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A tenet in macro economics is the long US Treasury yield reflects or is equivalent (over time) to the US GDP annual growth. This is based on Fisher’s theory of interest rates with long duration risk free based upon the expected Fed Funds over the tenor/time/maturity. Keynes also states that long duration US Treasury rates do synch with the US GDP growth via the liquidity preference, where long US duration rates are at the level to induce savers to leave the Zero duration of cash and extend out taking duration risk. Right now the savings rate is climbing and at a high level as US Treasury rates, though higher than recent century lows, are unusually low.

The long US Treasury yield is determined by the monetary policy of the Federal Reserve - the Fed Funds rate set by the Federal Reserve over the comparable time period of the long US Treasury yield.

The Fisher Rate (Fisher Equation)

Irving Fisher described the short term risk free bank rate - in the US, the Federal Finds rate - with his “Fisher Equation” (“The Theory of Interest Rates” 1930) :

“overnight risk free rate = real national economic growth + inflation”

        - or -

“Fed Funds = Real GDP + Inflation”

In the US the short term risk free rate are “Fed Funds”. The key rate for the Federal Reserve monetary policy.

The Fisher Equation describes Fed Funds as Real GDP + inflation. Real GDP is observed in a backwards manner using inflation, which is known, and the current Fed Funds an implied current real GDP is derived.

The “Lost Decade” of Japan 1991 to Date (Still Ongoing)

The Federal Reserve is very powerful, now with $4 trillion of balance sheet, most of it added by the Bernanke Federal Reserve to add liquidity to the US economy during the recent 2008 crisis. If the US economy is in flux or stagnant, perhaps as the recovery peaks or when a recovery has yet to start, or vice versa for a recession, the Federal Reserve policy can be a self fulfilling prophecy and while policy is changed to respond in a technical manner to changes in the US economy and inflation, and during such low volatility times the Fed Funds level can set the economic status and set the inflation rate.

In the US, there are signs that NGDP growth is declining consistent with a Neo Fisherian regime.

Note the latest from the NY Federal Reserve “Now Casting”

Risk Premium

A factor that qualifies the US Treasury yield curve is “risk premium”, the amount of yield required to compensate for extending one more year maturity. Since risk increases with maturity extension (the change in price of a US Treasury given a change in yield increases with maturity) this is rarely negative in value. However large, usually temporary, technical factors can distort the yield curve such that an erroneous risk premium value is calculated - especially if the shorter maturities are used being constantly stressed by Federal Reserve anticipated actions. A read of the curve is constructed in that part of the curve 5 years or more which is adjusted from other technical factors so a more useful and likely correct risk premium is derived.

Another plotting of the risk premium, now over a shorter time period.

The risk premium is now under 10 basis points per year.

The Term Structure of Fed Funds out to 7 Years

The first 2 years of the yield curve is efficient and is based on the market best assessment of Federal Reserve monetary policy in setting the Fed Funds rate. The risk premium derived is then used to build a yield curve out to, with this model, out for 7 years. It is important to note this is not the usual yield curve of ever longing US Treasury notes but a term structure of the instantaneous Fed Funds Rate out for 7 years.

The term structure of NGDP can be organized to show the progression of change from December 2018, when Powell announced that normalization ceased and that a steady ease would commence.

A close up of the Fed Funds term structure during the Trump administration where all the lifting of Fed Funds anticipated from the election to the March 2018 highs has been undone so that now the term structure of anticipated Fed Funds is lower than the election and the term structure is negative.

It should be noticed that the title to these term structure of Fed Funds is called “GDP Forwards” using the above Fisher Equation where Federal Funds are equivalent to US current GDP (NGDP) growth.

First the latest term structure of instantaneous GDP (NGDP) growth rates is given from spot to 7 years.

With Term Structure of NGDP Growth, Expected GDP Level in 7 Years Derived

The term structure of GDP (NGDP) growth per year is used to derive an expected GDP level in 7 years.

This is rich in information regarding market expectations and can be used to qualify current key US Treasury rates and the SP500. While it is noisy, the SP500 levels and changes in levels does reflect the general state of the US economy expected.

The GDP level in 7 years is derived by compounding out the term structure of NGDP growth.

The 7 years forward GDP level is then compared to current GDP.

The expected growth in 7 years for GDP as well as the level expected in 7 years for GDP showed strong growth since the election but then reversed and plunged from the end of 4th Q 2018 to today.

