Sunday, March 31, 2013

Darfur Helped Build a Simple Effective Way to Consider 10 Year US Treasurys Real Return and Price 10 Year US Treasurys

I was impressed with the heart wrenching and yet uplifting  60 Minutes story on the 'Lost Boys" of  Darfur.  It was a followup of the 12 young men who  received asylum in the USA after fleeing Eritrea for the Sudan a decade ago.  The Darfur calamity.

What amazes is that 12 years later after they were evacuated to the USA, despite how foreign in both terms of modernity and environment the USA was, almost all of the Darfur youth have thrived.

So I dug into population and immigration statistics to see what is going on now - first to defend an obvious view that the USA finest moments is when it becomes the 'Last Great Hope of Earth". So I wanted to show much greater immigration levels could take place that would be good for the USA economy, and also allow USA to reach even greater global altruism.

I found that despite the recent notion that the USA borders were "closed", immigration has soared in terms of the percentage makeup of the USA population growth.  I was  aware that a massive advantage the USA has over all OECD countries, and now China as well, is that we have had a population growth rate of around 1.25% over the long run, though it is declining.  With the Great Recession, the USA rate has dropped to .77% population growth, but that is still  very much higher than all of the other OECD countries, Russia, and China.

A surprise is that the population growth slowdown would be at  around   0.4%,  but for the surge in immigration that has taken place since about 2004.

In fact, immigration is now making over 1/3 of the USA population increase.

 Still it is obvious that the USA must increase immigration even more to allow the USA resume a 1.25% or better population growth rate.  That would be an approximately 2 million per annum increase  in immigration from approximately 1 million per annum now, to 3 million per annum total.

Why is population increase of importance, especially after the USA has suffered a severe solvency event and is still providing repair and with unemployment over 7%?

NGDP , or rather potential NGDP is a straight forward aggregation of the  USA native born population entering the workforce, the immigrants to the USA entering the work force, productivity and then inflation.

Immigration policy has been as effective - in forward space at least - as the Fed's QE - in providing remedy. And as native America birth death  rate decreases, immigration becomes vital so as to maintain the American current living standards.

Basically, over the last 60 years, population increase (a combination of immigration and native born) has formed  50% of real GDP,  (RGDP).

Rather than use trend GDP as per FRED etc, using RGDP composed of population increase equal weighted with productivity provides a better picture of potential.

It surprised me how robust this array was, especially when compared to realized RGDP.

Then I thought more utility from the array could be had if  the native born population increase is lagged by 18 years - a rough idea of how long after birth a contribution to the economy occurs,  and then lagging immigration increases by 7 years - keeping in mind the 60 minutes Darfur story and time it takes for an immigrant to become completely part of the US economy.  This lagged population increase with productivity resulted in a  potential GDP that was very robust when compared to other metrics, especially the risk free long rate.

Comparing this lagged population with productivity potential RGDP versus the realized RGDP shows the very large positive impact of the Reagan rationalization and reformatting of the USA economy, which I perceived to have been carried on by Clinton.  A very long and very successful growth period in the USA led to almost almost full GDP efficiency in terms of deploying all the potential. Then the Islamist war impacts, where the inefficiencies of war with a lower multiplier for public sector investment (bombs tanks and ships etc etc) along with waste, led to a falling behind  potential.  Later the solvency event clocks the USA, dropping it way beneath potential.

The usefulness of perceiving potential in this fashion versus than a CBO trend GDP, is that this potential can, or will, be closed via policy, especially when focused on immigration.  The USA has another 15% of real GDP growth to come based upon my RGDP.  And with the war inefficiencies being replaced with private sector commerce, that gain of 15% can happen rather quickly.

One can then consider the 10 year US Treasury.

It takes only common sense, and maybe a touch of Keynes, to realize that the US Treasury yield is a basket of Federal Funds rates over the tenor of that specific bond, or rather it is the expectations of those Federal Funds rates.  And the Federal Funds rate over the time of a complete business cycle, say 5 to 10 years, has to average out to NGDP.  For the last 30 years, since Volcker established the current monetary policy form of the Fed, the overshoot and undershoot has lessened.  The Great Moderation.   Another way to organize how to think on this is to consider the "Taylor Rule", not to figure out the "right" Fed Funds level, but rather to understand what are the weights of productivity and population of  a potential NGDP.

The  10 year US Treasury is showing the markets expectations for NGDP over the next 10 years, adjusted for the risk that perhaps, just perhaps, the Fed loses all reason and goes crazed, and for the positive convexity found in semi-annual coupon bond structures.  But in the  main 10 year pricing is expectations of NGDP, and the major pricing dynamics of the 10 year will be based upon the expectations changing for the general potential of NGDP.  Since I mentioned that we are considering a long enough time for at least a complete business cycle, that will mean with the modern Federal Reserve methodology,  Fed Funds will undershoot and overshoot NGDP, but will in the average, over that  tenor, be equivalent. Even if the total real return of the 10 year has to "catch up".

So, over time, the real total return of the 10 year US Treasury should approximate the all in increase in real GDP over the same time span - provided the time span is greater than a period that contains one complete business cycle.

And this is in fact what has taken place.

First, note how the adjustment by lagging the "coming on stream" of population growth makes for a more useful potential real GDP.  (Should become obvious why I am using real, as inflation has nothing to do with population or productivity.)  As said prior, one can see how the Reagan regime was a huge success.  Now for bonds, it can be seen that from early 1990s to just before the current crisis  - but for the stochastic properties in the convexity of the ten year -  the inflation impact ( or deflation), and the insurance like utility of a US Treasury longer tenor has swamped approximating RGDP.

Since I can expect maybe a slight increase in population impact to around 1%, and assuming productivity stays 1 1/4% to 1 1/2% - I can then explain some of the overshoot of US Treasurys.  But if RGDP potential stays around 2 1/2% , then over a 2 to 3 year periods a 60% hit has to be realized in 10 year US Treasurys real return.  That is back to back years of around -20% total real return.  Some of that can be inflation, of course. In short the overshoot the market priced into 10 year US Treasurys, reaching nadir in 1981, is to be repeated - and like 1981 onwards, will likely result in a 30 years of trending market - only this time a significant bear market for long maturity US Treasury.

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