The Case for Higher Real Rates

December 17, 2009 By Richard Berner & David Greenlaw | New York We think 10-year Treasury yields will jump to 5.5% by the end of 2010, driven primarily by a rise in real rates to 3% or more. That call is clearly inconsistent with the consensus view of modest growth and declining inflation, and it is light years away from the current level of real TIPS yields at 1.3%. Even those who agree with our somewhat upbeat view of sustainable growth and moderate inflation think that our rate call just does not jibe. We reiterate our rate forecast. Although we have outlined the factors behind our call over the past six months, investors are demanding and deserve more explanation. The purpose of this note is to elaborate on the framework and factors driving our call. In a nutshell, we think real rates are well below long-term norms. Over the next 12 months, unprecedented net saving shortfalls, a revival in investment, a less accommodative Fed, uncertainty about inflation and concerns about the sustainability of US fiscal policy will likely boost real rates significantly above those norms. Here we focus on the role of saving and investment. Long-term real risk-free rates tend to fluctuate around 3%. The framework for determining real rates varies with the time horizon, as different horizons change the emphasis on the factors involved. In the long run, and on average through the cycle, real rates should reflect returns on capital and potential real growth. Those who believe that returns on investment, productivity and potential growth have declined in recent years would argue that there should be a corresponding decline in real rates. We do not buy that story; productivity and potential growth are certainly lower than they were in the 1960s and in the late 1990s, but at about 2% and 2.5%, respectively, they are in line with the average of the last 60 years. Returns on capital declined as corporate overinvestment in the technology boom boosted capital-output ratios, and returns have declined cyclically in the recession. But to maintain profitability, Corporate America has slashed capital spending and boosted productivity; witness the 3.8% increase in labor productivity over the year ended in 3Q. Meanwhile, investors need compensation for taking on duration risk (e.g., the risk of holding a ten-year security as opposed to rolling over ten one-year instruments). Our colleague Jim Caron thinks that this ‘term premium' for risk in normal times should be at least half a percentage point or 50bp. Adding that to the 2.5% potential growth rate yields a 3% norm for real, risk-free yields. Thus, we think real, risk-free, long-term rates may fluctuate around that 3% norm, well above today's levels. But supply and demand can prevail in the short term. In the short-to-medium term, other factors can persistently drive real rates away from those long-term norms. In our view, the spectrum of real yields over a medium-term timeframe is determined by supplies of saving and demands for investment, or their financial counterparts, the supply and demand for credit. Of course, saving always equals investment ex post; the ex ante question is always at what price - what interest rate - will the market clear? Explaining today's rate levels is simple as pie. We find it easy to explain why real rates are exceptionally low despite record-low net national saving. First, the deepest recession since the Great Depression has clobbered investment across the board - in housing, corporate capital and inventories - and it is the excess of saving over investment that has driven rates down. In the corporate arena, the non-financial corporate financing gap (the difference between internally generated cash flows and corporate fixed and inventory investment) fell to a record low of -2.8% of non-financial corporate GDP in 3Q. Correspondingly, the demand for credit has plummeted to record lows. Second, on the supply side, the Fed designed its Large-Scale Asset Purchase programs (LSAPs) to take massive amounts of duration and convexity risk out of the fixed income markets. The LSAPs thus keep rates lower than they would otherwise be, inducing investors through portfolio balance effects to take on more risk. In our view, when investment rebounds, even modestly, the supply/demand balance driving real interest rates will change dramatically. Moreover, as the Fed ends the LSAPs early in 2010, duration and convexity will return to the fixed income markets, and portfolio balance effects will begin working in reverse to tighten the supply of credit. In the very short run, technical factors may be the primary catalyst for higher yields. For example, our colleague Jim Caron believes that sellers of high-strike interest rate insurance may have to sell bonds as rates go up - in a move akin to convexity hedging by mortgage investors and servicers (see 2010 Global Interest Rate Outlook: The World Is Uneven, November 30, 2009; and Asymmetric Risks Point To Higher Yields, Steeper Curve, December 10, 2009). Jim and team believe that those technical factors could push 10-year yields up quickly to 4.5%. In what follows, we present a review of the coming changes in saving-investment (im)balances that point to higher real yields. The end of quantitative easing and rising term premiums will further add to the pressure on yields. Slight rise in saving would still leave it close to record lows. Net national saving in relation to the size of the economy is a critical building block in our analysis. Fueled by rising wealth and easy credit, national saving has trended lower over the past 35 years - with the exception of the mid-1990s. Over the past year, while personal saving has risen significantly in response to the plunge in household net worth, ultra-aggressive fiscal stimulus and declines in national income relative to output took net national saving to a record-low -2.6% of GDP by 3Q09. Our analysis of the four sources of saving - personal, corporate, government and saving from abroad - indicates that net national saving will increase somewhat over the next year, but will only get back into positive territory in 2011. For the consumer, we believe that caution and modest wealth gains will push personal saving gradually higher. In our view, that will not result in consumer retrenchment; on the contrary, we think income will be growing rapidly enough to provide