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Want to guess the right Ten-Year rate?

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The Days Ahead: Big earnings week and Fed meeting.

Volumes were quiet this week. Some of that is seasonal, some because of the communication blackout ahead of the Fed meeting next week…but above all it’s the lack of a theme. We all know i) the weakness of the hard data ii) two big central banks in Europe and Japan saying “no change” to monetary policy iii) strong bond markets and iv) still no change on the inflation front. ECB President Draghi sounded bored as he said for the umpteenth time that inflation was well below what they want.

How low are volumes? Well, the S&P 500 trades around 3bn shares a day and last week it was about 2bn. We look at SPY, which is the biggest ETF tracking the S&P 500. It has massive turnover, as much as 25% a day (yes!). It regularly accounts for 11% of all market volume, even though it's around 1% of the market cap. Right now it’s trading about half its normal volume. So the thing to remember about these markets is that it doesn't take much to knock it back 3% or more if someone wants to make a bearish trade. We haven’t seen a meaningful correction for a while but our guess is that it would little to cause a classic summer tantrum.

On the politics, we’ll leave it to more knowledgeable and seasoned commentators. We’re reminded of the old Prussian definitions of officer class. We'll leave it to you to fill in the quadrant but we suspect we’re not in the top right corner.

1. So what’s the correct 10-Year Treasury rate?
What answer do you want? We can take inflation, add a bit, and send it back for 10, 20, 50 or 70 years. That will give five very different answers. We can take the Fed Funds rate and add a normal curve steepening. That will give another dozen or so answers. We can take the yield on stocks and subtract an average ten year rate and run that back too. And so on. Even the rules based approaches (here’s the most famous one) throw up inconsistent numbers because there are two huge guesses in the formulas: the neutral interest rate and the output gap.

One proxy is the change in the Nominal GDP and the spread over 10-Year Treasuries. Here it is:

So, lots of high nominal growth in the 1970s but that was in a time of 11% inflation. Rates were thus high and well above the rate of nominal GDP growth. The average gap over nearly 60 years is 30bps suggesting the 10-Year Treasuries should be 3.8% not 2.23%. But wait, the average 30 years would mean 3.6% and over five years it should be 2.6%. But if we use high inflation periods it should be negative 4%. See the problem? (h/t David Ader at Informa)

Anyway, we’d start by stating the obvious that we’re in a slow growth world of around 4% Nominal GDP and that a spread of around 70bps puts you at 3%. But then again we’re digging out of a deep recession. So make it 120bps and we’re about right at current levels. Next time someone pundits on the “normalization” of rates, feel free to show them this and let us know.

2. Is the debt ceiling going to be a problem?
Mark your calendars because around September, the Treasury will not have further authority to issue new bonds. Treasury receipts in the last quarter were around $1,033bn or $42bn greater than this time last year. That puts them in a slightly better position to pay bondholders, especially if the momentum on receipts continues through the summer. One Treasury official admitted that they're “brushing up on options in the crazy drawer”, which includes things like writing IOUs to other government agencies (which are the biggest holders of Treasury securities). This year the debt ceiling collides with the expiry of the current budget resolution so we’ll be looking at a very cautious period for bonds.

Currently, the market seems unfazed. Here's the Ten-Year Treasuries and 3-month T-bill spread:

We would expect that line to head down more if there is a fear of any technical default. Investors would bid up short rates to compensate for a late or (heaven forbid) missed coupon on a longer-dated bond. Anyway, watch this space. In other games of chance, let’s play catch with a beaker of nitroglycerine…

3. The dollar’s getting hit:
Good for international investments, at least in the short-term and possibly good for large-cap stocks with their overseas earnings. Most of the recent move is because of renewed confidence in the euro. But it also seems to be a sign of concern for the dollar and some technical market shortages. Big move though:

Bottom Line:
A good earnings week. Some 20% of companies reported earnings up 7.2% and 77% of those have beaten revenue expectations. So the S&P 500 and NASDAQ both reached record highs. Emerging Markets are up around 22% this year and had another good week. To a euro investor, they’re up 11%, which gives some idea of the currency effect.

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