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Gauging the correct level of the 10-year Treasury yield

| February 8, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Determining the “correct” level of Treasury yields based on US and global economic data, and incorporating the current stance of monetary policy, can be menacingly complex. Luckily, financial markets tend to be much more inter-related and transparent. Evaluating changes in a few US and global financial indices over time can create a highly accurate forecast of the 10-year Treasury yield. Right now: the actual and projected 10-year Treasury yield are dead in-line.

Evaluating asset prices instead of economic data

The level of bond yields, foreign exchange rates and credit spreads – and how those change over time – can indicate where investors find value based on their economic outlook and expectations for monetary policy. Global markets have long been interconnected, and investors move capital between assets, and between countries, based on embedded expectations for return. Using price and yield movements in assets that tend to be highly correlated it’s possible to project changes in the 10-year Treasury yield. The model projections shown for the 10-year Treasury yield are based on the changes in the 10-year Bund, the EUR-USD exchange rate, investment grade and emerging market credit spreads. The media storm around the FOMC’s recent shift towards dovish-ness has contributed to the latest rally in the 10-year Treasury. Interestingly the model projections- which know nothing of forward guidance and data dependency – indicated that the 10-year yield was 10-20 bp too high through much of the fall, but the two converged as of the February 7th close at 2.66%, which was dead-on the model projected yield (see Exhibit 1).

Exhibit 1: Actual and model-projected 10-year Treasury yield (weekly data)

Source: Bloomberg, Amherst Pierpont Securities

It has long been known that changes in the yield of the 10-year Bund are positively correlated to changes in the 10-year Treasury. Trading strategies have been built around the strength of that relationship. Although that correlation is still quite strong, the spread between the two indices has diverged meaningfully over time, as the ECB set short-term rates below zero, and rates  of many sovereigns including Germany turned negative across much of the curve.

Exhibit 2: 10-year US Treasury versus 10-year Bund yields

Source: Bloomberg, Amherst Pierpont Securities

Fixed income versus equities

Despite a casual relationship between equity prices and Treasury yields, including equity market movements does not improve projections in this model. This is perhaps due to higher weekly frequency of the data where changes in fixed income to equity allocations are unlikely to be captured. Several US and European stock indices were included, but none proved to be statistically significant.

What to watch going forward

There is absolutely no statement or expectation that Treasury yields are driven by changes in these other asset prices and yields. The famous caution that “correlation does not imply causality” cannot be overemphasized. The point of considering the projections are more to evaluate if the level of Treasury yields seems reasonable in context of changes in assets across the overall market. Thanks to the latest rally, the answer to that is “yes”. Going forward things will undoubtedly drift, and it will be interesting to see if Europe’s dim economic outlook results in still-lower Treasury yields.

Technical note: Weekly data was used over the prior 7 years. The model was also run using 18 years of data – one year after introduction of the Euro – and results were similar but the amount of variance in Treasury yields explained by the model was 63%. That increased to 71% when the investment grade and emerging market credit indices were included, though that data is only available beginning in 2012.

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