The Fed Reserve balance sheet is now just over 7 trillion, after peaking in June at 7.165 trillion, and the federal fiscal has committed $3 trillion under the CARES Act of 2020 and additional relief from the states has been about $2 trillion . Another $2 trillion is being considered by Congress. This fiscal and monetary add to the US economy is uncharted waters, but now has the US federal government deeply embedded into the US economy to levels not experienced since World War II.

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.

Most consider it a given that the Federal Reserve monetary actions has been very successful in supporting GDP. If that were the case it should be expected that a change in the Fed balance sheet should result in a change in GDP level. Not to get into nuances of Keynes multiplier or on excess reserves but just by simply seeing if the large addition to the Fed balance sheet can be shown to increase GDP. This has not been the case though a small increase in engagement of the economy to the massive massive sudden Federal Reserve balance sheet. The increase of the Fed balance sheet has not been seen in terms of speed and size since World War II. So far the economic impact has been negligiable.

The Federal Reserve is now most likely “pushing on a string”.

However, there is an obvious relationship between the level of risk free interest rates, US Treasurys, which are determined for the most part by the setting of Fed Funds, and the NGDP annual change.

Given the very large snapback in US GDP - the NY Fed “Nowcast” has 3rd quarter GDP anticipated to be a 13% SAAR of growth, the Atlanta Fed has it at 24% - the US Treasury 10 year should be well over 1 1/2% and starting a climb to “normal” rates of 2% plus.

This relationship between GDP and US Treasury yield is shown for recent daily levels. This is in accord with Fisher’s “Fisher Effect”.

Risk Premium

The “risk premium”, the amount of yield required to compensate for extending one more year maturity is first derived. Most wrongly - including the Fed - see the risk premium as the yield increase per year in US Treasurys from 2 years to 10 years or longer. The 2 year maturity is too short as the Fed basically sets all rates under 5 year to 5 years. This report does not use the yield curve to calculate risk premium, but “deconvexes” the curve well past 5 years adjusted using multiple inputs.

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

The risk premium is now approaching 20 basis points, after reaching a low of 8 basis points in Q3 2019. Any forward growth in NGDP implied by steepening risk premium is more than offset by increased volatility and the Fed “dropping” forward rates.

The Term Structure of Fed Funds/NGDP out to 7 Years

The first 5 years of the yield curve is efficient and is based on the market’s best assessment of Federal Reserve monetary policy setting of the Fed Funds rate. The risk premium derived, from structure and rates past 5 years, is 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 shows 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 with the rise in furture Fed Funds anticipated (normalization), from the election to 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 covid-19 emergency has had the Fed drop the term structure even further, so that now it is below the lows of the 2008 to 2015 “Great Recession” reached in 2012. It is trading at levels that are depression era.

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.

The term structure of GDP currently and then for the last 8 weeks.

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 NGDP 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 4.66 trillion, only recently achieved in 2018 to the current basis now at -0.15 trillion, a change of 4.82 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 Q1 2020, But Then Steepened.

Most watch the yield curve from the 2 year. The curve from 2 years to 5 years is an administrated rate set by the Fed and does not reflect the US economy. The yield curve that does reflect the US economy is from the 5 years and this report uses the 20 years as there is a continuous time series - the 30 years stops in the 90s when the 30 years were no longer issued for a while. The yield curve of 5 years US Treasury to 20 years US Treasury is given,

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. Note the forward GDP is in the then current dollars, or is NGDP.

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.

The level of the SP500 versus the R2000 is provided.

The SP500 level is rich versus the R2000 level. The R2000 is perceived as a domestic US stock index, with the members not able to arrange tax avoidance strategies. The leading weights of the SP500 all are intent in using international tax avoidance schemes.

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A Fisherian analysis has it that the US Treasury rate curve and US GDP and US risky assets like R2000 or SP500 will, over time, be in synch.

It is probable that the Federal Reserve has evoked a “Japanification”, or a “Lost Decade”, similar to what Japan experienced from the 1990 crisis well in the 2008 crisis. This will mean that the Fed stimulus in response to covid-19, that was not a classic Bagehot “discount window” solvency action lending freely against “good collateral”, will cap if not offset the CARES Act fiscal policy.

While the US Treasury rate and risk premum may adjust to levels that support the current equity levels, this is unlikely as a “catch all” that higher rates are negative for equities will likely drive equity down to recent lows. If Chinese excess capacity is no longer dumped into the US and with the massive fiscal and monetary intervention, then significant inflation will begin forcing the Federal Reserve to tighten at levels not seen since Volcker. But such ending of Chinese mercantalism is still not appearing.