It is difficult to change a 10-year trend.

Long-term expectations do not change as frequently as daily market fluctuations would make it seem.

A quick update on Treasury rates through the lens of the DKW model

*As of Dec. 31*

1/

In previous threads, I made the distinction between long-term secular trends in growth and inflation and shorter-term (2-6 quarters) trends in nGDP growth

https://t.co/0jBvHOWuHw

2/
Right now, the long-term trends are unaltered because long-term trends just don't change that fast but we have a very strong cyclical upturn in the economy, centered primarily on the shift to goods consumption bolstering the manufacturing sector and industrial commodities.

3/
As long as the industrial sector continues to roar, TSY rates will have an upward bias as rates generally follow the trend in nGDP growth

A 10yr TSY has longterm expectations embedded in the rate so several qrters, while important, won't necessarily change the longterm trend

4/
This is confirmed by the Dec update to the DKW model which breaks down *actual* inflation expectations, the expected real short-term rate (real growth), term premium, liquidity premium etc.

The DKW model is one of many models that is useful but has many limitations.

5/
As of Dec 31, according to the DKW model, inflation expectations are directionally rising, in line with the industrial upturn, but have only increase ~12bps from the summer low.

It is hard to alter a long-term trend with just a couple of quarters.

6/
Real growth expectations remain on the floor in the DKW model as (again) a transitory upturn in growth won't alter the 10-year average rate of growth all that much.

7/
So what is causing the bulk of the move in Treasury rates?

The real term premium.

Expectations for massive fiscal spending rightfully won't alter the economy's long-term growth prospects but do place extra risk on duration in the near term.

8/
Adding actual inflation expectations and the real ST rate expectations gives what I call the "fundamental" drivers of TSY rates which have increased cumulatively about 14bps since the summer.

This makes sense with the trend in nGDP growth.

9/
In short, the long-term trends that have caused TSY rates to decline for decades are still in place.

Weaker growth and lower inflation over the long-run will depress the risk-free rate.

In the short-term (2-6 quarters), you have to follow the direction in nGDP growth.

10/
Once this manufacturing upturn starts to fade (no signs yet) TSYs will be a great buy again as the next cyclical downturn in the economy will push the long-end to the zero-bound.

11/11
@R_Perli has more timely updates on this model and can perhaps shed some light on the January move in rates so far.

More from Trading

Many of you have seen the famous Westrum Organizational Typology model, so prominently featured in State of DevOps Research, Accelerate, DevOps Handbook, etc.

This model was created Dr. Ron Westrum, a widely-cited sociologist who studied the impact of culture on safety


Thanks to Dr. @nicolefv, I was able to interview him for an upcoming episode of the Idealcast! 🤯

It was a very heady experience, and while preparing to interview him, I was startled to discover how much work he's done in healthcare, aviation, spaceflight, but also innovation.

I've read 4+ of his papers, so I thought I was familiar with his work. (Here's one paper:
https://t.co/7X00O67VgS)

I was startled to learn he has also studied in depth what enables innovation. He wrote a wonderful book "Sidewinder: Creative Missile Development at China Lake"


Dr. Westrum writes about China Lake Research Labs: "its design and structure had one purpose: to foster technical creativity. It did; China Lake operated far outside the normal envelope... Sidewinder & others were "impossible" accomplishments,

I love this book because it describes traits of organizations that routinely create and maintain greatness: US space program (Mercury, Gemini, Apollo), US Naval Reactors, Toyota, Team of Teams, Tesla, the tech giants (Amazon, Google, Netflix, Google)

You May Also Like