Global
The Term-Premium Case for Higher Yields
Jan 20, 2006

Richard Berner (New York) and David Miles (New York)

The US yield curve has continued to move towards inversion along its length, with short-term rates this week temporarily moving above 10-year yields for the first time since just before the recession of 2001, and the inversion of the Eurodollar curve between June 2006 and June 2007 grew to 20 bp.   But this inversion is different: Nominal and real yields are lower now than when the Fed started tightening in mid-2004, not just in the United States, but globally.  If the bond market isn’t signaling a recession or at least much weaker growth ahead, then what are the sources of this cyclical ‘conundrum,’ and what are its implications for growth and monetary policy?

In our view, a decline in the “term premium” to near zero has been the major factor holding yields down over the past 20 months.   We define the term premium as the excess of the yield on a longer dated (say, 10-year) note over the weighted average of expected short-term rates.   On average, it is the extra return an investor earns by holding a ten-year note instead of rolling over a sequence of short-term deposits to the same maturity.  In other words, the term premium compensates investors for the risks in holding the longer-duration security.  The sharp decline in distant-horizon forward rates (such as 9-year forward 1-year rates) relative to 10-year yields suggests that term premiums have declined. 

In the US, comparing surveys of expected future short-term rates with long-term rates points in the same direction.   For example, Brian Sack of Macroeconomic Advisers points out that longer-term expectations of the path of monetary policy have been relatively stable over the past few years, while 10-year yields have declined steadily.  Likewise, a variety of empirical models (augmented by survey data) that extract the change in the slope, level, and curvature of the yield curve suggest that it is a plunge in term premiums, and not a radically lower path for future monetary policy, that has depressed yields (see, for example, Don Kim and Jonathan Wright, "An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates," FEDS Paper 2005-33). 

None of this explains why term premiums have declined.  In our view, that decline reflects the Fed’s and other central banks’ unusually forward-looking guidance about monetary policy.  Other factors — such as swings in saving-investment balances, increased faith in central banks’ anti-inflation credibility and thus reduced inflation risks, the ‘Great Moderation’ implying reduced economic volatility, and incipient demand for long-duration debt by pension funds seeking to reduce asset-liability mismatches — may also have contributed to the decline in yields over a longer time frame.  But their recent, cyclical role has in, our view, been limited; instead, these are important secular forces, and none has changed much in the past two years.   We do expect that changes in pension accounting and funding rules will escalate future demand to satisfy pensions’ duration-matching needs, but so far, the increase has been small and slow in coming.

The idea that a recent surge in world savings has driven term premiums lower is, for example, not easily reconciled with the latest IMF data on estimated global savings rates.  The latest IMF estimates of the global saving-GDP ratio show the recent levels now slightly below the average since 1980, and they have barely increased in recent years.

Of course, it is possible that savings have nonetheless risen relative to the desire to invest globally.  But that seems more like an ex-post rationalization of falling yields rather than something for which there is independent evidence.  Indeed, the savings glut story is consistent with almost any movement in actual savings and in that sense something of an empty theory.  If world savings/investment is higher, the advocates can say it is because the supply of savings schedule has gone up relative to the demand for investment and driven real rates down.  If world savings/investment goes down, they can say it is because the investment demand curve has fallen relative to supply of savings, and this is why real rates go down.   In other words, whatever happens to actual levels of investment and saving is consistent with some version of the story.

What needs to be done to make the savings glut story really persuasive is to convincingly identify the world supply of saving and separately identify world demand for capital schedules and show that supply has moved up relative to demand.  But our judgment is that there is no clear evidence to support that.

Figuring out what has driven term premia and yields down is not just an academic exercise.   At issue is how much of the term premium compression is permanent and how much is temporary.  By promoting price stability, by damping macroeconomic volatility, and by increasing what officials call the “transparency” of their communication to the public, the Fed has contributed to the permanent decline in the term premium, we think (see “Risk Premiums and the Fed,” Global Economic Forum, July 25, 2005).  More scientifically, our rate strategy team confirms quantitatively and convincingly that Fed words and tactics in the current tightening cycle have been the primary factor behind an additional decline in the premium that may or may not last (see Graig Fantuzzi and Nilsson Kocher, “Resolving the Conundrum,” November 14, 2005).  By splitting a regression of the yield curve on the real Federal funds rate into two distinct sub-periods —1990-2003 and 2004 to the present — they show two very different patterns; using the results of the earlier period suggests that the curve from 2-year to 10-year yields would be substantially steeper.  The Fed’s language clearly telegraphed the pace of monetary tightening, and with ambiguity over pace gone, investors could profitably reach for yield. 

