Last Wednesday, the FOMC continued on its expected path of tapering, reducing purchases of U.S. Treasuries and MBS by another $10 billion each. The Fed also stated that policy rates would remain low for a “considerable time after the asset purchase program ends.” So why did the bond markets sell off after the Fed’s statement (and even more after Fed Chair Yellen’s press conference comments)? Because bond market participants made short-term bets based on what they believed would be ultra-dovish comments from the Yellen-led Fed. When Fed language was just merely dovish, these bets were taken off. We opined last Thursday that Wednesday’s volatility was probably due to bond market bets. Since late Wednesday, the yield of the 10-year U.S. Treasury note has been stuck, right around 2.78%. Why did the 10-year note yield halt (pause) around 2.78% when the economy is strengthening and the Fed might not be as dovish as some market participants expected? The story of the long end of the yield curve is the story of inflation.
Long-term interest rates are a proxy for inflation expectations. Since 1990 the spread between headline CPI (including much pointed- to-food and energy prices) has averaged about 234 basis points. At the present time, CPI YoY is running at 1.1%. Since the end of the recession, CPI has averaged 1.8%. Since January 2012, CPI YoY has averaged 1.7%. Since the Fed began QE∞ in September 2012, CPI YoY has averaged 1.5%. Get the picture? In spite of the most aggressive policy accommodation in U.S. history, the U.S. economy has been dealing with disinflation from the past two years. With disinflation (and even deflation) present around the globe, it is going to be difficult for CPI to get to the Fed’s comfort level of 2.0%. It could be even more difficult for Core PCE (the Fed’s favored measure of inflation) to reach 2.0% as it tends to run cooler than CPI. Do the math. If inflation averages in the mid 1.0% (the Fed does not expect to see 2.0% until the end of 2016), it is going to be difficult for the 10-year note to break over 4.00%.
We believe that the 10-year note could trade at a tighter spread to inflation than it had in the past. Although we believe that the growth of the U.S. economy will not break much above trend (3.00% or so), U.S. dynamism and demographics could (should) result in the U.S. economy outperforming its developed brethren. Higher U.S. rates could also attract capital which was previously invested in EM debt. We have seen evidence of this during the past year. Nearly every time long-term U.S. rates have risen, the dollar has strengthened. A 3.00% 10-year note has attracted investor capital. We also need to understand that higher Fed Funds Rates created headwinds against rising long-term rates.
Investors often misunderstand that when the Fed is raising policy rates, all rates must rise. Although it might appear this way at the beginning of a policy-tightening cycle, rising short-term rates often result in stalling and, eventually, declining long-term interest rates. The cycle typically plays out as follows:
- The economy accelerates causing inflation. As a result long-term rates begin rising.
- The Fed sees inflation pressures building and begin tightening policy (raising the Fed Funds Rate).
- As the Fed is usually behind the curve and the effects of Fed policy tend to lag, short-term and long-term rates rise together.
- However, as the Fed continues to tighten, higher short-term rates increase the cost of capital for lenders (which tend to borrow short and lend long). At the same time, higher long-term rates tend to reduce the demand for credit. The result is long-term rates which stabilize and the yield curve flattens.
- A flatter yield curve results in tight lending conditions which tend to slow the economy. At this point, inflation pressures abate as growth slows. Once again, the Fed is probably, once again, behind the curve and begins easing (lowering the Fed Funds Rate), but not before the economy is likely in recession.
- For a period of time, both short-term and long-term rates fall. However, when short-term rates are sufficiently low (a moving target), lending picks up, as does consumption and inflation pressures build. This starts the interest rate cycle anew.
Things are a little different now because the Fed had embarked on a mission to artificially lower long-term interest rates. On May 1st, 2013, the FOMC’s statement indicated that the Fed could begin tapering some time in 2013. Almost immediately, long-term rates began rising, essentially repricing to reflect interest rate and growth expectations. We believe that about half of the cyclical rise of long term rates has already occurred.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY