What Is The Proper Level For Rates?

  Regarding the concern that interest rates will rise to dangerously high levels, I doubt this will occur. The fear that Quantitative Tightening, where the Fed sells its holdings of bonds to undo QE, will make rates go up a lot is incorrect. When QE was implemented from 2009-2014 it didn’t create inflation and probably only lowered interest rates by 0.5%. The reason yields went down was because of global fears of falling into a debt/deflation trap and because other Developed countries (the EU, Japan, Scandinavia, Switzerland) had negative rates. I don’t see things getting better in Europe; probably the economic problems have not been truly solved in Japan. Thus since the fundamental reason for low yields in the U.S. is the misbehavior of the rest of the Developed world then I don’t see much reason for U.S. rates to rise.
Assuming the QT program proceeds at its current pace of selling 6% a year of assets then it will take 15 more years to finish QT. That means the 0.5% rate cut caused by QE, divided by the annual QT sales of 6% a year, would make rates rise 0.5/15 = 0.03% a year (3 basis points). During this 15 year period there may be another three Fed chiefs, three U.S. presidents, two dozen new Fed board members, and hundreds of new Congress members asking naïve questions during hearings. Can QT survive running this gauntlet?
Typically before the GFC of 2008 real yields for the benchmark 10 year Treasury were 2.1%. Today real 10 year TIPS yields are 1.14%, a gap of roughly 1% from the historical average, of which 0.5% can be attributable to QE. Assuming that it will take another 15 years at the current pace to finish the QT asset sales then for the next few years there won’t be much effect from QT and if a recession hits they will suspend and reverse QT. So that leaves 0.5% potential increase in yields, not related to QT, but those low yields can’t be raised unless the other Developed countries get their act together and somehow impossibly go back in time before the 2008 GFC and return to normal. But how can they as they have so much socialism, lack of growth, high taxes, regulations, and huge debt. Thus the current level of real yield seems appropriate.
If “Owner’s Equivalent Rent” housing costs are mismeasured by the BLS then inflation could be 0.5% lower for CPI (and 0.25% lower for PPI), making core CPI roughly 1.85%. This means the gap between the average 2.1% real rate and the current real rate would be roughly 0.5% which is attributable to QE. And if QT never gets done, because the Fed wimps out next year, then we have already reached equilibrium for yields (assuming a permanent holding of QE acquired assets) for the ten year Treasury, which today is at 3.21%.
Get used to it, the Fed will never complete QT. It reminds me of post WWI debt settlements where Germany and others simply couldn’t pay the war related debts scheduled over the next sixty years and eventually these debts in 1927 were written down substantially, only to be followed by more newly incurred war related debt after WWII which was written down in a 1953 settlement. When debts are huge and unpayable then it gets written down. In this case the Fed doesn’t owe money, it merely would get more credibility if it could undo QE by selling its hoard of bonds. Thus there is less pressure on the Fed to stick to its plan and thus unlikely it will get done.
The market hasn’t fully recognized how global rates are interconnected and how desperate, yield starved investors may leap into unhedged foreign currency denominated bonds (where foreigners buy US debt). The prudent way for a bureaucratic pension fund to buy foreign debt is to hedge the currency risk, but it now costs too much to hedge. This policy gets written into economics papers as a barrier to globally integrating interest rates. But in real terms, as described by behavioral economics, many individual investors lose their self-control and invest rashly, throwing caution to the winds. This means retail investors in Japan or in the EU may explode with rage at the impossibility of negative yields and decide to simply buy dollar denominated debt without paying for a currency hedge.
The intellectual justification for such an unhedged transaction is that in the 47 years since Nixon abrogated Bretton Woods gold standard the dollar has only dropped about roughly 10% divided by 50 years or about 0.2% a year. If one measures this drop by amortizing it since 1944 to present then the decline would be about 0.135% a year, hardly measurable since there are many anomalies and hypothetical adjustments to economic data then being off 0.135% is not a big deal. Assuming an investor can hold on for the long run they may be able to avoid significant loss from devaluation. Currently currency markets pricing of a hedge assumes the dollar’s rise was an unjustified anomaly which will soon mean revert downward and thus the sellers of puts charge too much for foreign investors to afford a hedge. However, if one wants to examine mean reversion please remember in the 1980’s and in the 1998-2000 tech boom the dollar was very high, so measured against those periods perhaps the mean reversion theory implies the dollar needs to go up more, instead of down. If foreign investors believe this or if sellers of currency put options believe this then it will be easier for yield starved foreigners to have their money “emigrate” to the U.S. If they live offshore then the yield is legally tax free (in terms of no tax is owned to the U.S.), thus a 4.7% yielding BBB bond would be like getting a 7.8% taxable yield, assuming a 40% tax bracket.

   The market hasn’t recognized the contingent risk that China’s boom may come to an end as Japan’s did in 1989. Much of the globe’s growth comes from China; if that is a big “misunderstanding” (the data is not reliable) then when the market recognizes the truth then that will be a force for global disinflation and devaluation. If more EM countries’ currencies are devalued against the dollar eventually the cost of hedging will drop as currency put sellers change their view. See an article in the FT “Global Slowdown Begins To Look More Troublesome”, growth dropped from 5% to 3%. Since declining growth is disinflationary then that helps justify low interest rates.

   Bottom line is the world economy is more integrated and more disinflationary than the market understands. When the market wakes up then rates will be seen as near equilibrium even with no recession.
To be fair to the people who fear return of inflation, perhaps after the next recession, a new, bigger round of pump priming (coupled with an aggressive QE debt jubilee) will somehow trigger inflation but that’s several years away (and no evidence such dramatic programs will be enacted), assuming a recession next year. If it takes a year to get into a recession and a year to get motivated and switch to a new round of QE and another year for the effects on inflation to come out then perhaps in 2021 inflation will return, which would be time (when stimulus was announced) to either avoid bonds or else get a portfolio of variable rate bonds.
Investors need independent financial advice about the risks of misunderstanding interest rates.

2018-11-05T17:54:35+00:00November 5th, 2018|mayflowercapital blog|0 Comments

About the Author:

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Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years. Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services. Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.