Tuesday, July 15, 2014

The outlook for interest rates

Everyone knows that interest rates are going to rise in the future. So the real question is not whether they will rise, but when and by how much. Janet Yellen didn't change the consensus opinion regarding these questions much in her testimony today. The market thinks the Fed is almost certainly going to end the tapering of QE3 in October, and about six months later, give or take a few months, the Fed is expected to start raising short-term rates. They will probably do this by increasing—very slowly—the interest rate they pay on bank reserves, using reverse repo transactions, and by not rolling over maturing Treasuries and MBS.


The above graph shows the Treasury yield curve at different points in time: April 2013 (the all-time low for the 10-yr Treasury yield), today, and two and five years in the future. The latter two are derived mathematically from the current Treasury curve. If you compare this graph to the one in my post last March ("How much are yields going to rise?") you can see that not much has changed of late. The Fed is expected to raise short-term rates in a very gradual fashion beginning next year, and five or so years from now rates are going to be topping out around 3½ to 4%.


There's nothing very scary about this. As the graph above shows, for most of modern history 5-yr Treasury yields have traded well in excess of 3%. That 5-yr yields today aren't expect to rise above 4% for as far as the eye can see is pretty unusual from an historical perspective.

Interest rates aren't expected to rise by much because 1) the market doesn't think the U.S. economy has much chance of returning to its former growth glory, and 2) the market doesn't think that inflation has much chance of exceeding 2-3%. In other words, the bond market today seems fairly convinced that growth will be sluggish and inflation will therefore be tame for as far as the eye can see.

If you disagree with the assumptions behind the market's current consensus, then you can take actions to bet that interest rates will be either higher or lower than current expectations. For example, if you see more potential for growth and inflation, then bet that rates will rise faster than expected: lock in long-term borrowing costs today; keep the duration of bonds you own as short as possible; and avoid excessive leverage (or place hedges to protect against higher-than expected borrowing costs). Consider an increased exposure to real estate, since it should benefit from stronger growth and higher inflation, and it is not necessarily expensive today. Consider also an increased exposure to equities, since stronger growth and higher inflation should have a positive impact on future expected cash flows.

For my part, I acknowledge that I have been overly concerned about rising interest rates for most of the past 5 years or so. Being wrong for so long is humbling, but it is not a reason to shy away from worrying about a faster-than-expected rise in interest rates today. In the end, it's all about what happens to the economy and to inflation.


I'm still an optimist on the economy, since I think the market's growth expectations are overly pessimistic. I think 5-yr real yields on TIPS tell us a lot about the market's underlying expectations for real economic growth. As the graph above suggests, the current -0.38% real yield on 5-yr TIPS points to economic growth expectations of perhaps 1% per year, which in turn is a bit less than we've seen in recent years. If the market were convinced that future growth would be a solid 3% a year, then real yields today would be a lot higher than they are now.


I'm still more worried about inflation than the market is, since I think the market is being a bit too complacent about the inflationary potential of the Fed's massive balance sheet expansion and the Fed's ability to reverse course in a timely fashion. As the graph above shows, the market expects CPI inflation over the next 5 years to average a mere 2.1%, which is actually less than the 2.3% it's averaged over the past 10 years. I'm not predicting hyperinflation or anything like it, I'm just saying that expecting inflation as usual for as far as the eye can see despite the Fed's huge and unprecedented experiment in quantitative easing is a bridge too far for me.

There's nothing scary about expecting interest rates to rise more than expected. Rates aren't likely to surprise on the upside unless real growth expectations and/or nominal GDP expectations rise, and given the pessimism inherent in the market's current expectations, either one of those would be very welcome developments.

Interest rates are a good barometer of the market's expectations for growth and inflation. That they are still so low today means that the market holds little hope for any meaningful improvement in the outlook for the economy and/or any meaningful rise in inflation. We're living in a slow-growth, low-inflation world for now, and—as often occurs just before something hits us from left field—the market is extrapolating that today's conditions will prevail for as far as the eye can see.

7 comments:

PD Dennison said...

Scott,

My theory for 6 or more years, is that Europe is becoming Japan and the US is becoming Europe.

The idea that Japan's rates must rise has been a constant theme for many decades.

Without political change to free market policies, monetary policy is the only politically acceptable game in town.

With a highly competitive global economy and power/money hungry governments, the result is little growth, low interest rates and little private investment.

It will take political change to stop the cycle. Japan and the Chicago Cubs are well into a 30 year rebuilding program.

theyenguy said...

On Tuesday, July 15, 2014, Fed Chairman Jane Jellen spoke in Semiannual Monetary Policy Report To Congress, and stocks, commodities, bonds, and currencies all traded lower, evidencing the failure of fiat money.

Debt deflation is underway as Credit Investments, AGG, traded lower, as the Interest Rate on the US Ten Year Notes, ^TNX, traded higher from its Friday July 11, 2014, value of 2.52% to 2.55%; thus evidencing that the bond vigilantes are in control of Interest Rates worldwide.

Major World Currencies, DBV, were led lower by the Canadian Dollar, FXC; and Emerging Market Currencies, CEW, were led lower by the Brazilian Real, BZF.


On July 2, 2014, the failure of credit commenced as Aggregate Credit, AGG, traded lower in value.


