James W. Paulsen, Ph.D.

Economic and Market

April 29, 2014

Perspective
Bringing you national and global economic trends for more than 30 years

Are Bonds Cruising for a Bruising?

While bond yields seem mostly benign so far this year, investors should not be overly complacent about the potential for yields to rise significantly yet in 2014. Several forces are aligning which are darkening the environment surrounding the fixed income market. Indeed, we highlight 10 reasons why the 10-year Treasury yield may still near 4% this year suggesting recent bond market action may simply represent the calm before the storm. Are bonds cruising for another bruising in 2014? Despite this improvement, bond yields currently remain significantly below fair fundamental levels. With an annual core consumer price inflation rate of 1.7%, the 10-year bond yield would need to rise to 3.7% (about 1% higher than its current level) just to reach the lower-end of normal and to reconnect with the current economic recovery. To reach the middle dotted line (i.e., 3% above the current core inflation rate) requires a 10-year yield of 4.7%2% above current levels! Yields have finally started to reconnect with the recovery and Chart 1 illustrates how much more potential damage bond investors may face before yields can again be considered fairly priced.

1. Bond yields are not yet fully reconnected to the economic cycle!

Chart 1 illustrates the historical valuation of the 10-year bond yield relative to the annual rate of core consumer price inflation. Since 1960, when fairly valued, the 10-year yield has oscillated between 2% and 4% above the rate of inflation. That is, the dotted lines in this chart suggest an equilibrium yield levelone whereby bonds seem appropriately priced for the economic recovery. Yields were too low in the late-1960s throughout the 1970s as they remained significantly divorced from rising inflation realities. Similarly, during much of the 1980s, yields were consistently too high relative to inflation. A consensus priced bonds through the rear view mirror of the 1970s experience rather than based on the current inflation reality through the windshield. After a period of mostly being appropriately priced (i.e., between 1985 and 2007 the 10-year bond yield was typically between the dotted lines), bond yields have again become divorced from the economic cycle since the 2008 crisis. The severity of the crisis sent investors flocking into safe-haven government bonds pushing yields far below levels justified by fundamentals. However, since the 10-year yield reached an all-time low in 2012, the bond market has started reconnecting with the economic cycle. Last year, the 10-year yield rose to about 3% cutting the gap to the lower equilibrium band in Chart 1 by nearly one-half.

Chart 1: Real 10-year Treasury bond yield* *10-year bond yield less Core CPI inflation rate

Economic and Market Perspective

2

2. U.S. real GDP growth is moving north of 3%?!

With only brief exceptions, real economic growth in this recovery has usually been below 3%. This has constantly amplified concerns that the economy was near stall speed. Sluggish growth has kept recession fears elevated and has simply not been sufficient to boost credit demands, tighten resource markets, or produce inflationary pressures to a level required to lift yields. This may be about to change. Charts 2 and 3 suggest the economic recovery has recently accelerated and we expect real GDP growth to move rise above 3% in the second quarter and remain above this pace for the rest of 2014. With tighter resource markets (i.e., the unemployment rate is headed toward 6% and the factory utilization rate will soon rise above 80%) and credit demands which are starting to stir, the bond market could soon face its first serious cyclical pressure of the recovery.
Chart 2: Economic boom-bust barometer* *Ratio of CRB Industrial Commodity Price Index divided by four-week moving average of initial unemployment claims

As shown in Chart 2, after languishing during the last three years, the economic boom-bust barometer recently surged to a new all-time high suggesting the economic recovery has moved to a higher gear! Better economic momentum is also indicated by Chart 3 showing that despite a contracting public sector holding back overall real GDP growth, last year private sector economic activity accelerated to one of the strongest growth rates of the recovery. Indeed, in the last two quarters of 2013, private sector real GDP growth averaged 4.7%! With the end of sequester and assuming the government does not shut down again this year, public sector economic growth should at least be flat. With the private sector growing faster than 4% (82% of total GDP), overall real GDP growth should near 3.5% suggesting greater upward pressure on long-term yields.

