The recent strength in economic data has many pundits, investors and strategists downright giddy. Their giddiness may turn out to be warranted, but I would point out that the U.S. economy has experienced several failures-to-launch in the quest for economic escape velocity.

U.S. GDP since 2009 (Bloomberg):

It was believed that the surges in GDP growth in late 2009, mid 2010, mid 2011, early 2012 and several times thereafter, were a sign of the economy nearing escape velocity. Each time proved to be a rebound from an economic soft patch. The aberration was the long soft patch from mid-2014 through mid-2016, which corresponded with the collapse of the energy super-cycle and Fed tapering and tightening. I believe the 2014 to 2016 soft patch, as well as the energy bust itself, were influenced by tapering. If quantitative easing was monetary policy easing, then, if one thinks logically, tapering was the first step in quantitative renormalization.

The question which must be asked is: Is the economic rebound experienced in the second-half of 2016 a sign that the economy is finally gaining traction, on its way to escape velocity, or is it just another rebound after a soft patch?

I am mainly in the soft patch rebound camp, with some caveats.

There is little doubt in my mind that the 2016 second-half rebound is, in part, a recovery from a soft first-half of the year. However, I believe that it is also a rebound from a longer-term soft patch which began late in 2014. Thus, barring policy missteps and exogenous geopolitical/geo-economic events, we could see continued economic strength throughout 2017. By economic strength, I mean mid-to-high-2.00% GDP. This might not sound like much of a rebound, but when we consider that U.S. GDP averaged just 1.9% from Q4 2014 through Q3 2016 and the U.S. economy printed GDP growth over 3.00% only once (3.5% in Q3 16 and that print received a 90 basis point benefit from agriculture sales due to crop damage in South America), GDP averaging between 2.00% and 2.50% would be a step up. If we can get some movement on tax and regulatory policy reform and can skip most of the protectionist trade proposals, we may be able to generate 2.75% to 3.00% annual GDP growth. However, we are likely to see trade policies and protectionist measures, which offset some of the benefits from tax and regulation reform. I am concerned that the new President will try to coerce corporations into using repatriated capital for hiring and wage growth rather than share repurchases and dividend increases. This could be a boon for Main Street, but it could prove less positive for Wall Street than markets have priced in.

Contrary to popular belief (or popular propaganda), GDP growth is not the primary driver of long-term interest rates/bond yields. It is not the Fed either, at least not directly. The primary driver of long-term interest rates is inflation.

U.S GDP and 10-year UST Yield, since 1970 (Bloomberg):

The correlation between GDP and the 10-year yield has been pretty close, but there have been divergences, the greatest of which was in the early 1980s. The relationship between CPI and the 10-year UST yield is much closer and has no large divergences.

U.S. Annual CPI and 10-year UST Yield, since 1970 (Bloomberg):

Notice the lack of divergence between CPI and the 10-year UST yield in the early 1980s. Yes, the spread between inflation and the 10-year note yield has waxed and waned, but they have never moved in opposite directions like GDP and the 10-year UST yield had. Long rates will always and forever follow inflation pressures and expectations. This is because inflation erodes the purchasing power of money. Thus, if one is to lockup capital for 10-years, one wants a higher yield to do so when inflation appears as if it will run hot.

Another phenomenon which has become apparent is that, in recent years, the spread between CPI and the 10-year UST yield has narrowed, both on an absolute and percentage basis. This narrowing trend began, in earnest, around 2000. I don’t think it was a coincidence that narrower spreads between CPI and long-term interest rates began when the Baby Boomers reached their mid-50s. In my opinion, demographics augur for a historically-tight relationship between CPI and the 10-year UST note, for the next decade, or two. (5) (6) (7)

Rock the Kasbah

Inflation pressures have been a major story in the bond market. Rising energy prices and ideas that new fiscal policies could increase inflation pressures have had many investors (mainly retail) running from long-dated bonds and into TIPS. Admittedly when the 10-year TIPS breakeven fell below 1.70%, it looked fairly attractive, at least from a hedging perspective. However, with the 10-year TIPS breakeven now around 2.06, I feel TIPS are less compelling. This is because I do not see inflation pressures as especially durable.

The recent surge in inflation has been largely due to the year over year rise in oil prices.

