Exploring the "Right-tail-risk": An Upside Surprise to Growth Expectations
November 05, 2018
While many are consumed with calling the next recession, we feel it’s important to incorporate the ‘right-tail-risk,’ where growth is stronger than consensus expectations and yields rise accordingly.
U.S. Treasury (UST) 10-year real yields are breaking above the range in which they recently have been fluctuating, suggesting that real growth (potential growth, the neutral fed funds rate (r*), productivity) may be in the process of “normalizing” and shifting higher. This is a risk-outcome that we cannot easily dismiss. The likely culprit is regulatory reform and fiscal reform (namely corporate taxes). These two policy levers were used to spur higher growth, a core part of our macro thesis. The question is whether this is just a “sugar high,” or something more permanent? We need to consider the risk that it is in fact more permanent as these policy measures revive animal spirits, effectively kick starting economic activity that was previously dormant.
We link this thesis to an observable market metric that we can simplify as the real yield of the UST 10-year, i.e. the nominal 10-year less the average of expected inflation over the next 10 years. We recognize this is not a perfect measure – in that there are technicalities to consider – but it is a reasonable market relationship that we can easily observe. The linkage is that real yields are positively correlated with real growth, potential growth, r* and productivity. A rise in real yields suggests that all the rest are rising too.
A summary history of real UST 10-year real yields
The chart above illustrates that real UST yields are breaking to the upside and may stay there, something the market was not widely expecting. The analysis suggests that ten years after the fall from the 2008 global financial crisis, potential growth rates may be in a process of normalizing. While most in the markets are calling for the end of the cycle and the next
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks.
Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest rate environment, the Portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities ("junk bonds") are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).