Chart 3: U.S. real GDP growthOverall versus private sector

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

3

3. Rising condence is eliminating the Treasury bond safe-haven premium!

As illustrated in Chart 4, confidence plays a critical role in establishing the level of yields. Multiple shocks to overall economic confidence since 2000 including the dot-com meltdown, the 2001 terror attack, multiple mid-east wars, and the 2008 recession have constantly elevated the safe-haven value of Treasury bonds.

Since the 2008 crisis, dominant and persistent fears (low confidence) have overwhelmed the economic cycle and helped to keep bond yields low. Beginning last year, confidence finally started to improve and bond yields have likewise begun to rise again. Confidence remains quite low by historic standards. Should economic growth accelerate above 3%, confidence is likely to rise even further during the rest of this year continuing to diminish the safe-haven premium in bonds.

Chart 4: Treaury bond yield and CONFIDENCE Left scale10-year Treasury bond yield (solid) Right scaleBloomberg U.S. Consumer Comfort Index (dotted)

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

4

4. An emerging world economic bottom is a risk for U.S. bond yields???

Except when exiting from the bottom of the 2008-2009 global recession, the economic recovery has not yet enjoyed a simultaneous acceleration in both developed and emerging economic growth. Earlier, while emerging economic growth was strong, many developed economies (e.g., eurozone and Japan) were contracting. Now, when most developed economies are growing, emerging world economic growth is slowing. As shown in Chart 5, a healthy performance by emerging economies has typically pressured the U.S. bond market. This chart overlays the 10-year Treasury yield with the performance of emerging market stocks relative to the S&P 500 Index. Although not a perfect relationship, it does highlight how the underperformance of emerging economies in the last few years has helped keep bond market pressures at bay.

In recent weeks, emerging stocks have outpaced domestic stocks by the largest amount since 2012 when the 10-year yield bottomed. This may prove to be just another false start (like late last year), but if the recent performance of emerging stocks is a precursor to improved emerging economic growth, upward pressure on bond yields may soon intensify. Indeed, should emerging economic growth soon bottom, the bond market may face the strongest global cyclical pressure of the recovery as both developed and emerging economic growth simultaneously accelerate.

Chart 5: U.S. bond yields and emerging market stocks Left scale10-year U.S. Treasury bond yield (solid) Right scaleRelative price performance of Emerging Market Index (EEM)

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

5

5. Credit propensities have nally turned up!!

Debt liquidation lasted longer in this recovery than typical. While uncommonly weak credit demands have so far kept interest rate pressures modest, for the first time in this recovery, borrowing appetites may be awakening. After steadily declining throughout this recovery, Chart 6 shows that

annual total household debt growth has risen in each of the last two quarters! Moreover, as illustrated in Chart 7, total bank loans (led by renewed strength in business borrowings) have recently risen at the quickest pace of the recovery. How will the bond market react now that the recovery is finally generating more normal borrowing demands?

Chart 6: Total U.S. bank loans

Chart 7: Total U.S. household debtannual growth rate

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

6

6. Is wage ination already accelerating?

Overall wage inflation (Chart 8) has remained dormant at about 2% throughout this recovery. This has kept most bond participants calm about any imminent wage-push inflationary pressures. However, for 80% of wage earners, labor inflation has already been accelerating for more than a year.
Chart 8: Total Annual wage inflation* Annual growth in U.S. average hourly earningsboth supervisory and non-supervisory workers. Three-month moving average of annual inflation rates

We believe wage inflation could surprisingly rise before the year is over. Even a relatively small rise in overall annual wage inflation (e.g., even if wage inflation in Chart 8 would to rise to 2.5%) would probably bring outsized panic surrounding Fed policy and bond yields. If conventional wisdom finally begins to fear problematic cost-push pressures (primarily rising wage pressures), bond yields would almost surely rise.
Chart 9: Annual wage inflation* Annual growth in U.S. average hourly earningssupervisory workers. Three-month moving average of annual inflation rates