While SP500 traded down in December 2018 as GDP forward growth and level turned down, SP500 recovered and then has traded down a few times with the the current trade off the most recent. Most use the developments with China to explain these turns.

Forward GDP is steady in direction and has turned down only from 4th quarter 2018 onward and has been steady and large in that downturn since. It does not seem to be responding to China news.

The “Basis” of 7 Years Forward GDP to Current GDP

The 7 Years forward GDP is netted against current GDP and a basis is calculated. This is the level (in billions here) of expected growth in GDP over the next 7 years.

The basis is in free fall, diving from peak level of 4.58 trillion, only recently achieved in 2018 to the current basis now at 1.99 trillion, a change of 2.59 trillion from peak to now - a calamity.

Error to Use Current GDP to Qualify the SP500

The US economy is depicted by current GDP as reported every 3 months by the Department of Commerce. The US economy is unusually steady in growth over the years so most see current SP500 levels as reflecting the current US economy. as shown. With this view the recent sell off in SP500, ostensibly from the China trade policy negotiations, indicated that while down the basic trend is intact. And with the recent rise in SP500 back towards 3000 would seem to indicate a return back to the bull market trend.

The US Treasury Curve Flattens

While the China news was given the blame for the most recent sell-off in SP500, the swift and large flattening of the US Treasury curve - the difference between the longer maturity US Treasury less a shorter maturity US Treasury - alarmed the market. Many commented that when the US Treasury curve “inverts”, with shorter maturity used yield larger than the longer maturity, a recession will surely follow. However this was rustic “folk wisdom” and not useful in really qualifying SP500 levels as the recent rise in SP500 has shown.

Another approach is to use probability density curves as priced in options on Eurodollar 3 month LIBOR futures. A good summary of this approach is from Bauer and Mertens of the San Francisco Federal Reserve Zero Lower Bound Risk according to Option Prices . However Bauer and Mertens only go out as far as the Eurodollar options in 2021, or 2 years forward and there is still alot of noise present. However they do show it is a better estimate of likely probability of a slowdown in GDP than the curve, as they depict Image 3 Evolution of downside risk since January 2018.

The “Maturity” of SP500

The 7 Years Forward GDP Level Does Not Support Current SP500 Levels

A Significant Sell Off In SP500 Likely to Occur

The focus on the curve was perhaps immediately misplaced, but considering a longer forward looking data to qualify SP500 rather than current GDP level is correct. And the scatter plot of SP500 to the curve concerns.

SP500 has a maturity of about 8 to 15 years, bond math calls this maturity “duration”.

The better forward longer maturity value to qualify the SP500, far better than current GDP, is the above 7 years forward GDP level value. This is an “apples to apples” match and as the SP500 does reflect the US economy, but in the future, this comparison of 7 years forward GDP to SP500 is alarming.

The support of the SP500 is absent at current SP500 levels and the 7 years forward GDP level suggests the SP500 could trade to 2500 before finding support from the US economy status.

The “Basis” of 7 Years Forward GDP to Current GDP

The 7 years forward GDP level difference to current GDP - a " GDP basis" - gives even more concern. The SP500 level has an implicit growth rate of the US economy. It makes sense to compare the GDP basis to current SP500 levels.

This suggests that SP500 will not find support, if it is discounting a growth expected over the next 7 years, until 2000 to 2200 level is reached.

The Federal Reserve, using a Neo Fisherian monetary analysis, is midstream of a major policy error which siill have gnificant ramification. It is very likely the Federal Reserve will induce a “Neo Fisher regime” a long lasting stagnant NGDP growth regime in the USA.

If the Japanese experience, when a similar regime was imposed by the Bank of Japan starting in 1992, shows the Neo Fisher process then what is occuring now in the USA will have the US economy enter into a “Lost Decade” of substandard below potnetial growth. This “Lost Decade” of long running stagnant growth and disinflation and at times deflation has lasted, so far, for 27 years.

It is not clear that the Federal Reserve triggering a similar regime to what Japan experienced, will stay as a long chronic problem for the USA as Japan experienced, but it is very likely that the US stock market will start to handicap this possibility with this repricing occurring shortly with a large fairly sharp drop in stock index values.

There is a possibility that large fiscal policy conducted by the Trump administration can offset or even remedy this Federal Reserve policy error. This would require large public investments in infrastructure and the issuance of long or even ultra long US Treasurys.

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