Evaluating Nominal GDP & Treasuries

Welcome to The Observatory. The Observatory is how we at Prometheus monitor the evolution of the economy and financial markets in real-time. The insights provided here are slivers of our research process that are integrated algorithmically into our systems to create rules-based portfolios.

Our primary takeaways are as follows:

• Nominal GDP sits at 4.85% versus one year prior, with the potential for decelerating real growth and persistent inflation. 
• Consumption and government expenditures have been the primary drivers of real activity over the last year and remain an integral part of the resilience in nominal activity. 
•  Elevated nominal GDP, along with an increased supply of Treasuries duration, will likely create a tough environment for long-duration treasuries. While these headwinds remain, they are less so than prior months. 

For the latest data through August, our systems place Real GDP growth at 1.87% versus one year prior. Below, we show our monthly estimates of Real GDP relative to the official data:

In August, GDP came in at 0.18% versus the prior month. Below, we show the weighted contributions to the most recent one-month change in real GDP, along with the recent history of month-on-month GDP. Additionally, we show the contribution by sector to monthly GDP in the table below:

Real consumption spending decreased by -0.06%. Over the last year, consumption has added 1.71% to GDP growth of 1.87%.

Real gross investment increased by 0.1%. Over the last year, investment has subtracted -0.38% from GDP growth of 1.87%

Real government expenditures increased by 0.03%. Over the last year, government spending has added 0.38% to GDP growth of 1.87%

Real exports revenues decreased by -0.04%. Over the last year, exports have added 0.04% to GDP growth of 1.87%

Real import expenditures increased by 0.14%. Over the last year, imports have added 0.11% to GDP growth of 1.87%

Additionally, we show the composition of monthly estimates nominal GDP, broken into real GDP growth and inflation. Our latest estimates place nominal GDP at 4.85% versus one year prior.

This nominal GDP picture continues to put significant pressure on fixed-income securities, in particular, treasury bonds. Thus far this year, we have had a re-rating of interest rate cut expectations, which has hurt treasuries across the yield curve. This mispricing has largely faded from its high levels earlier this year to more reasonable levels. To better contextualize these recent changes in policy expectations, we show the latest discount rate path priced over the next eighteen months.

Short-term interest rate markets are expecting a peak in policy rates on Feb 24 at 5.44%, followed by a trough on Feb 25 at 4.54%. This implies approximately 3 interest rate cuts cumulatively over the next eighteen months. We show this path below:

For further insight into what markets are pricing for the expected policy path, we show market expectations for discount rates priced across the yield curve. Currently, 10-year notes are pricing 4 cuts, 5-year notes are pricing 2 cuts, and 2-year notes are pricing 1 cut.

While the market pricing of these cuts remains at odds with current economic conditions, the severity of this mispricing has reduced significantly, creating less of an opportunity to exploit. Below, we show how aggregate short-signal strength across our various macro and market signals has declined in the recent past for Treasuries:

Nonetheless, what is important to recognize is that the issuance of Treasury duration will be a detriment to liquidity conditions, which will weigh on all assets. We have yet to see the full impact of issuance. Below, we show how only a minimal amount of issuance has come from duration supply:

As we move forward in time, notes and bonds are likely to tick up further as a share of total issuance. This will put pressure on the yield curve to further steepen, especially if we remain in an environment with resilient nominal spending, which remains likely in the immediate term. Thus, while alpha opportunities are less abundant, Treasury beta remains unattractive.

We offer some big-picture context for allocators below. While many in modern history are used to Treasuries being the best-performing risk-adjusted return assets, widening one’s historical lenses paints a dramatically different picture. Below, we show our estimates of rolling one-year Sharpe ratios for 10-year treasuries, along with a slow-moving 10-year median. As we can see, over the last two decades, Treasuries have provided great risk-adjusted returns until recently.

However, looking further back, we see that Treasuries have undergone decades-long periods of negative share ratios from 1950 to 1980. We are not and do not forecast decades of asset price performance. However, the question we think investors must ask themselves today is if their allocations or investment strategies can deal with periods akin to those we have seen in the past. As policy rates rise, sharpe ratios on long treasuries will fall. The question before investors is whether their allocations can handle such periods.

For our part, we remain well-prepared. Resilient nominal GDP continues to weigh on Treasuries, and supply will likely steepen the curve. Until next time.