Tuesday, December 1, 2015

Bond market embraces higher short rates

We're now two weeks away from the December FOMC meeting, when it is widely expected—and feared—that the Fed will lift short-term interest rates for the first time since mid-2004. It's not yet a slam dunk, given today's weak ISM manufacturing report, but market pricing implies a 70% probability of a move, and short-term rates are already rising in anticipation. The bond market is doing its best to give the Fed the "all clear," and the stock market looks to be in agreement. This is great news.



The two charts above put the Fed's upcoming move into historical context. The decline in interest rates which began 34 years ago is now coming to an end. 2-yr Treasury yields, which are equivalent to the market's expectation for the average Federal funds rate over the next two years, are now 0.9%, up from an all-time low of 0.16% in September 2011. They haven't been this high for over 5 years. 10-yr Treasury yields are now 2.15%, up some 75 bps from their all-time low of 1.39% in July 2012.

There's nothing unusual or scary about the current slope of the yield curve; it simply means that the market fully expects higher rates, but not so high as to threaten growth. The time to worry is when the yield curve becomes flat or negative, and we are probably years away from that. No one expects the Fed's upcoming or subsequent moves to threaten anything.


As the chart above shows, 3-mo T-bill yields have jumped some 20 bps in the past six weeks, after hugging zero for several years. Market participants are no doubt deciding that the yields available on alternatives—such as bank reserves and 3-mo LIBOR—are more attractive than earning nothing on bills: swapping out of bills into the alternatives is the logical maneuver. It's encouraging to see the price of the world's premier safe asset fall, since that suggests that the economic and financial market fundamentals have improved on the margin. Expect to see money market rates in general moving higher. Finally.


It's also encouraging to see that the recent rise in T-bill yields has been associated with a decline in the TED spread (the difference between the yield on 3-mo LIBOR and 3-mo T-bills). This spread has always been a good indicator of financial market stress. The current spread, about 20 bps, is almost exactly at the level you would expect to see during periods of normalcy. It's narrowed mainly because LIBOR yields have risen less the T-bill yields. As such, it reflects the dynamic of rising interest rate expectations, and not any deterioration of the fundamentals.

5 comments:

marcusbalbus said...

dull. trite.

Benjamin Cole said...

The decline in interest rates which began 34 years ago is now coming to an end.--Scott Grannis.

I used to think this would be right; after all, you "can't go below zero on interest rates."

Um. Except you can. See Europe. You have to pay Switzerland for the right to own a 10-year bond from that nation.

Also, during that entire 34-year stretch (which coincides with continual declines in inflation rates) you continuously had pundits predicting higher rates of inflation and interest rates. During the whole stretch. Some pundits stayed true to their predictions for three and half decades, so why change now?

Alas, higher rates never happened. The secular trend was down, down, down, down.

The Fed is now conducting reverse QE (shrinking its balance sheet), paying banks not to lend (IOER) and going to raise short-term rates Dec. 15.

Danger Will Robinson! The last time the Fed shrank its balance sheet...was just before the 2008 bust-Great Recession.

The Fed is following extremely risky policies.

Bonus points if you are old enough to remember Will Robinson.

Thinking Hard said...

Benjamin - Link to Fed conducting reverse QE? Balance sheet has leveled off (https://research.stlouisfed.org/fred2/series/WALCL) and the forward guidance I have read states the Fed will be rolling over maturing debt at least in the short term.

Scott - I also point to Benjamin's point of contention above. I do not see how interest rates can rise to any appreciable level. I am interested in your technical analysis pointing to a higher probability of interest rates "normalizing" at 4% FFR vs. lower probability of interest rates declining below the low in 2012.

I see evidence out of a long term indicator pointing to caution on interest rates, namely mortgage rates. The last three recessions have been precluded by a three year period where mortgage rates failed to reach a new low. We surpassed three years towards the end of November (https://research.stlouisfed.org/fred2/series/MORTGAGE30US). This coupled with the fact that the shadow rate has already risen over 245bps (https://www.frbatlanta.org/cqer/research/shadow_rate.aspx?panel=1) and the fact the WSJ dollar index has strengthened approximately 25% over the last 18 months (http://quotes.wsj.com/index/XX/BUXX) points me to the conclusion we are not likely to see the FFR go over 1% in the next couple of years, but instead we are more likely to see continued easing and likely lower interest rates. Refinancing has also declined significantly over the last 3 years.

Scott Grannis said...

Re: interest rates. Don't get me wrong. I'm not forecasting 4% short term interest rates anytime soon. I don't see any problem with short rates going to 1-2% over the next year or so. That would still be relatively low in real terms (inflation being 1.5-2%). Ultimately, the level of interest rates will be determined by the strength of the economy and inflation expectations.

Let me recap how I see QE working. I've said many times that QE was not designed as a "stimulus" program for the economy. Low interest rates, even artificially-depressed low interest rates, cannot create economic growth and productivity out of thin air. They are not necessarily a stimulus to investment; they may encourage some to borrow, but they may also discourage others from saving.

QE was all about satisfying the world's demand for money and money equivalents. The Fed engaged in QE in order to transmogrify notes and bonds into T-bill substitutes (aka bank reserves). The Fed never "printed money" as so many people mistakenly believe. Safe assets were in huge demand and the Fed needed to satisfy that demand. And since that demand is no longer as intense, it is appropriate for them to not do more QE, and to in fact begin to slowly unwind QE by raising the rate they pay on reserves and by slowing selling their note and bond holdings.

If they fail to raise rates by enough to keep the demand for bank reserves strong, then banks will eventually begin converting excess reserves into required reserves by lending more and more. And the public will by the same logic begin trying to reduce their holdings of cash (e.g., $8 trillion of bank savings deposits) in favor of other things, thereby increasing the velocity of money. That would be the mechanism that would enable an acceleration of nominal GDP (and higher inflation).

I would much rather the Fed err on the side of caution by raising rates sooner rather than later. Banks still have an almost unlimited capacity to lend, and there does not appear to be any shortage of liquidity in the financial markets. A 1% fed funds rate is not going to hurt the economy at all, and it may even help.

Bottom line: since zero interest rates and QE were not "stimulative," reversing them will not prove harmful to the economy. Zero interest rates did not sustain an otherwise fragile economy; the provision of trillions of bank reserves satisfied an intense demand for money and restored liquidity and confidence to the financial markets. Financial markets look quite healthy right now, and do not appear to need any more of the Fed's ministrations.

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