Where Will Yields Be Next Year?
Last week, I discussed the Fed’s surprisingly high projections for GDP growth,
which exceeded consensus estimates, and as a result, caught the bond market off
guard. Today, I would like to take these estimates and and perform two
exercises: 1) gauge where yields should currently be trading, and 2) make
some very crude projections for Treasuries yields–based on the high historical
correlation between the two rates. But first, let me recap the Fed’s stats from
last week. The Federal reserve is forecasting that real GDP growth for 2004 will
come in between 3.75% and 4.75% and nominal growth will come in between 5.25%
and 6.25%.
 Examining the relationship between the 10 year Treasury
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nominal GDP growth.
One of the primary reasons why bond yields lead GDP growth is that bond holders
want to be compensated for inflation. Remember, inflation decreases the real
returns of future bond payments. Meaning, investors will be able to purchase
fewer goods with the fixed income generated from the bonds they own as inflation
increases. Conversely, investors will be able to purchase more goods with the
fixed income generated from the bonds they own as inflation decreases.
As can be seen in the chart below, with few exceptions, the yield on the 10 year
Treasury has rarely gone below the rate of nominal GDP growth. In fact, for the
past ten years, the average spread between the 10 year yield over GDP has
measured .62%.
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If we add this spread to the past four quarters of GDP growth of 3.59%, we
come up with 4.21%–which is currently .09% away from where the Ten year note
closed today. Let’s now add the spread to the Fed’s projections for GDP growth.
If the Fed expects nominal GDP growth for 2003 to measure between 3.75% –
4.5%, the market should expect the ten year yield to finish the year around
4.37% and 5.12%. And for 2002, taking the Fed’s 5.25% – 6.25% GDP
forecast–which is wide enough to drive a truck through–we can expect that the
10 year yield will fall somewhere between 5.87% and 6.87% by the end of next
year.
As I mentioned above, this is a crude model. Nevertheless, it is currently
indicating that Treasury yields are really not that far away from where they
should be.     Â
Ed Allen