Further parsing the term premium into nominal and real components, as have Kim and Wright, suggests that two-thirds of the decline in the term premium over the period since June 2004 has been real and only 30 basis points has reflected a decline in inflation premiums.  We’d be the first to admit that this evidence is highly tentative, as have the authors.  But pricing in the TIPS market approximately backs up that conclusion, unless one concludes that the market is seriously mispriced; ten-year break-even inflation is running about 230-250 bp, while US real yields stand at 2% and in the UK they are at 1%.  If inflation risks have indeed dropped significantly, the cost of inflation insurance should be lower and TIPS yields should be significantly higher than they are.   In fact, yields on inflation-proof bonds have fallen by roughly as much as, if not more than, yields on conventional bonds in most of the major markets.

In both the US and the UK, nominal bond yields on long dated conventional government bonds have fallen fairly substantially over the past three years or so.   In the US, long dated Treasuries now yield about 4.5%.   The average over 2002 was a bit under 5.5%.   In the UK, long dated conventional bonds yield a little under 4% now and were at around 4.75% in 2002 (on average).  In both countries, the fall in (real) yields on long dated inflation-proof bonds over this period has been greater than the fall in long dated conventional yields.  

So the gap between nominal and real yields over this period -— which is some combination of expected inflation plus an inflation-risk premium — has in both countries increased.   This makes the story that the fall in long yields is largely driven by much lower expected inflation and inflation volatility a bit hard to swallow.  Another way to put this is to say that the data suggest that the fall in nominal yields is roughly accounted for by a fall in real yields, leaving limited room for the inflation factors to play a role.   Falling real yields on inflation-proof French debt tell the same story.

Yields on long dated TIPS and French OATiS have come down from about 3.5% in 2001 and the first part of 2002 to about 2.5% in 2004 and to about 2% now (and a bit below that for OATiS).   That's a fall of around 1.5% over the period since early 2002.  Real yields on long-dated index-linked gilts over same period also fell by about 1.5% (from about 2.5 to under 1%).  So the decline in real yields is comparable across these markets and in all cases is more than the fall in yields on conventional (nominal) bonds.

For market participants, this seemingly theoretical debate about the sources of lower yields is actually of critical importance.   Those temporary factors compressing term premiums may be ending.  Now that monetary policy is completely dependent on the inflation and growth outlook, and thus is inherently less certain, term premiums and long-term yields are likely to rise.  Indeed, there is an ironic twist in the yield curve debate.  Many fear that the flattening in the US yield curve is an omen of much slower US and thus global growth or even recession.  They point to the tendency of the Fed to overdo tightening, the yield curve’s business-cycle forecasting prowess, the asset-driven nature of the US consumer, and evidence of a housing slowdown (see “Debating the Yield Curve,” Global Economic Forum, November 23, 2005). 

But if a declining term premium — rather than the weighted sum of expected future changes in short-term interest rates — has recently contributed both to lower long-term yields and to a flatter yield curve, both imply faster, not slower, future growth, exactly the opposite of the traditional interpretation.   And if the term premium has declined permanently for whatever reason, making the current structure of interest rates more stimulative than otherwise, then the Fed will have to raise short-term rates by more than otherwise to achieve its goals (see “Yield Curve Angst,” Investment Perspectives, November 23, 2005). 

Despite our confidence about the validity of each of these assertions, recent experience of being wrong about yields has made us humble about the risks to this call.  Among them: Secular disinflationary forces may overwhelm the cyclical factors boosting inflation.  Term premiums may stay low for some time, reflecting the Fed’s measured approach.

