The holy grail of bond investors is to find new ways to “refine” bond yields and extrapolate useful valuation metrics. But what kind of refinement may work?
To evaluate the attractiveness of a bond, we have no choice but to try to guess the path of monetary policy. Indeed, recall that the yield of a long-term Treasury security can be decomposed into at least two components:
Bond Yield = Expected Average Short Rate + Risk Premium
Hence, we must form an estimate of the expected average short rate by the market, which is necessary in order to quantify the risk premium priced into the security. This rate is a function of the decisions of the Federal Reserve, and because of the way the Fed nominally operates, the rate should reflect the fundamentals of the US economy over long horizons. That is, higher inflation and potential real GDP would typically be associated with a higher level of interest rates. Instead, a low bond yield may be symptomatic of expected subpar macroeconomic expectations.
Guessing future average short rates is a tricky exercise. On the one hand, inflation is a known major driver of bond yields, so various measures of long-term inflation expectations can offer a reasonable forecast. On the other hand, substantial disagreement still exists on the long-term drivers of real yields, whose secular value is known as the natural or equilibrium rate of interest. In particular, real yields appear mostly unrelated to the rate of economic growth, a fact that has prompted researchers to look for alternative explanations, such as global capital imbalances (e.g., Rachel and Smith, 2015).
Two thought-provoking papers by James Montier (2015a, 2015b) exemplify the degree of skepticism surrounding the economic drivers of real interest rates in the investment community. Montier is critical of the building-block approach applied to forecasting and argues that the equilibrium rate of interest is “a make-believe concept with no foundation in the way our financial world really works” (2015a). We respectfully disagree with this statement.
In Garg and Mazzoleni (2017), we argue that the connection between the real economy and bond markets is much stronger than otherwise thought. In particular, introducing growth data in an otherwise canonical term-structure model allows for more accurate predictions of bond excess returns, and therefore, offers a more refined bond valuation metric. In other words, modeling the equilibrium rate of interest is essential for properly valuing Treasury bonds.
The following table illustrates our insight, showing that inflation and real GDP growth are, in fact, major drivers of the three-month Treasury bill rate. The first column illustrates no significant association exists between the quarterly rate of real GDP growth and short rates, after controlling for the quarterly rate of core inflation. This negative result is not new and may be initially viewed as a puzzle, however, the evidence differs when we employ backward-looking measures of economic performance.