Tuesday, September 17, 2013

How much higher should interest rates be?


We're leaving paradise today, so in the absence of time I offer this chart which makes a statement about the level of inflation and interest rates over the past decade. Inflation and inflation expectations are one of the most important determinants of interest rates.

From 1993 through early 2011, Treasury yields tracked core inflation quite closely, and interest rates were always somewhat higher than inflation, just as theory would predict. But from early 2011 through April of this year, that wasn't the case: interest rates moved down while inflation rose, and interest rates fell below the level of inflation (and real interest rates entered negative territory).


Most observers seem to believe that interest rates were abnormally low because of the Fed's QE program. But as the chart above shows, interest rates actually rose each time the Fed bought large quantities of bonds.

I've argued that interest rates fell to unusually low levels because the world expected U.S. economic growth to be very weak, and feared that another recession was on the horizon. Interest rates have moved higher of late because the outlook for the U.S. economy has improved somewhat.

The recent jump in rates appears to be the first step in restoring the normal relationship between interest rates and inflation. Rates are still relatively low, however; if inflation remains at current levels and the economic outlook continues to improve (e.g., the market begins to price in growth expectations of 3% or better), then short- and intermediate-term interest rates should and could rise by another 100 bps. 10-yr Treasury yields could rise by another 50 bps or so.

9 comments:

Benjamin said...

Interesting post.

Hopefully, we will see sustained higher rates of inflation and interest in the USA,

In Japan, they never got there---they have been in or very near zero lower bound for 21 years.

I think robust growth, moderate inflation and higher interest rates are going to take sustained and aggressive growth-oriented monetary and tax polices.

Will our leaders commit?

Time will tell....

steve said...

scott, considering that A) the sentiment against bonds is easily at all time highs (a contra indicator) and by your own chart, rates tend to fall as QE's end (taper) we should expect rates to FALL over the coming mos. moreover, I can't put my finger on it exactly but I am sensing too much complacency in stocks. I'm a bond fund TRADER and am 100% long munis right now having bought just recently. rather be there than in stocks for the near term.

sgt.red.blue.red said...

The answer, after this aftenoon's Fed 'taper' meeting--lower.

The Cleveland Fed's ten year expected inflation rate is 1.8+ percent (see yesterdays updated information);

Yesterday's CPI and CPI ex Food & Energy (all Urban), was +0.1% for August for both indices. Annualized, that is about 1.3% if my HP doesn't deceive me.

The Fed reiterated they will continue to keep interest rates exceptionally low for an extended period of time.

William McKibbin said...

The lesson learned from the Fed today is that QE will continue until unemployment drops below 5% -- if unemployment does not drop below 5%, then QE will go on forever -- said another way, if unemployment does not drop below 5%, then QE will continue full power for the rest of Scott's life...

Rob said...

Scott, we urgently await your take on the Fed's (non) actions !

Scott Grannis said...

Briefly, I'd say that the Fed's decision to delay the tapering of QE isn't very significant, since the amount involved (~20 billion per month) is very small compared to total excess reserves (about 0.5%). Whether they taper or not, the banking system is still going to be flooded with excess reserves, which means monetary policy is very accommodative no matter what. But it does illustrate the Fed's propensity to err on the side of caution (giving more weight to GDP growth than to inflation), and that shows up in a weaker dollar and higher gold prices. We are seeing a glimpse of what the Fed will be like under Yellen, a notorious dove.

Rob said...

Thanks Scott ! So does this non-action mean that, contrary to your opening words, we are not in fact leaving paradise now ?

theyenguy said...

You write, I've argued that interest rates fell to unusually low levels because the world expected U.S. economic growth to be very weak, and feared that another recession was on the horizon. Interest rates have moved higher of late because the outlook for the U.S. economy has improved somewhat.

The recent jump in rates appears to be the first step in restoring the normal relationship between interest rates and inflation. Rates are still relatively low, however; if inflation remains at current levels and the economic outlook continues to improve (e.g., the market begins to price in growth expectations of 3% or better), then short and intermediate term interest rates should and could rise by another 100 bps. 10-yr Treasury yields could rise by another 50 bps or so.

I ask, what is to stop the rates rising even more significantly than you sugges.

Here's the reality.

The global central bank credit bubble, BWX, began to collapse, as bond vigilantes called the Interest Rate on the US Ten Year Note, ^TNX, higher to 2.1% on May 24, 2013, and then to 2.9% on Friday September 13, 2013, on fears of US Fed tapering, with the result that the crack up boom in stocks began to implode; but only reflated with QEternity, on September 18, 2013. The benchmark rate fell to 2.73% the week ending September 20, 2013.

The 37 ETFs seen in this Finviz Screener ... http://tinyurl.com/m5zadum ... have risen strongly under US Fed relentless QE monetary policy, and are poised to fall strongly lower on the exhaustion of the US Fed’s and world central bank’s monetary authority, that is as bond vigilantes, begin calling the Interest Rate on the US Ten Year Note, ^TNX, higher from 2.75%, and currency traders once again, begin selling Major World Currencies, DBV, and Emerging Market Currencies, CEW, these are XIV, FDN, CARZ, PBS, IBB, RZV, PSCI, FPX, IAI, XTN, SMH, XRT, PJP, PSP, TAN, RXI, FLM, EIRL, WOOD, EUFN, RWW, FXR, BJK, PBJ, EFNL, YAO, PPA, PNQI, EZA, KROO, ARGT, EWY, GNW

Scott Grannis said...

steve: Rates don't rise because QE ends or tapers. Rates rise because the economic fundamentals improve. Where they go from here is a function of the strength of the economy and the outlook for inflation.