A.G. EDWARDS & SONS, INC.
One North Jefferson, St. Louis, Missouri
314-955-3050
(February 14, 2002) FINANCIAL INSTRUMENTS: The secular trend in T-note yields is normally a function of long-term inflation trends. Besides looking at the long-term average of inflation, another way to capture this idea is the trend in nominal GDP changes. Gross Domestic Product tends to be reported in two primary forms; inflation adjusted and nominal. Most analysis concentrates on the "real," or inflation adjusted data, as it strips away the impact of price changes on growth. However, measuring inflation issues, using the nominal data gives better results.
Nominal GDP growth is real GDP plus inflation. For example, nominal GDP growth of 5% can be generated by 1% real growth and 4% inflation or any similar combination. What this model captures is the combination of growth and inflation's impact on long-term interest rates.
GDP T-Note Model
Chart courtesy of A.G. Edwards.
This is a chart of our GDP T-note model. We use a five-year moving average of nominal yearly change in GDP with a 42-month lag. Overall, it does a good job in predicting the trend in rates. The deviation line shows the difference from actual and forecast. Since 1995, when rates are running about 200 bp above forecast, yields tend to decline.
T-Note Forecast
Chart courtesy of A.G. Edwards.
This chart shows a forecast from this model. It suggests relatively steady yields through 2004. Current yields are below forecast, indicating the market is modestly overvalued. At this point, we expect the market to mostly follow changes in monetary policy. We do not expect the Federal Reserve to begin tightening until late summer at the earliest. Thus, for now, we remain on the sidelines. However, a rally to 112-00, which is roughly equivalent to a 4% yield, would be an attractive place to sell T-notes, based on this model.
Bill O'Grady
www.agedwards.com