There is a bubble in the markets, Deutsche Bank analysis concludes. It is “The Real Bubble,” the title of a March 16 report that considers US interest rates, where a market imbalance is on the verge of being unmasked.

Real Bubble toil and trouble: The US Ten Year Note is at unnaturally low rates

With the US Ten Year Note yielding 2.5%, it is operating at “levels comparable to those seen at the depths of the financial crisis,” Deutsche Bank Chief Strategist Binky Chadha, Strategists Parag Thatte and Rajat Dua note.

So much has changed since the financial crisis. The unemployment rate, for instance, is now below 5%, nearly half the rate after the global financial crisis. What hasn’t changed, however, are interest rates, which, at negative real levels around the world, imply a financial crisis has been upon us. What is now changing is the controlled level of US rates.

“We see real rates as extremely misvalued if not in a bubble,” the report flatly stated, pegging a “real” normalized rate of 3.5% if monetary policy had been driven by historic norms. “Monetary policy has been set instead on a view of the future that embodies a break from the past.”

That break from the past, in part, is based on the relationship between inflation and unemployment and the slowdown in productivity growth. But their analysis is missing a key driver: the US dollar. “Nor does productivity growth look to have fallen below its historical trend in this cycle,” they wrote, pointing to a historical norm of trend growth remaining consistent near 1.4% to 1.5%. “Indeed we see the historical drivers of productivity aligning for an inflection up,” which is also based in a gap in GDP growth:

Monetary policy actions created and perpetuated the large divergence of real rates below GDP growth. During the first two years of this recovery, Mar 2009-Jun 2011, real rates remained relatively well aligned with real GDP growth. Real rates first fell well below GDP growth in July 2011, around the US debt downgrade. But the divergence was perpetuated by the Fed’s adoption of calendar rate guidance soon after. Though growth and equities rebounded over the next 6 months, the Fed continued its policy of calendar rate guidance and real rates sustained far below GDP growth for the next 2 years. The Fed’s abrupt announcement of taper in mid-2013 saw real rates climb by 150bps over 6 months, with the divergence to GDP growth shrinking to within the norm of historical variation. Starting in early 2014, real rates fell for 2½ years as the ECB moved to negative policy rates, the dollar rose sharply, oil prices collapsed and the Fed repeatedly pushed out rate normalization. Real rates have risen since their Brexit lows last summer as US and global growth has continued to rebound from the dollar shock but they remain very low.

Real Bubble
Real Bubble

Real Bubble: Real rate for US Ten Year Note Should be 3.5%

If markets were functioning without undue interference, the real rate of the US Ten Year Note might be at 3.5% today. The question is: how do we get there?

The Deutsche Bank report notes “catalysts for a correction of real rates,” which points to the “higher market expectations of the speed and eventual level to which the Fed will hike policy rates.” Last week’s report comes as the one-time poster boy for Fed rate hike doves, Chicago Fed President Charles Evans, is now saying four rate hikes is possible in 2017, indicating an aggressive path.

Market expectations of Fed policy rates have risen significantly since last summer’s lows but remain well below the Fed’s guidance. But this is relatively typical, with the market underestimating the speed and extent of hikes in past cycles. Indeed past hiking cycles saw a significant repricing with average price losses on the 10y of -11% (at current duration levels 120bps on the 10y). The Fed simply sticking to its present guidance should see market expectations move up towards it in a “seeing is believing” manner. We expect this to take a couple of hikes, so clear communication of a June hike for example should see a notable move up in market expectations as it would leave open the possibility of the Fed moving 4 times this year.

But is not just June, the report noted. Watch for a September and December event, which is expected to lead the US Ten Year note to close 2017 with a rate of 3.25% and end 2018 at 4%, the report predicted. This is expected to follow a similar uptick in inflation which is expected to make the Fed “anxious.”

The real question is when this results in markets getting equally “anxious.” It hasn’t happened yet.

Real Bubble
Real Bubble