But investors would do well to be mindful of risks in the other direction.  A weaker dollar and the elimination of slack in the economy could combine to push inflation up more rapidly.  Term premiums could unwind as rapidly as they have declined.  And for market participants, three years of crying wolf about yields has bred market complacency about upside risks to interest rates.

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Euroland
Stabilization or Acceleration?
Jan 20, 2006

Eric Chaney (New York) and Javier Rodriguez (London)

While we are still awaiting last quarter GDP releases, next week’s business surveys will give us a hint on the pace of the recovery in the euro area.  After the November soft patch, last month readings pointed to a re-acceleration of growth as summarized by the jump of our Surprise Gap Index above the acceleration threshold.  Behind the improvement in business sentiment since last summer, a steady acceleration in demand trends has made companies more ready to bet on the future.  However, Christmas sales were still unknown when companies answered the last crop of manufacturing surveys.  Since then, they know better and that makes the January surveys all the more important.

Positive signs from consumers

On the consumer side, the demand recovery has rather been timid so far.  Only the traditional suspects, that is, French and Spanish consumers have shown some signs of life.  However, consumer surveys are getting more and more positive: in the EU Commission version of the national surveys, consumer confidence has steadily improved since last summer and moved above long-term average in December for the first time in three year.  Jobs, not wages, probably explain the consumer sentiment recovery: the unemployment rate fell to 8.3% in November, half a percentage point below its end of 2004.  Overall, we expect consumer spending to have accelerated across the euro area, and to have reinforced companies’ expectations.

And from capex plans

Corporate spending should also drive domestic demand.   Since the burst of the ICT bubble, European companies have repaired their balance sheets, helped by a friendly monetary policy, and restored their profit margins, helped by wage moderation.  With final demand improving, all stars are progressively aligning for a capex decent recovery.  This is indeed the main conclusion from our European Analysts Survey in early January (See “Capex Recovery Confirmed”, Weekly International Briefing, January 15, 2006).  Since the traditional business surveys we watch to build our business cycle assessment are reporting an assessment on capital goods production still one-third below its peak level of 2000, there is significant room for improvement. 

The shadow of the oil threat

The August-September oil products spike did not derail business confidence.   Although the recent rise in crude and product prices is much smaller, we cannot exclude that, at some point, not only the rise but also the level of prices may seriously hurt business expectations.  Much more than the 25bp rate hike by the ECB December, an oil supply disruption triggered by political events (Iran, Nigeria), or even the fear of such event, is the main risk factor for the European recovery, we believe. 

To read Ifo-Insee-Isae tea leaves, watch our Compass

Reflecting these various factors, next week business surveys should stabilize on average in the euro area.   At the country level, we might get a slightly different picture: Having spearheaded the rebound, the German Ifo index should stabilize at 99.5 after reaching its highest level since 2000, we think, risks being probably on the upside.  We also expect the Isae index, whose recent rally is difficult to reconcile with disappointing production numbers, to rally.  On the other hand, we expect the Insee synthetic index to rise, as suggested by the jump of the Insee reversal indicator in December.  In smaller countries such as the Netherlands and Belgium, which are highly sensitive to demand from their bigger neighbors, we expect headline indicators to improve, after positive signs from demand indicators in previous surveys. 

At this stage, our survey-based quantitative indicators are discounting a slight acceleration in GDP growth in early 2006, from 0.5%Q in the last period of last year to 0.6% in the current quarter.  Next week surveys will give a more reliable verdict on the acceleration thesis that European equity markets seem to have underwritten.  Will our Business Cycle Compass move in the “Strong and Accelerating” zone?  We will give you the answer on January 26.

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Japan
A Step Toward Inflation Targeting
Jan 20, 2006

Robert Alan Feldman (Hong Kong)

What’s New

The debate about the new CPI has widened from a question of Bank of Japan credibility to one of inflation targeting.

Conclusion

With some strings attached, the improvements of the CPI scheduled for this August should be sufficient to convince the Bank of Japan that index quality is no longer a barrier to the introduction of inflation targeting. The strings are (1) a government commitment to continue improvements in the CPI and (2) allocation of budget to implement the improvements.

