Wednesday, July 18, 2018

Why are interest rates so low?

Late last year, in my Predictions for 2018, I thought the main theme for the year would be "waiting for GDP." Policy changes in the previous year had set the stage for much stronger growth, higher interest rates, and a stronger dollar, but I thought the market would be skeptical until clear signs of stronger growth emerged. While there is still every reason to believe economic growth is accelerating, the evidence of a new economic boom is still not yet conclusive. The economy is improving on the margin, but budding tariff wars are dampening enthusiasm and keeping risk aversion alive.

Interest rates have moved higher over the course of this year: 5-yr real yields on TIPS have increased from 0.3% to 0.7%, and 10-yr Treasury yields have risen from 2.3% to almost 2.9%, paced by a 0.5% boost to the Fed's short-term interest rate target. That's small potatoes in the great scheme of things. Both the bond market and the Fed have priced in somewhat stronger growth, but these moves are still modest compared to what one would expect from a solid package of supply-side tax cuts and reduced regulatory burdens such as we saw enacted last year. These things take time, to be sure, and we're still in the early innings. Meanwhile, the risk of tariff wars is driving demand for hedges, and Treasuries are the market's favorite port when economic storms threaten. Consequently, interest rates arguably are still depressed relative to where they should be in a robust growth environment.

Back in December I cautioned that higher interest rates would not be well-received, and a month later the equity market shed over 10% of its value in a few days. More recently, nerves have been tested as US-China trade relations deteriorate and reciprocal tariff hikes are announced. In December I thought that further gains in equity prices would not come from higher earnings multiples but rather from rising earnings; so far, the PE ratio of the S&P 500 has fallen from 21.7 to 21.3, and earnings per share (based on trailing 12-month reported earnings) have increased only modestly, from 123.2 to 132.1. Earnings are going to have to continue improving if equities are to march still higher, and that is all part and parcel of a ratcheting up of economic growth that is likely underway but still not yet obvious.

In the meantime, as we await news of unusually strong economic activity, a stronger dollar has accompanied weaker commodity and gold prices, and all have conspired to squeeze emerging market economies, much as I feared. But the dollar is only moderately strong, commodity prices are still quite strong, and the Fed has yet to tighten monetary policy, so the pressure on emerging market economies is nowhere near what it was in the late 1990s and earl 2000s. I think we'll see emerging markets begin to recover, especially as—and if—evidence of a stronger US economy emerges.

Chart #1

The point of Chart #1 is to demonstrate that real yields tend to track the real growth rate of the economy. Currently, real yields on 5-yr TIPS (the best market-based proxy for short-term real yields I know of) are consistent with economic growth of about 2.5% per year. This happens to be only slightly higher than the 2.2% annualized growth the economy has registered since mid-2009, when the current business cycle expansion began. If the market (and the Fed) were convinced that real growth would be 4% or better, we would very likely see real yields on TIPS trading in the range of 3% or so.

Chart #2

Chart #2 demonstrates the link between market-based real yields on 5-yr TIPS, and the ex-post real yield on the Fed's target funds rate. The real funds rate is the Fed's true target, since that is the best measure of borrowing costs. Note that the real funds rate has been zero or less for the past decade, and it hasn't increased much, if any, for almost a year. The red line, the real yield on 5-yr TIPS, is essentially the market's expectation for what the blue line will average over the next 5 years. The market is not expecting the Fed to do much in the way of tightening, but it is definitely pricing in somewhat tighter policy for the foreseeable future.

Chart #2 is also a good way to look at the shape of the real yield curve, which is arguably more important than the shape of the nominal curve, which has been flattening for the past several years (the 2-10 spread is now down to about 25 bps). What we see in Chart #2 is that the real yield curve has been steepening over the past year—expectations of future real rates have risen relative to current real rates. Taken together, the shape of the real and nominal yield curves tells us not that the economy is being squeezed, but rather that neither the market nor the Fed are very enthusiastic about the idea of a stronger economy. 