On Monday, July 7, 2014, the destruction of fiat wealth commenced, as risk-on investing turned to risk-off investing, with World Stocks, ACWI, Nation Investment, EFA, Global Financials, IXG, and Yield Bearing Investments, DTN, all trading lower from rally highs, as investors fear that the monetary policies of the world central banks no longer stimulate investment gains nor global economic growth.

On Tuesday, July 15, 2014, the death of currencies commenced as is seen in the Commodity Currencies, CCX, such as the Canadian Dollar, FXC, the Euro, FXA, and the Australian Dollar, FXA, trading lower, on fear that the monetary policies of the world central banks have crossed the rubicon of sound monetary policy and have made money good investments bad.

One should not be invested in Equity Investments, Nation Investments, Banking Investments, Yield Bearing Investment, or Credit Investments, as the death of Sovereign Currencies, commenced on Tuesday July 15, 2014, after Janet Yellen spoke in Semiannual Monetary Policy Report To Congress.

Fiat Money, defined as the combination of Credit, AGG, and Major World Currencies, DBV, and Emerging Market Currencies, CEW, died on Tuesday July 15, 2014, as investors fear that the monetary policies have crossed the rubicon of sound monetary policies and have made money good investments bad.

It may be that Gold will be trading lower in value, as it does, one should be dollar cost averaging into the physical possession of gold bullion, as it is the only safe asset and will eventually be trading higher as all fiat assets trade lower in value. Gold is in the middle of an Elliott Wave 3 Up, these are the most dynamic and sweeping of all economic waves, as they move higher to their Elliott Wave 5 High.

One should not be invested in Equity Investments, Nation Investments, Banking Investments, Yield Bearing Investment, or Credit Investments, as the death of Sovereign Currencies, commenced on Tuesday July 15, 2014, after Janet Yellen spoke in Semiannual Monetary Policy Report To Congress.

Fiat Money, defined as the combination of Credit, AGG, and Major World Currencies, DBV, and Emerging Market Currencies, CEW, died on Tuesday July 15, 2014, as investors fear that the monetary policies have crossed the rubicon of sound monetary policies and have made money good investments bad.

Please consider that given that Fiat Wealth, That Is The Coinage Of The Banker Regime, Is Trading Lower In Value, The World Has Pivoted Into Kondratieff Winter.


The failure of credit, which occurred on July 2, 1014, and the death of currencies, which occurred on July 15, 2014, are dual extinction events, which will rapidly make the investor extinct.

The Bond Vigilantes, being in firm control of The Bow of Economic Sovereignty, that is the Benchmark Interest Rate, will be calling Interest Rates higher worldwide, introducing political coup d etats; out of which the new money, diktat money, defined as the mandates of regional leaders for regional security, stability, and sustainability, will underwrite regional fascism replacing today’s crony capitalism, socialism, and communism.

Inasmuch as destructionism is replacing inflationism, the economic future is one of global economic deflation, and rising headline price inflation.

Benjamin Cohen said...

Everyone knows that interest rates are going to rise in the future.--Scott Grannis.

Well, the future is a long time, so I suppose we can let this one pass.

But it may be we see interest rates fall or drift for a long time, as in decades.

As one Grannis chart shows, interest rates have been in a 30-year swoon. Why stop now? What caused the 30-year swoon, and what has changed to reverse it? I think central banks are more inflation-phobic than ever. Volcker was happy with 4 percent inflation. Now Yellen is a "dove" and would stamp out inflation above 2 percent.

The world has never generated so much capital--vast pools of it, more than the market can absorb. Supply and demand, means lower interest rates.

Savers like to say they are "entitled" to returns. That is a fiction. Savers are also "entitled" to losses then.

Savers are only "entitled" to a return if a government artificially provides a guarantee.

We could be entering a long period of losses for savers, caused by too-high savings rates in non-market economies.

A real question is whether the Fed is keeping interest rates artificially low or high.

Also, Grannis speaks of the Fed unwinding its balance sheet. Maybe it will, maybe it won't. Why would it? John Cochrane advocates a massive expansion beyond this level. Certainly the balance sheet is an asset for the government, and throws off income, offsetting taxes. Not sure why Uncle Sam would ever sell.

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William said...

A diversified equities portfolio has been the best performing asset (gold excluded) over the past 5 years and would perform well in a slowly rising inflation environment since corporations function in the world of nominal GDP growth rates and nominal inflation rates.

The S & P 500 index provides a mixture of growth and higher yielding value stocks. Under Scott's scenario there is no need to get fancy to profit from the current and likely future economic environment.

Most equities raise their dividend annually to boot. And it's cost effective!

chilands said...

Scott, you mention briefly that markets think growth will be low and therefore inflation will be low. I'd be very interested in a blog post on inflation: what is the right definition, does growth cause inflation, proper measurements (i.e., how do we know when/where it shows up), Phillips curve, etc. One of your influencers Wanniski wrote extensively on these topics. Would be good to get your views in a current context.

Scott Grannis said...

I have quite a few posts on the subject of inflation and growth, but it's been awhile since I've treated the subject explicitly. I'll try to do so in a future post. In the meantime, suffice it to say I don't believe that slow or below trend growth necessarily leads to low or falling inflation. Inflation is a monetary phenomenon, period. The fed is more inclined to believe the Phillips curve theory of inflation however, which I think increases the chance of the, making an inflationary error.