Market Implications

Higher likelihood of inflation targeting should contribute to a steeper yield curve and improved expectations of sustained economic growth. Thus, the floor under the equity market should be stronger, and the ceiling on bond yields thicker.

Risks

The debate over CPI quality could become politicized.

Attention should grow to the revision of Japan’s consumer price index (CPI) coming this August. One reason is the importance of the indicator for monetary policy. However, most investors are missing another key point. The revision has an even larger meaning, since it will also be critical in the debate about inflation targeting.

The CPI Revision and the Inflation Rate

Most investors view the CPI revision as a risk factor for the credibility of the Bank of Japan (BoJ). The final effect of the CPI revision on the year-to-year change of the CPI excluding fresh food (CPIxFF) is more important than revisions of the index in earlier years. The added importance derives from the BoJ’s use of the CPIxFF as its key trigger for when to end the quantitative easing policy, which has been in place since March 2001. A year-to-year CPIxFF change that is stably above zero is the mantra that the BoJ has used as the trigger for policy change.

When the trigger was introduced along with the quantitative easing policy, the index was up to date. With weights for the year 2000, there was no particular problem from the Laspeyres bias in the index. Five years later, in 2005, however, the bias is likely to be quite large. Indeed, to correct such index biases, Japan has revised its CPI every five years, far more frequently than some other countries revise their indices. (For example, as my colleague Dick Berner points out, the employment cost index in the US is based on the employment structure of 1990 — quite out of date in light of changes in the US job market.)

The problem will come if the reading on inflation with the new weights differs significantly from the reading with the old weights. Since the BoJ has a single point target — that is, zero — for the CPIxFF inflation rate, then any significant revision could cause trouble. For example, if the BoJ were to end quantitative easing because the old CPIxFF exceeded zero for a few months, but the revisions then put the new index below zero, then BoJ critics would undoubtedly use the difference to skewer the BoJ for premature tightening. With the political atmosphere over monetary policy somewhat tense in light of recent statements from senior officials, any renewed dispute could unsettle markets. Since estimates of the effect of the revision on the measured inflation rate range from a downward move of between 0.2% and 0.4%, such an outcome is a real possibility.

The New CPI and Inflation Targeting

Of even greater importance is the effect of the new CPI on the inflation targeting debate. Among the objections to the introduction of inflation targeting has been the various inaccuracies of the CPI. Should the revisions be sufficient to correct or at least reduce some of the biases, then inflation targeting could be easier to adopt.

Some of the changes to the CPI will be trivial, and others significant. Even more important, however, will be some of the auxiliary indices, which other biases.

The changes of product composition will bring the index up to date. For example, canned peaches will be out, and doughnuts will be in. More important, video tape recorders will be out, and DVD players will be in. In general, the weight of new electronics products such as mobile phones and flat-screen TVs will rise at the expense of food, clothing, and obsolete household machinery (such as single function word processors, sewing machines, leg-warmer tables).

Among the auxiliary indices, two are particularly important. One will be the monthly announcement of a chain-weighted CPI. Heretofore, a chain-weighted index has been constructed, but only announced once per year. Now, with the up-to-date chain weighted index, it will be easy to track the distortion from the standard weighting scheme. In addition, an index based on the consumption of all households (instead of only households with two or more persons) will also be announced monthly, and allow an estimate of this distortion. Separately, some recently introduced subcategory indices will be continued, such as a subcategory for energy. This will make possible an ongoing look at the total index excluding food and energy, an index comparable to that often used in the United States.

Unfortunately, some things about the index will not change. The focus on a single store per observation district will not change. Major changes will not occur in the practice of using one brand per product or in rules for treatment of discounted prices. Nor will there be a major change in quality adjustment procedures — which some experts believe is the most significant distortion in the index. Finally, there are no plans to calculate geometric indices, which track prices better than either the arithmetic indices used for the standard CPI or the harmonic indices used for the GDP deflator.

