When Will Rates Finally Normalize?

interest rates

interest ratesDuring the first half of 2009, when longer-term Treasury yields were soaring and the consensus among bond-market pundits was that Federal Reserve rate hikes were not that far off, people would have thought you were nuts if you said short-term rates wouldn’t normalize for decades.  I still remember some of the reactions I received when telling people I didn’t think the Fed would raise rates for many years to come.

Not surprisingly, most investors didn’t want to believe in the possibility of Japan’s bond-market experience being repeated in the United States.  Some investors may have formed this opinion on their own.  Others may have been swayed by the army of equity and fixed-income analysts telling the investment community to avoid bonds.  Either way, if Ben Bernanke is right, I think a lot of income-focused investors who failed to capture the many opportunities in intermediate- to long-term bonds in recent years will regret their decision.

In a May 16 Reuters article discussing the series of $250,000 dinners Bernanke recently had with private investors, there was one particular sentence that struck me.  It reads, “At least one guest left a New York restaurant with the impressions Bernanke, 60, does not expect the federal funds rate, the Fed’s main benchmark interest rate, to rise back to its long-term average of around 4 percent in Bernanke’s lifetime . . . [emphasis added]”

So, according to at least one person who paid a pretty penny to dine with Bernanke and pick his brain, Bernanke senses that rates will stay low for, perhaps, decades to come.  And why shouldn’t they?  During the financial crisis, the Fed prevented the economy from implementing the clearing mechanism that would create the self-sustainable growth necessary to allow for normalized rates.  The unconventional monetary policy encouraged malinvestment and set the economy up to fail should tighter financial conditions materialize.  Furthermore, as the aforementioned Reuters article noted, “Bernanke has also argued the Fed would want to delay raising rates if the tighter financial conditions created could threaten to harm the economy.”  If the Fed won’t “normalize” rates until it is convinced tighter financial conditions won’t harm the economy, but the economy has been set up to fail should tighter financial conditions materialize, then chances are really good investors will be waiting a long time to see normalized rates.

Two concluding thoughts: (1) Should the definition of “normalized” change in the post-financial-crisis world?  I think it should be changed to represent a lower level of rates.  I also think if the Fed does raise rates in the coming years, it will only be to levels that are lower than the level the Fed historically would hit during a rate-hike cycle.  (2) If Treasury rates will remain low for many years to come, the opportunity for fixed-income investors will come from playing spreads in the corporate and municipal bond markets.  When spreads widen that will be the time to buy bonds again.  Now, however, is the time for patience.

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