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Why The Recent Drop In Interest Rates May Not Be What You Think

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interest-ratesLast Wednesday I finished a three-part series on how one might dissect longer-term bond interest rates to try and understand what the financial markets are trying to tell us about what is going on. These three posts dealt with the real rate of interest, inflationary expectations, and the term premium, or, other factors that might impact these longer-term yields.

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Last Wednesday some interesting things occurred that had an immediate influence on interest rates and might serve as a model of how we can interpret the movements in interest rates and, hopefully, increase our understanding of what is happening in the world.

Last Wednesday, Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System announced at the close of the Open Market Committee meetings that the Federal Reserve was going to continue purchasing $85 billion per month of U. S. Treasury securities and mortgage-backed securities. This was a part of the program of “quantitative easing” in which the Fed injected funds into the banking system to spur on the economy to faster economic growth in hopes of reducing the level of unemployment in America.

Financial markets had been expecting that the Federal Reserve was going to reduce the amount that was purchased every month, to “taper” purchases, so as to ease off on the amount of funds being injected into the economy.

From this experience we learn an important lesson. The Federal Reserve, and, more specifically, the Chairman of the Board of Governors can set up market expectations about what the Fed is going to do in the future. These expectations get built into the market place. When these expectations are not fulfilled…the market can jump around trying to build the new expectations into market prices.

There was a break in expectations last Wednesday. And, the bond markets reacted.

Before Mr. Bernanke made his announcement last Wednesday, the yield on the 10-year U. S. Treasury bond was trading around 3.00 percent. At the market close on Thursday, the yield had fallen by about 30 basis points to settle in around 2.70 percent. This was quite a one-day jump.

In trying to understand what is going on, let’s try to dissect the yield.

One of the factors that can impact yields, as discussed in last week’s post, are Federal Reserve asset purchases. Since participants in the financial markets expected the Federal Reserve to lessen these purchases from $85 billion to $70 or $75 billion the announcement that the Fed was not cutting back on purchases meant that more funds would be injected into the market than had been expected.

To try and find out whether or not this is the cause, let’s now look at what we called the expected real rate of interest. It was argued that the expected real rate of interest should be equal to the expected real rate of growth of the economy over the maturity span we are examining. In the case of the 10-year bond, the horizon for the growth is ten years.

The economy has been growing in recent years at a rate of growth just under 2.00 percent. If we use 2.00 percent as our expectation of real growth in the future then our estimate for the real rate of interest would be 2.00 percent.

But, with the yield on the 10-year Treasury at 3.00 percent, this would mean that the market only was projecting inflation to be 1.00 percent over this time period. This seems to be a little low.

In a previous post I suggested that the yield on the 10-year Treasury inflation adjusted security (TIPS) be used as a proxy for the real rate of interest. Before Mr. Bernanke’s announcement, the 10-year TIPS were trading to yield around 0.85 percent. And, with a bond rate of 3.00 percent this would mean that the inflationary expectations built into the market rate was about 2.25 percent, perhaps a little high.

Looking at other potential influences in the list of possible contributors to the term premium I have focused upon “haven flows”, movements of funds internationally that might impact U. S interest rates. Over the past four years, given the financial problems being experienced in Europe, massive flows of funds have come from the European continent seeking a “safe haven” in U. S. Treasury securities.

These flows, I have argued, have driven the yield on the TIPS below zero. In fact, it has only been since early June of this year that the yield on TIPS has moved into positive territory again. These movements were connected with flows of funds back to the European continent, as conditions seemed to settle down on the continent. From zero, the yield on the 10-year went to 0.85 percent before Mr. Bernanke’s announcement.

I have argued very strongly that these movements in yields have not been caused by the asset purchases of the Federal Reserve but by a movement of “haven funds” as relative financial conditions have changed. I also argued that the yield of 0.85 percent was still below where it should have been because lots of money still were locked up here in the United States waiting to flow back to Europe as the environment continued to improve there. I believe that the yield on TIPS is still approximately 100 to 125 basis points too low.

Thus, I have discounted the impact of Federal Reserve asset purchases on longer-term interest rates and tied the movements in these rates to changes in international money flows connected with funds going into and out of “safe havens”. The timing is just more closely aligned.

One additional factor, to me, is the conclusive proof. If one estimates inflationary expectations by subtracting the TIPS yield from the yield on the 10-year Treasury bond one comes up with a figure of 2.10 percent or a little more. The convincing fact is that this spread has remained relatively constant over a long period of time. That is, through all the ups and downs of the yield on the 10-year TIPS, inflationary expectations have remained relatively constant. I take comfort in this fact.

Thus, if we focus on the interest rate on the 10-year TIPS and argue that it is a proxy for the expected real rate of interest impacted by “haven” flows of funds then we need to look at what happened to this yield after Mr. Bernanke’s announcement.

The yield on 10-year TIPS dropped by about 30 basis points since Mr. Bernanke spoke. What could have caused this fall? Well, Mr. Bernanke supplied the argument that the economy was not growing as strongly as the Fed would like and, as a consequence, the “tapering” would not begin with the economy growing so weakly.

Did the TIPS yield fall because market expectations of economic growth were reduced?
Market expectations of future inflation remained roughly constant.

Since I have discounted the impact of changes in Federal Reserve asset purchases in my analysis, the best argument I can present is that financial market participants have lowered their expectations of future economic growth because of the Fed’s review. And, this lowered expectations is consistent with new poll data indicating that more and more people are experiencing slower and slower economic growth.

This is how one can dissect movements in interest rates in an effort to understand what is going on.

About John Mason

John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.

 

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2 Comments

  1. John, good analysis of forces and perceptions affecting bond market. One small point of fact on which we might differ is the bond market’s immediate reaction to no-taper. You say the 10-yr yield was at 3% and so we saw a 30bps move lower. I believe it was trading more around 2.85 on that Wednesday.

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