Chart #3

Chart #3 shows that nominal Treasury yields have been unusually low relative to the prevailing rate of inflation for the past seven years. Only in the past year have nominal yields begun to catch back up to inflation—and they're still relatively low. The fact that the bond market has been willing to accept only paltry real yields for so long is a function, I believe, of a relatively strong degree of risk aversion and a lack of enthusiasm for real growth prospects. Markets have been willing to accept minimal returns in exchange for the safety of Treasuries. In a stronger growth environment, this would not be the case. If inflation holds around 2% and the economy picks up convincingly, I would expect 5-yr Treasury yields to rise to 4% or more.

Chart #4

Chart #4 compares the ISM manufacturing survey to quarterly real GDP growth. If there is any one chart that makes the case for a significant pickup in growth, this is it. Based on past experience, the current ISM reading suggests second quarter growth could be well in excess of the 4% that is currently expected. But that tells us nothing about the long-term outlook for growth. The second quarter GDP release is almost certain to be strong, but doubts still linger about later quarters.

Chart #5

Chart #5 shows the growth rate of private sector jobs. Much has been made of recent "strong" jobs reports, but the truth is that the growth of jobs remains rather mild compared to recent years. The best that can be said is that the growth of jobs over the past 6- to 12-months has increased from 1.6% several months ago to now about 2%. With these kinds of numbers, strong-growth skepticism is warranted. In order to get 4% or better GDP growth, we're going to need a big increase in productivity, and that in turn is going to require lots of new investment. I think we'll see it, but we can't find the evidence yet. 

Chart #6

Today's release of June housing starts was disappointing (+1273K vs +1320K), but as Chart #6 shows, starts can be very volatile from month to month. Strong sentiment readings from builders suggests we haven't yet seen the peak in housing construction, but for the time being housing is not going gangbusters.

Chart #7

Architecture billings have been in positive (increasing) territory for quite some time now, and that points to increased construction spending for the next 9-12 months, according to the AIA. But compared to past cycles, it's hard to see anything like a boom underway.

Chart #8

Chart #8 compares industrial production in the U.S. to that of the Eurozone. Production is rising, but not by much compared to prior peaks. 

Chart #9

If conditions in the U.S. were booming, not only would you expect to see much higher interest rates, you would also expect to see a very strong dollar. However, as Chart #9 shows, the dollar today is only modestly higher than its long-term average vis a vis other currencies.

Chart #10

In past cycles, a strong dollar has tended to correspond to weak commodity prices (note that the dollar is plotted on an inverted scale in Chart #10) and vice versa. But: although the dollar today is a lot stronger than it was 5 years ago, commodity prices are roughly unchanged compared to 2013. That's good news for emerging market economies, since they are particularly sensitive to commodity prices. They are also sensitive to competing returns in the U.S. and other developed economies. Despite the relative strong dollar, it remains the case that real returns in developed economies are still unusually low, and commodity prices are still historically high. So recent concerns about emerging market economies are likely overblown. Look for some recovery from recently-depressed levels.

Chart #11

In the final analysis, the biggest concern these days is the potential fallout from escalating tariff wars. To give Trump the benefit of the doubt—which not many are willing to do these days—his ultimate objective is to lower all tariff and non-tariff barriers, and he believes this can be accomplished only by a demonstrated willingness to do the opposite: Trump is playing a game of "tariff chicken." Chart #11 shows facts that he arguably believes bolster his strategy. In the past 12 months, the US has imported about $525 billion of Chinese goods, while at the same time exporting to China only $135 billion. China is selling almost four times more "stuff" to us than we are selling to them. So, the thinking goes, if both countries jack up tariff rates to prohibitive levels, the Chinese have much more to lose than we do, particularly since our economy is still half again as big as China's. At some point the Chinese will wave the white flag, we'll all agree to reduce or eliminate tariffs and intellectual property right theft, and sweetness and light will return to international trade relations.

We can't rule out a successful end to today's tariff wars, but neither can we be confident that they will inexorably lead to a repeat of the Smoot-Hawley tariff wars which in turn led to the Great Depression. I continue to believe that tariffs are so universally understood to be bad and even stupid that eventually our leaders will do the right thing and make trade freer and fairer. Why bet against what would be a win-win for all parties? (Zero tariffs are an economist's dream, since by facilitating free trade they would be a boon to all countries.) So I remain optimistic, but there is ample reason for many to remain cautious and concerned.

And that is another reason why interest rates remain so low and the U.S. economy appears to be reluctant to take off for points north of 4%.


steve said...

Well Scott I agree with everything you wrote EXCEPT re trade. DT is nothing but intransigent and this game of chicken is so inanely stupid as to defy description. If he slaps tariffs on cars imported from EU the poop is gonna hit the fan-finally and he could very well jeopardize the Nov elections. I maintain that DT is an innately supercilious, obtuse man who cannot stand criticism and he won't budge on trade. Expect serious fireworks in the near term-not to mention Mueller investigation which either must show their hand very soon or wait after elections.
The next 8-12 weeks will be critical for the markets.

NormanB said...

I don't understand the references to emerging economies. How can I benefit from that? Further I can't believe their economic data nor what they say their company earnings are (including
China) so except on a trading basis I'll have nothing to to with them. Thanks for all the other analysis, though.

Cameron Khajavi said...

Scott - the gap between us equities and emerging market equities hasn’t been this wide for a very long time - I agree now is the time to purchase emerging markets - eem makes sense - thanks for your post

WealthMony said...

I'm not sure I disagree with the president's policies, but his dag blame rhetoric upsets me. Does he have to speak out about his own personal opinion about everything? I think it could be his tongue that is holding back the economic growth we might have otherwise seen as a result of his tax policy and shaving of regulations. How could that be? Uncertainty. Investors don't know what to expect. They worry that a trade war will develop.

Granted, we are probably late in the business cycle (but perhaps not) and higher growth is hard to come by, but the fiscal policy changes made by this administration plus deregulation should cause this economy to surge. Okay, it has picked up a little but 2.9% is only a nudge.

Here's hoping that the president's plan (if there is one) comes to production very soon, as in 2018. People are better off, but only marginally so, so I'm concerned there could be a move to the left and that would not be good.

Scott Grannis said...

Re Trump's mouth: I was an early and fervent opponent of Trump, but with time I have learned that what he says is far less important than what he actually does. What he has accomplished so far is really impressive, if you ignore all the tweets and the blabber. The only real mistakes he's made are with tariffs, which hurt our consumers. But he could be forgiven these mistakes if the end result is freer and fairer trade, which I believe is his true, long-term objective. Watch what he does, not what he says.

NormanB said...

Trump has taken on the issues that needed to be addressed and got the ball rolling on all of them. Good for him. Too bad he's such an a-h. I can't stand his self-aggrandizing nor the repeating of his points at the end of each exclamation.

Scott Grannis said...

NormanB: yes, I think we all wish he would just shut his mouth and stop tweeting. But would you rather have a president who speaks eloquently, who eschews Twitter, who is handsome and well-mannered, but who accomplishes little or nothing of value?

Benjamin Cole said...

Another terrific review by Scott Grannis.

Interest rates low?

Try this on for size: Germany 10-year bonds pay 0.328%. Remember, they borrow and pay in Euros, not marks.

Japan 10-years: 0.032%. France 10-years: 0.623% (also paid in Euros). Is ;ending to France less risky than the US/ I do not get this.

People say I am wrong when I say "there is a capital glut," but it sure seems like capital is abundant. I do not know of any good start-ups, properties, or business ventures that cannot get funded (and a lot of dubious enterprises can get funded). The prices paid for trophy office towers (especially in Hong Kong) sure seem to say, "We have too much money to invest!"


I am not so sure Trump is wrong on trade. I understand absolute and comparative advantages and free-trade theory.

Still, nations that promote and protect manufacturing do well. See the Far East.

