period where rates have been this low: the period between 1940 and 1950. For those interested the lows over this entire time was around 2% for long end rates in the USA while the highs have reached above 14%.
There are a number of reasons why over the next 12-18 months we do believe yields in the USA to appreciate noticably.
1.) Tail risks are being priced out of the market as we have mentioned in previous reports and with it investors are increasingly looking at additional sources of income, rather than just capital protection. This is a slow process but is underway
2.) World economic growth is at a turning point for the better especially fuelled by the USA and Asia, while the worst for Europe in our opinion is increasingly priced in (though we do expect a world economic slowdown in Q2 and a pick up in the second half of the year).
3.) Lower commodity prices (see our previous reports) overall will assist in world economic growth to pick-up further over the next 12 months
4.) The Fed has clearly stated what their QE programme depends on i.e. the underlying economic development in the USA and their reflection in the unemployment rate
5.) Real interest rates all the way out for 10 years are negative and outside of the Fed and fearful investors, who will want to own bonds if economies do improve?
6.) More than 60% of equities are yielding more than the 10 year US Treasuries and are becoming more attractive as input prices are diminishing and revenues beginning to pick up in line with economic growth. The normalisation of risk perception is also noticable in the equities market in the USA where the highest performances have been witnessed in high dividend paying stocks. The next step of normalisation will be when growth stocks begin to outperform.
7.) The USA is growing and equity markets are rallying despite the fiscal drag forced upon the economy in 2013. This drag will be reduced in the second half and have less and less impact in 2014. If the US economy and its equity markets can show this performance with the fiscal drag, how good can it get without.
Finally, there is last point to mention that we do not subscribe to in the short-term but it could become an issue in the longer term, and that is the potential for inflation picking up - once the transmission mechanism begins working fully and economies are steaming ahead. Though we may not see much evidence of this but if expectations change the 10-year and 30-year areas of the interest rate curve is where it would get priced into..."There is treasure in them Treasuries". Aye.
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