Price of WTI crude since 2015 (Bloomberg):

U.S. Headline Annual CPI since 2015 (Bloomberg):

Since the middle of 2016, U.S. CPI has been highly correlated with WTI crude prices. The biggest surge in CPI corresponds with the biggest year-over-year change in oil prices, to date. If crude oil prices stay around current levels, Headline Annual CPI could surge higher from here. However, by May, the year-over year change in WTI prices largely evaporates. I am not of the opinion that WTI prices surge from here. Much U.S. shale production is profitable with WTI priced in the $50s. As such, it is a tall order to expect oil to break $60. I believe that $49 oil is more likely than $60 oil. This could mean that CPI falls back to Q3 2016 levels, or just above. In my view, after possibly breaking above 2.3%, Headline Annual CPI could, once again, break below 1.70% or, perhaps, below 1.50%. However, I do not envision CPI revisiting 1.00% as demand has picked up sufficiently to keep inflation between 1.00% and 2.00%. (5) (6) (7)

It’s not easy being Greenback

Another phenomenon which could contain inflation is a strong or, perhaps, stronger U.S. dollar. A strong/stronger dollar is, inherently anti-inflationary. It takes fewer dollars to purchase a widget, in that scenario. Protectionist trade policies augur for a stronger U.S. dollar. Repatriation of foreign capital could augur for a stronger U.S. dollar, as well. Lastly, Fed policy renormalization (which I believe will be more regular, in 2017), augurs for USD strength. Thus, as Fed tightening is designed to do, monetary policy renormalization should help to contain inflation and, therefore, long-term interest rates.

This is not to say that long-term rates cannot and will not trend higher. I believe that investor capital flows will help push long-term UST yields higher. As with the summer of 2013, I believe that this will prove a poor strategy. My base case is for the 10-year UST yield to end 2017 around 2.70%, but head back down from there (unless of course we get pro-growth tax and regulatory policies without growth crippling trade policies). Even then, I doubt inflation will be strong enough to push the 10-year UST note yield above 3.00% for any length of time. We must also consider the global demographic demand for income. Pensions, insurance companies and individuals should be strong buyers of duration for the next decade, in my opinion. (5) (6) (7)

Market Bull

What about the end of the “bond bull market”? Discussions of a bond bull market or a bond bear market are, in my opinion, asinine. Bond yields are low because inflation is low and demographic demand for income is high. Change these conditions and you change the bond yield paradigm. Bond market activity makes me believe that, if I am wrong about long-term rates, I will be wrong to the high side. According to Bloomberg data, there are record bets against the price/value of the UST 10-year note.

Bloomberg CFTC CBT 10-Yr US Treasury Notes Net Non-Commercial Futures Positions:

This would appear bearish for the bond market, but consider this: Even with the largest amount of negative bets against the 10-year UST, ever, its yield is about 2.47% at the time this chart was created. What happens when these trades are unwound (or shorts covered)? At some point, there is going to be a cap, if not renewed downward pressure, on long-term interest rates. I think this occurs late spring or early summer, as inflation pressures begin to abate.

What I believe these professionals are doing, is; they are shorting the 10-year UST and once there is a retail rush for the door, they will (hopefully) buy at lower prices. This is not dissimilar to what they did in 2013. By the end of 2013, when the 10-year UST yield reached 3.00%, shorts were covered and speculators were basically neutral by the end of 2014, when the 10-year UST yield was 2.20%. The buying then stopped and the 10-year yield surged 2.485%, by 6/10/15. Let’s be clear; these 10-year futures are not driving bond prices, they are responding to bond market conditions or, even more correctly, to economic conditions which could/should move long-term bond yields.

Annual CPI versus 10-year UST futures bets (Bloomberg):

Look at that, when CPI rose, bets on 10-year UST futures turned bearish, or at least less bullish. When CPI fell, the opposite was true. This should put to bed the debate over to what long-term UST notes and bonds price. Yes, there are other factors involved in long-dated UST prices. Supply and demand, global interest rates, and currency exchange rates are all involved in bond pricing, but it's inflation which drives the bets on the long end of the yield curve.

If you want to know the direction of interest rates, figure out the path of inflation. If you want to figure out how Fed policy action will affect the long end of the curve, understand what Fed policy is designed to do with respect to inflation. When I consider the possible fading influences on inflation from oil prices and a somewhat more hawkish Fed, I cannot help but to envision a scenario in which the 10-year UST yield has limited room to rise (from here) and it is on the short end of the yield curve where most of the interest rate rise will take place. Evidence is mounting for a somewhat flatter, but still positively-sloped yield curve, a curve that is conducive of moderate economic growth, but does not augur for a further expansion of credit or surging U.S. GDP. If we see more than a 50 to 75 basis point pickup to GDP, I would be surprised. However, since the last time the U.S. economy grew at 3.00% for the entire year was 2005 (and that was during an economic bubble), I would sign up for 2.50% to 2.75% annual GDP, right now.