Noting How Rich SP500 is to R2000

SP500 and R2000 levels have dropped about 12% last week from the Covid-19 pandemic. There is now great “uncertainty”, which is an economic “dog whistle” for the Fed to justify even further rash drop in rates. And subsequently, the US Treasury 10 year is now at an extraordinarily low rate of 1.16% (at the time of this writing).

US equity this week, given Biden’s primary win but despite worsening covid19 status, rebounded about 30% of the 12% lost last week.

The Relationship Between Long Duration US Treasurys and US GDP (current dollars - NGDP)

The long US Treasury yield is equivalent (over time) to 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.

Risk Premium

The “risk premium”, the amount of yield required to compensate for extending one more year maturity is first derived.

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

The risk premium is now about 12 basis points, after reacing a low of 8 basis points in Q3 2019.

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 Fed Funds yield curve out for 7 years. This is, according to Fisher, one and the same with NGDP.

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.

The term structure of US GDP at key dates:

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.

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. This is the 7 year “basis” of GDP.

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 has dropped from peak level of 4.64 trillion, only recently achieved in 2018 to the current basis now at 1.37 trillion, a change of 3.27 trillion from peak to now.

Using Current GDP to Qualify the R2000

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 But Then has Steepened.

The “Maturity” of R2000

The 7 Years Forward GDP Level Does Not Support Current R2000 Levels

A Significant Sell Off In R2000 Likely to Occur

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

The 7 years forward GDP level difference to current GDP - the " GDP basis". The R2000 level prices an implicit growth rate of the US economy. It makes sense to compare the GDP basis to current R2000 levels.

This suggests that R2000 will not find support, if it is discounting a growth expected over the next 7 years, until the R2000 is at to 110 to 120 level, a drop of an additional 12% to 15%%.

The Same Analysis Using 7 Year Forward GDP and the 7 Year GDP Basis to Qualify SP500

The above analysis is applied to the SP500. The ETF “SPY” is used for levels over time.

Also the level of the SP500 versus the R2000 is also provided.

From a Fisherian analysis, that the US Treasury rate curve and US GDP and US risky assets like R2000 or even SP500 will, over time, be in synch, but not at levels that will allow Trump to be re-elected.

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