Read about Singapore's 40-year program to create a petro-refining industry in Singapore. There was nothing free-markets or free-trade about the Singapore drive to become a petro-refining center. The government became a full-on partner in the development of the industry--literally. Singapore owns plants through JVs. The government of Singapore owns the island it built to house petro-plants. They put tariffs on refined petro-imports (actually Singapore also has a 7% sales tax on all imports). Exxon just built the world's biggest and best resin plant in Singapore. A shipyard in Singapore (also half-owned by Singapore) helps build the most advanced deep-sea oil-drilling rigs (those things are monsters, btw).

Why did Singapore do this? It wants the income associated with production.

Detroit is a city that used to produce, and no longer does. Reduced income. Singapore is a city that built up a manufacturing base, and now has per capita GDP PPP 50% higher than that of the US.

If you wanna consume, you gotta produce.

There ain't no such thing as a free lunch.

I do not believe the US can import and borrow its way to sustained prosperity.

Maybe orthodox economists are wrong on the trade issue. The globalists strike me as a bit glib. (Back when I was in college, in the gas-lamp era, the orthodoxy was that the US should run trade surpluses or balanced trade).

I am reserving judgement on Trump and efforts to balance global trade.

Besides that, is not Trump great entertainment?

The Trump reality show, and for free!

John said...

Another strong analysis by Mr. Grannis and interesting comments. I wonder about two additional factors: 1) how does Trump’s tarrif chicken game with China affect US companies that have production facilities there? Does an interconnected global economy render tarrif threats empty? 2) Wages for non-managerial private sector workers are flat or even slightly behind inflation. Lack of demand may be what ultimately stalls growth. If you want to consume more you need to make more dough. Workers need to share those record company profits.

Rich said...

I would prefer a president who doesn’t blame both sides for Charlottesville, who doesn’t support anti-democratic values and norms while standing next to Putin, and who doesn’t try to reduce the legal immigration of talented people who could build the next great American companies, as so many immigrants have.

So while there is much fiscal policy that I can support, I think this president has disqualified himself from remaining in the office he currently holds.

Peter X said...


Did you forget Chart #12, and did you mean to say Great Depression in the next to last paragraph instead of Great Recession?

amritsari said...

Isn't it clear by now - as long as the president bribes us with tax cuts, it doesn't matter what he says or does. That is the essence of conservatism nowadays. Sheesh.

Adam said...

Scott, 10y/2y tips spread has inverted two weeks ago, what is your take on that, plse.

Scott Grannis said...

Peter X: Thanks for spotting those typos. Now fixed. I was referencing Chart #11.

Scott Grannis said...

Adam, re real yield curve: I think the best measure of the front end of the real yield curve is the real funds rate, which has been roughly zero for the past year. Meanwhile 5-yr real yields have moved steadily higher. See Chart #2 above. Today, by that measure the curve has a nice upward slope of about 80 bps.

Adam said...

Thank you

Scott Grannis said...

Adam, re 2-yr TIPS: Real yields on short-maturity TIPS can at times be very distorted by timing and market conditions, which is why I avoid tracking them. In large part this is due to the fact that the inflation adjustment that is built in to TIPS uses the non-seasonally adjusted CPI. Seasonal factors can be sizable at times during the course of the year. Typically, prices tend to rise in the first half of the year, then they tend to fall in the latter half of the year. We're now in the period in which the inflation adjustment to TIPS will be very small or perhaps even negative. Consequently their prices are artificially depressed, and their real yields are artificially inflated. Longer-term TIPS, beginning with the 5-yr, are largely immune to this.

Adam said...

Thanks a lot.

honestcreditguy said...

Really Rich, Charlottesville? What is he supposed to do, there were all sides there....
Immigrants? They are free to petition for citizenship whenever, we take in more immigrants than the rest of the world combined...We don't need illegal immigrants as the fiscal drain is 200 billion plus a year. Enforce every countries immigration and border policies on their citizens coming here, see what happens. The southern illegal surge created by an illegal executive action by Czar 44 is a blatant invasion.....stop with your silly one world argument, better yet move to note have money, no benefits will ever come to you, don't expect to vote or own a home, don't protest, waive an american flag and wait 8 years.....