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The long US Treasury yield is equivalent (over time) to the US GDP annual growth. The long duration US Treasury rate is anchored upon the expected Fed Funds over that tenor/time/maturity. And Fisher defines Fed Funds as instantaneous real GDP growth plus inflation (Fisher Effect). Keynes states that long duration US Treasury rates synch with US GDP growth as the Keynes Liquidity Preference has 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 Effect])

Irving Fisher described the short term risk free bank rate - in the US, the Federal Funds rate - “Fisher Effect” (“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 now very powerful, with $4 trillion plus balance sheet, most of it added by the Bernanke Federal Reserve as a remedy to 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 for the nation. Only large consistent fiscal policy could offset this “Fisher Effect”.

Risk Premium

The “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 useful and 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, at about 8 fasis points per annum..

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 setting of the Fed Funds rate. The risk premium derived is then used to build a yield curve 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 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 rise in furture 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 negatively sloped.

It should be noticed that the title to these term structure of Fed Funds is called “GDP Forwards” using the above Fisher Effect 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.

The term structure of US GDP at key dates is provided:

The term structure of GDP currently and then for the last 8 months and then for November 2018 when Powell announced that the Fed would no longer normalize rates.

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 a 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 4.57 trillion, only recently achieved in 2018 to the current basis now at 2.12 trillion, a change of 2.45 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 below uses a current GDP level on a daily level. This is from a smoothed spline and disaggregated reported quarterly GDP with last GDP level coming from Federal Reserve “NowCasting” of GDP. )

The US Treasury Curve Flattens Jan 2019 to Date

While the China trade news was seen by most to explain the most recent sell-off and then the upward surge in the SP500, another reason given was the swift and large flattening of the US Treasury curve - the difference between the longer maturity US Treasury less a shorter maturity US Treasury - was and is still cause for concern. 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.

There are better ways to consider the yield curve.

One 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 immediately misplaced, but considering a longer forward looking GDP data to qualify SP500, rather than current GDP level, is a correct way to qualify current SP500 market levels. A scatter plot of SP500 to the curve gives concern but it is very noisy.

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 and the US Treasury curve, is a 7 years forward GDP level. This is an “apples to apples” match and as the SP500 does reflect the US economy,in the end - but the US GDP in the future. Few consider a 7 year forward GDP level as few have a way to derive this value. I derive the forward 7 year GDP level by constructing a term structure of Fed Funds out to 7 years and then use the “Fisher Effect” to translate that to a forward GDP then current dollars level. 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 - the " GDP basis" - gives even more concern. The SP500 level has an implicit growth rate of the US economy priced. 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 the SP500 2000 to 2200 level is reached, a drop of 30% or more in the SP500.

When considering a “Fisher Effect”, Federal Reserve monetary policy is midstream of a major policy error which will have significant ramifications. The Federal Reserve has induced 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, indicates the results of a central bank Neo Fisher process over time, then what is occuring now in the USA will have the US economy enter into a “Lost Decade” of substandard below potential growth. This “Lost Decade” in Japan 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 be 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 a large fairly sharp drop in stock index values.The above model of 7 year forward GDP shows SP500 support at 2500.

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

End