- Compared to the market consensus, our views have been more negative on three key duration fundamentals.
- Following recent remarks by Fed Chair Janet Yellen, we are now less confident about how to read Yellen’s policy strategy.
- We are still expecting higher rates; however, we now have less conviction that 3-5yr Treasuries will continue to underperform on the curve.
For the last couple of months we have argued that portfolios should remain underweight duration and be especially cautious about the 3-5yr part of the curve. Broadly speaking this view remains intact, and we still expect Treasury yields to rise meaningfully over the coming months. However, we now have less conviction that 3-5yr Treasuries will continue to underperform on the curve.
Compared to the market consensus, our views have been more negative on three key duration fundamentals:
1. The amount of slack in the U.S. economy
2. The credibility of the Fed’s forward guidance (the “dots”)
3. The willingness of Fed officials to overshoot their inflation and financial stability “targets”
Taking each of these issues in turn:
Slack: Today’s employment report was most notable for favorable supply-side news: although employment showed solid gains, measures of slack were unchanged or worsened. The labor force participation rate ticked up, and is now four tenths above its level in December. Average hourly earnings growth also slipped to 2.1% year-over-year. However, we would caution against reading too much into a single jobs report. Based on demographic trends, we estimate that “breakeven” payroll growth—the amount needed to lower the unemployment rate—is around 75-100k per month. If job growth continues around 200k per month, it’s very likely the unemployment rate will keep falling.
More importantly, the bigger issue is not the month-to-month details but the amount of labor market slack in general. Few serious observers think the U.S. economy is running at full capacity—the unemployment rate is still 6.7% after all. The disconnect is that slack in the economy looks on par with a typical recession, but monetary policy is calibrated for something much worse. At this point we do not see that much ambiguity in the data around this issue (see some of our research here), so our views have not changed after today’s report. Shrinking slack is likely to keep questions about the Fed’s exit on the front burner for bond investors all year.
Forward guidance: We continue to be struck by the confidence investors place in the Fed’s own forecasts for the federal funds rate (these are the so-called “dots”, named after the chart the FOMC publishes showing the forecasts, below). The focus on these forecasts has not seemed to change despite meaningful revisions at the last FOMC meeting. As we have explained before (see here), the credibility of the Fed’s guidance beyond 2014 should be considered low, and should not alone be used to value the front-end of the yield curve, in our view. All else equal this would imply higher front-end rates—especially when combined with modest slack. Our views on this topic also remain unchanged.
Overshooting: Where we have been persuaded by recent events is around the tolerance to risk overshooting. Our view had been that when faced with the realities of the exit strategy—some of which are related to political economy considerations—Fed officials would turn more conservative about the costs of overshooting the inflation target and/or letting credit markets run too hot. These questions have important implications for both the level of rates and the shape of the yield curve.
The statement and the press conference from the last FOMC meeting seemed to support our view. Although the committee said that the funds rate would remain abnormally low even after unemployment and inflation normalized, the stated explanation was not intentionally going “lower for longer”, but rather “headwinds” restraining growth (background here). This is a more cautious story, and one that’s easier to revise as broader financial conditions or other growth drivers change.
Janet Yellen’s speech on Monday has tipped our views at least partly in the other direction. Yellen is a dovish central banker (see here), but this had not really shown through in her first few appearances as Fed Chair. Monday’s remarks were exceptionally dovish, in our view, and in some ways could be viewed as a return to form. Besides the personal anecdotes in the speech, the lines that jumped to us were:
“In some ways, the job market is tougher now than in any recession.”
And, in her discussion of the decline in labor force participation:
“some ‘retirements’ are not voluntary, and some of these workers may rejoin the labor force in a stronger economy. Participation rates have been falling broadly for workers of different ages, including many in the prime of their working lives.”
These comments suggest Yellen’s own read on labor market slack is very different than our own (the latter comment especially, because it takes an unusual stance on the retirement question, and ignores trends in disability and other structural factors depressing prime-age participation). They are more reminiscent of research (here and here) that argues the Fed should overstimulate in an effort to boost potential growth. Indeed, Monday’s remarks perhaps hint that the “headwinds” story should be read as a committee compromise rather than Yellen’s own view.
In summary, our views on two of these three duration fundamentals—the degree of slack and the credibility of the Fed’s forward guidance—are unchanged. However, we are now less confident about how to read Yellen’s policy strategy. Combined with the marked flattening of the curve year-to-date, this has lowered our conviction that 3-5yr rates will continue to underperform. We hope to get more clarity on the policy strategy in the FOMC minutes released next Wednesday and from Janet Yellen’s remarks to the New York Economic Club on April 16.