Thus, the new CPI will be a better index than the old one, and will be supported but important new auxiliary indices. Whether these improvements are sufficient to change opinions about the advisability of numerical inflation targeting is a judgment that the BoJ and the government together will have to make. My view is that the government will say yes, with the proviso that progress on some of the remaining problems in the CPI be addressed on a specific time schedule. This approach would gain credibility with investors only if the very sparse resources available to the statistical authorities for gathering the CPI are augmented by government order. If commitments to CPI improvements are made and resources provided to implement those improvements, then the BoJ is likely to agree that the quality of the CPI is no longer a barrier to inflation targeting.

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Japan
Remaining Upbeat
Jan 20, 2006

Takehiro Sato (New York)

During our trip to New York to attend the annual Macrovision conference, the Tokyo market was jolted by an accounting scandal at an Internet company. The sharp decline in Japanese stock prices had a global impact along with the weaker-than-expected earnings of high-tech firms. This event presented an early crisis for a key component of our forecast that the “golden combination” would continue again this year. Investor questions focused entirely on the potential impact. However, the underlying scandal does not reverse our scenario and we maintain our constructive stance toward Japan’s asset markets.

First, the scandal is unrelated to the basic economic fundamentals. Consumption and capital investment environments are unprecedentedly healthy, and we expect Oct-Dec GDP data released next month to considerably exceed our existing estimate (+2.5% annualized) with special factors such as a seasonal lift for the consumption of winter items from cold weather and a retracement of real imports. Now Japan’s F2005 real GDP growth is not only within reach of 3%, but also it is increasingly headed toward beating this level. Meanwhile, prices remain under control despite robust growth of around 3% with help from a quiet productivity revolution. We anticipate a fairly high 0.4-0.5% YoY rise for the core CPI rate in Jan-Mar quarter due to a sharp rise in energy prices, but the momentum of non-energy prices is likely to stay slightly negative to flat. Investors in Japanese equities looking for an end to deflation-type of story might be somewhat disappointed by this stable price outlook. Yet it is possible to have expansion of the consumption pie with a shift to luxury products and higher purchase prices from a change in consumer preferences and a stable prices level at the same time. This apparent contradiction stems from the presence of quality adjustments in prices statistics. We think improved productivity in public and services sectors is also contributing to prices stability. There is no immediate risk of monetary tightening when rising productivity is responsible for performance disparity between the brisk economy and the stable prices. These are excellent conditions for asset markets.   

Second, we expect the lessons from this scandal to enhance the quality of the Japanese stock market gain. Recent rallies have included undisciplined run-ups for stocks with comparatively weak financial standing and profitability alongside of high-quality stocks amid fierce expansion of trading volume from rotating intra-day transactions by individual investors. However, we think this incident has altered investors to the importance of compliance and proper disclosure. Although the stock market’s upward pace might slow somewhat, we are even relieved by the correction to a more suitable level from the overshooting territory. Going ahead, we hope to see rallies that are aligned to improvements in corporate profits. As for this, we have an out of consensus view, looking for more than 20% growth in recurring profit for F2006. We base this stance on the switch in the nominal-real trend reversal for GDP growth rate at a higher level than the government’s economic outlook in F2006, which implies the acceleration of the nominal GDP growth enhances faster top-line growth. As a matter of fact, TOPIX at the year-start level of 1,700 can only be justified through such a bullish profit forecast, without the extension of the valuation. We hence do not anticipate a rapid rally similar to last year, and the market is likely to show steadier and healthier gain, with the potential for lower risk premium reflecting healthier general economic conditions. We think the scandal has increased the probability of this scenario.

The Nikkei 225 had broken through the neckline of a massive reverse head-and-shoulder pattern for the past five years in summer 2005 and traded near our ¥16,500 target level early in 2006, which is the target from the technical perspective as well. The market’s quick arrival at our 2006 targets frankly was a problem for our outlook, and this setback has provided some breathing room. We should stay sharp, however. We expect liquidity-driven momentum to continue on a global scale in both stock and bond markets with a recycling effect from excess savings in emerging countries fueled by higher energy and materials prices. Also the Japanese market has a surprising track record of rapid recovery from recent dips on the scale of a few hundred yen, setting new highs just a few days later. We think the market will remain firm with risk still on the upside. Investors should also continue to taking constructive approach toward Japan over the medium term.

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