Charts 9 and 10 illustrate wage inflation among supervisory workers (20% of wage earners) and non-supervisory workers (80% of wage earners), respectively. Clearly, as shown in Chart 9, wage inflation has remained subdued in the last year primarily because supervisory wage growth has slowed. However, Chart 10 shows most workers have been enjoying rising wage gains since late 2012. For non-supervisory workers, wage inflation has risen by a full percentage point from its low of 1.3%! As illustrated, supervisory wage inflation tends to be more volatileit rose in early-2009, declined until late 2010, rose again until 2013, and has since fallen again. Consequently, it certainly would not be surprising if yet another acceleration in supervisory wages was forthcoming. Conversely, nonsupervisory wage inflation tends to be less choppy often continuing to accelerate throughout a recovery once it establishes a major upturn as it did in 2012.

Chart 10: Annual wage inflation* Annual growth in U.S. average hourly earningsnon-supervisory workers. Three-month moving average of annual inflation rates

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

7

7. Resource markets are tightening???

Chart 12: U.S. factory utilization rate

So far in this recovery, abundant resource slack has helped keep interest rate pressures subdued. Both the overall labor unemployment rate and the underutilization of factory capacity rose to near post-war records in the last recession. However, as illustrated by Charts 11 and 12, both the labor market and factory utilization has tightened significantly. While the overall unemployment rate remains above average, the short-term unemployment rate is near 4% (those who have been unemployed for less than 27 weeks) and is now below its historic average. Likewise, the factory utilization rate will soon rise above 80%. A short-term unemployment rate near 4% and a factory utilization rate near 80% has historically been associated with wage and interest rate pressures. Moreover, the real broad U.S. dollar index is currently near an all-time record low (Chart 13). Should this attractively priced dollar begin to improve U.S. international trade flows (indeed, real net exports improved and added to overall real GDP growth in each of the last two quarters), the U.S. resource markets could tighten faster than most appreciate as additional foreign demands augment domestic spending trends.

Chart 11: U.S. short-term* labor unemployment *Includes all unemployed for 26 weeks or less

Chart 13: U.S. trade-weighted real broad dollar index

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

8

8. Bond yields are too low relative to nominal GDP growth?!?

As illustrated in Chart 14, during the 1980s, the 10-year bond yield was typically at a significant premium to the pace of annual nominal GDP growth. During the 1990s, the 10-year yield was often about on par with the pace of nominal economic growth and since 2000, the 10-year yield has frequently been at a discount to the pace of overall economic activity. Overall, since 1980, the 10-year bond yield has averaged about 1% above the pace of nominal GDP growth and since 2000, the yield has been almost identical with the pace of economic growth.

Currently, however, the 10-year yield remains at a significant discount of almost 1.4% relative to nominal GDP growth (i.e., 4.1% nominal GDP growth versus a 10-year Treasury yield of about 2.7%). Trading at such a big discount to the pace of overall economic growth depicts a bond market with risk. We expect a sizable improvement in nominal GDP growth yet this year which could roil an already heavily discounted 10-year bond yield. Annual nominal GDP growth may rise to about 5.5% by year-end (comprised, perhaps, by about 3.5% real GDP growth and about 2% inflation). If this proves correct, even if the current 1.4% discount to nominal GDP is maintained, the 10-year bond yield would rise to about 4%.

Chart 14: Treasury bond yield versus nominal GDP growth 10-year Treasury bond yield (solid) Annual nominal U.S. GDP growth (dotted)

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

9

9. Will bond yields rise as money velocity turns up??!

We believe one reason economic growth has recently improved is because the velocity of the money supply (the rate at which the money supply is turned over each year in economic transactions) has probably turned higher. As illustrated by Charts 15 and 16, bonds often do not do well once money velocity begins rising in a recovery. The diamonds on each chart mark the beginning of every major increase in money velocity since 1965. Bond yields suffered significant increases in every instance except for during the early 1990s (yields continued to decline despite the upward turn in velocity) and again in 2009 (the start of this recovery when bond yields rose before velocity bottomed and then velocity soon started declining again).