wherewithal for spending growth of roughly 2% in real terms, and to boost the saving rate by about a percentage point over the next year from 4.5% to 5.5% (representing about a US$120 billion increment to saving). That is consistent with employment gains of about 1%, a half-hour increase in the workweek, a rebound in property income (such as dividends), and further significant growth in unemployment insurance benefits, Cobra assistance and the second installment of the Making Work Pay tax credit. Corporate America will also contribute modestly to private saving, as stronger revenue gains will boost the top line and higher profit margins will boost the bottom line. In turn, companies are able to expand margins and exploit the operating leverage in their businesses because they have slashed capacity. For example, recent gains in production have lifted operating rates by some 250bp from their lows. We expect that much of the profit gain henceforth will be paid out in dividends rather than retained; dividends have plunged by a record 21% over the past two years. As a result, undistributed profits (the net corporate contribution to national saving) likely will decline as a share of GDP in 2010. Government dissaving is likely to decline somewhat through 2010, and inflows of saving from abroad probably will increase as the current account deficit widens. With regard to the US budget deficit, however, we would stress two points that represent a one-two punch for interest rates: First, Federal red ink will remain well above all past records for at least five years, and neither the Administration nor Congressional leaders have so far put forth any credible plan to reduce future deficits. Second, as discussed below, Treasury debt managers are making dramatic changes to the maturity of debt issuance, which will change the balance between supply and demand out the curve. We expect the Federal budget deficit to be about US$1.3 trillion in F2010 - a shade below the US$1.4 trillion gap seen in F2009. The slippage reflects a modest pick-up in tax revenue as the economy begins to grow and a pullback in outlays aimed at supporting the financial sector, which should more than offset an acceleration in stimulus spending tied to the American Recovery and Reinvestment Act that was enacted last February and other new measures (such as the expanded homebuyer tax credit and bonus depreciation changes). As a result, total government dissaving may decline slightly in the year ahead. But the real story in Treasury issuance is that the composition is shifting dramatically towards coupon securities as debt managers attempt to gradually boost the average maturity of the Treasury debt outstanding from its current level of about 4 years up to a range of 6-7 years. Gross coupon issuance - the best gauge of the supply burden confronting the market - likely will top US$2.5 trillion in the current fiscal year, up 40% from F2009. In fact, the increase in coupon issuance during the year ahead should be about equal to the amount of total issuance in a ‘normal' year (such as F2008). That step-up in supply, coming as the Fed concludes its Treasury buying program and as the Fed tapers its purchases of RMBS, constitutes a key source of uncertainty in our analysis. The overall data on government dissaving are not sufficient for us to gauge the impact on rates of large budget deficits and the Treasury issuance required to fund them. Inflows from global investors to increase again. Despite strong export gains, rising oil and other import prices likely will combine with rising imports and shrinking US surpluses on services and investment income to widen the nominal current account deficit. As represented by the GDP accounts, we estimate that the corresponding inflows from global investors will rise by about 0.6% of GDP to 4.2% over the four quarters of 2010, or by about US$110 billion. Yet that inflow won't likely come easily in today's context. Concerns about sovereign credit risk and fiscal sustainability imply that global investors will demand a concession to buy US debt. Although the US won't default on its debt, investors are always handicapping the risks of owning even the benchmarks for global sovereign credit. Ex ante, investment is poised to increase more than saving; higher rates required to clear market. At first blush, the increased saving that we expect may sound bullish for interest rates. What many fail to appreciate, however, is the extent to which investment outlays will rise over the course of the next year in spite of the rise in rates. Housing, of course, is credit-sensitive, but credit availability and collateral requirements are as important as interest rates. The fact that traditionally measured housing affordability has skyrocketed and yet housing is staging only a modest recovery from a record plunge speaks to the importance of credit availability. Our hunch is that improved availability in the coming year means that housing demand will improve even as rates rise. For Corporate America, there is a parallel story. Capital spending plunged in the recession to an unprecedented degree, and new investment is needed to rebuild capital stocks. The ‘accelerator' of rising output on a sustained basis and improved corporate cash flow will also drive capex higher. Moreover, empirical work suggests that corporate capital spending is relatively insensitive to changes in interest rates. Finally, we believe that companies will shift from a record 10 quarters of liquidation to accumulating inventories by year-end. Combined, this shift to sustainable growth in housing, business investment and inventories will result in a significant increase in private credit demand. The upshot is that the necessary balance between rising saving and rising net investment is unlikely to occur at today's interest rates. Finally, two other factors are expected to lift real interest rates. First is a repricing of the likely path for short-term interest rates. Currently, fed funds and eurodollar futures are pricing in a 90bp move up in rates by year-end 2010, and a cumulative move by year-end 2011 of about 200bp - less than what we expect through year-end 2010. As a result, we think the market has more repricing of the yield curve to do. Second, uncertainty over fiscal credibility and inflation will lift term premiums and likely add to the looming pressure on real yields.