Investor expectations have changed in two notable ways in two and a half months. Firstly, expectations for dividend payments in the 2020s and early 2030s rose by 15% relative to where they had been previously as reflected by S&P 500® Annual Dividend futures (Figure 1). Secondly, the yield curve has steepened, which is traditionally a sign that investors anticipate a faster pace of economic growth (Figure 2).
So, are investors more optimistic about the economy or is something else at play? Despite the recent change in dividend expectations, investors remain cautious about U.S. economic prospects. For example, they expect only a 5% growth in dividends over the coming 10 years after the 155% surge between 2010 and 2020. While that’s less gloomy than the 10% decline in dividends they had priced for the 2030s two months ago, a 5% growth is quiet modest given that break-even inflation spreads anticipate a 2.15% annualized rise in consumer prices. A 2.15% annualized inflation rate is cumulatively about 23.7% over the course of a decade. In other words, investors are pricing a 19% decline in the real value of dividend payments over the course of the 2020s.
While the yield curve has steepened over the past two months, it is flat by historical standards. In the early phases of the previous two economic recoveries, yield curves were much steeper than they are today. For example, in 2003, yield on the 30Y Treasury bond was 5%, a full 4% above the Fed funds rate at that time. Likewise, in 2009, 30Y yield averaged around 4.5%, over 400 basis points (bps) above Fed funds, which were stuck at around 12.5 bps then, as they are now. By contrast, the recent steepening of the yield curve has taken the 30Y yield up to only about 1.87%.
That said, the yield curve may be understating the degree of optimism on the part of investors. Successive quantitative easing (QE) by the Federal Reserve (Fed) may have reduced the spread between long-term and short-term interest rates as a large portion of the outstanding Federal debt has been absorbed onto the Fed’s balance sheet (Figure 3). Moreover, the Fed is hardly alone in purchasing assets. Some of its counterparts have done even larger QE programs relative to the size of their economies (Figure 4). These programs likely played a role in reducing bond yields in Europe and Japan to levels far below those on U.S. Treasuries, and have probably dragged U.S. Treasury yields down in the process. In this context, even a relatively modest steepening of the U.S. yield curve may reveal investor optimism.
Equally interesting is the question of why investors have become more optimistic about dividend payments, and why they are charging more interest in exchange for making 10Y and 30Y loans to the U.S. Treasury. Is it because they expect greater growth or just more inflation?
Inflation expectations, as measured by the difference between nominal U.S. Treasury bonds and Treasury Inflation-Protected Securities (TIPS), has grown from 1.71% around Thanksgiving 2020 to 2.2% by early February (Figure 5). Compounded out over 10 years, that’s a difference of 18% versus 25% cumulative inflation. In other words, about a third of the rise in expected future dividends can be explained based on higher inflation expectations.
Indeed, the entire steepening of the yield curve that took place over the past few months has possibly occurred because of rising inflation expectations. Nominal U.S. Treasuries have seen their yields rise by 40 bps on the 10Y portion of the yield curve. By contrast, TIPS yields are nearly unchanged at around negative 105 bps (Figure 6).
Somewhat higher inflation isn’t necessarily a bad thing. Inflation has undershot the Fed’s target for much of the past decade, and a slightly faster pace of price increases could make it easier for borrowers to service rather large public and private debt burdens in the U.S. A continued and sustained rise in inflation expectations, however, could upset the delicate balance of asset prices. The high level of equity prices, for example, appears to be closely related to the relative unattractiveness of bond yields (Figure 7). Moreover, future cashflows such as earnings and dividends are worth more in present value terms when long-term interest rates are low than when they are high.
Exactly what is behind the recent rise in nominal bond yields is not entirely clear either. It could be that investors are concerned about the size of the U.S. budget deficit, which rose to 16% of GDP in December 2020 before Congress passed an additional $908 billion (4.5% of GDP) relief package (Figure 08). Moreover, the new Administration proposes an additional $1.9 trillion (9.5% of GDP) in stimulus. If approved, the Federal budget deficit could be heading towards 30% of gross domestic product. Even Fed buying assets worth $40 billion per month (around half a trillion dollars per year) would only be enough to absorb about one sixth of this debt. On the other hand, the rise of break-even inflation spreads could also be a temporary reaction to the rise in oil prices to around $50 per barrel.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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