Typically, once velocity begins to rise, it continues rising until the next recession. Rising velocity tends to present several challenges for the bond market. For example, it constantly fosters faster economic growth, forces the Fed to tighten policy, and heightens inflationary fears. Although velocity has not yet bottomed, we expect it may in the next couple quarters. If so, the environment surrounding the bond market will likely turn decidedly more hostile.

Chart 15: M2 money supply velocity* *The diamonds mark the beginning of all significant increases in M2 money velocity

Chart 16: U.S. 10-year Treasury bond yield versus major money velocity turns* *The diamonds mark the beginning of all significant increases in M2 money velocity Natural log scale

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

10

10. Fiscal contraction typically BAD for bond yields!??

Charts 17 and 18 illustrate that bond yields typically rise as the government returns to financial health. That is, bond yields have usually risen as the U.S. government deficit contracts (improves). It is no coincidence the 10-year Treasury bond yield bottomed in 2012 when the government deficit began to significantly improve.

Since 1970, nearly every major period of fiscal improvement in the government sector has been associated with upward pressure on bond yields. Since the deficit as a percent of nominal GDP is still currently about 4%, it is likely to improve much further in the next few years suggesting bond yields also are likely to continue rising.

Chart 17: U.S. governement deficit as a percent of nominal GDP

Chart 18: 10-year Treasury bond yield Natural log scale

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

11

Summary and conclusions?

The bond market has been bolstered by many favorable influences so far in this recovery including an uncommonly weak recovery, a large output gap, a populace worried mostly about depressionary/deflationary outcomes, and uncharacteristically weak credit usage. Combined, these forces have allowed the 10-year Treasury yield to remain extremely low despite almost five years of continuous economic growth. It has also probably lulled most investors into a mindset which is underestimating the potential for yields to rise. Although real GDP growth currently remains modest and while there is very little evidence of imminent inflationary pressures, we think many factors are aligning which could cause a significant rise in bond yields before the year is over. First, bond yields have not yet fully reconnected with the economic cycle after dislodging in panic during the 2008 crisis. That is, the 10-year Treasury yield is still too low relative to both current inflation and relative to current nominal GDP growth. Second, the economy is showing signs of finally exiting stall speed (i.e., real GDP growth near 2%) and real growth appears poised to rise above 3% this year. Third, after languishing near post-war lows, confidence has finally recovered to five-year highs and continues to improve. Rising confidence is reducing the safe-haven discount evident in bond yields since the crisis. Fourth, the recent outperformance of emerging market stocks may be signaling a bottom in the emerging economic growth rate. Should a bottom be confirmed, the most synchronized and fastest global growth of the economic recovery would likely pressure bond yields.

Fifth, borrowing propensities have turned noticeably stronger in recent months for the first time in this recovery. Sixth, wage inflation among 80% of wage earners has already been accelerating for more than a year making it likely that overall wage inflation will soon begin rising. Seventh, slack in the U.S. resource markets (labor and capital unemployment) has diminished significantly in the last year increasing the possibility and frequency of broad-based cost-push inflationary pressures. Eighth, while money supply velocity has been declining throughout this recovery, we expect it may soon bottom. If velocity does begin rising soon, overall economic momentum, inflationary evidence, and concerns surrounding the Feds exit strategy may all increase and worsen conditions surrounding the bond market. Finally, the U.S. government deficit continues to improve which, historically, has usually been associated with rising bond yields. Predicting an imminent rise in bond yields has not been a successful approach during much of the last three decades. A call for caution this year may once again prove premature. However, conditions surrounding the bond market are no longer nearly as hospitable as they have been in recent years. Indeed, for the first time in this recovery, several forces are aligning against bonds and investors should ensure they are adequately protected against yield risks.

WELLS CAPITAL MANAGEMENT

Economic and Market Perspective

12

Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for prot as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000. WELLS CAPITAL MANAGEMENT is a registered service mark of Wells Capital Management, Inc. Written by James W. Paulsen, Ph.D. 612.667.5489 | For distribution changes call 415.222.1706 | www.wellscap.com | 2014 Wells Capital Management