Jan 30, 2005

Long-term Interest Rates

I lost some money short treasuries through the end of last year and beginning of this year. I am still a bit confused as to why long rates are so unresponsive to short rates crawling higher. In particular I am amazed that the bond market completely underestimated the length of this hiking cycle expecting the FOMC to leave O/N rates at 2% or lower. In November the Fed promptly informed the markets that view was incorrect and while the short markets quickly projected a new series of hikes to 3% the long end yawned. At least I am not alone in wondering what is going on.

If America's economy continues to grow robustly, monetary policy will shift from "loose" to "neutral" and rates will go up. Although there is plenty of controversy about what a neutral fed-funds rate might be, estimates tend to be 3.5-5.5%. Oddly, financial markets are pitching it lower. Futures contracts imply that the central bank will raise short-term rates at each of its next three meetings to 3%, but will then stop, so there will be virtually no more Fed tightening in the second half of 2005 or in 2006.

If that is puzzling, the behavior of long-term interest rates is even odder. At around 4.2%, yields on ten-year Treasury bonds, America's benchmark long-term interest rate, are virtually identical to where they were a year ago (see chart). Adjusted for some measures of inflation, real long-term interest rates are lower. Stephen Roach of Morgan Stanley reckons inflation-adjusted long-term rates are now more than 2.5 percentage points below their average level of the past 20 years.

This long-term rate has a big impact on how much American companies and consumers borrow, and thus on the American economy and Mr Bush's second term. Its level reflects all sorts of things, including demand from investors for bonds, expectations of future inflation and a risk premium for holding longer-term assets. But if you look at what has happened to America's economy over the past year, you would expect long-term rates to be heading much higher. After all, short-term interest rates and inflation are both rising, the current-account deficit is huge and widening, the dollar has fallen and the fiscal outlook has worsened. Surely investors looking over the next ten years will want a better return than 4.2%?

Economists are genuinely puzzled by all this. There are several explanations, each of which has a different implication for Mr Bush's second term. None of them are terribly good.

  • The most gloomy theory is that America's economy is, in fact, rather more fragile than the current statistics suggest (and most forecasters presume). Debt-laden American consumers, so the argument goes, will not be able to sustain their current spending patterns, particularly if the housing bubble bursts. Low long-term interest rates, far from being out of kilter, are actually an accurate sign of incipient economic weakness. Mr Bush's second term, in other words, may see another sharp slowdown - not a good backdrop to his domestic revolution.

  • A more hopeful argument for Mr Bush is that there has been a deeper "structural" change in the investment markets in favour of bonds. A new theory on Wall Street is that domestic pension funds are shifting more of their cash into long-term bonds in advance of possible regulatory changes from Washington. Asia's central banks have also been buying Treasury bonds to stop their currencies appreciating against the dollar; that demand has certainly pushed down the yields on American bonds, but nobody really knows by how much or how much longer the Asians will continue to be such unchoosy investors. If the Asians were to moderate their appetite, interest rates would shoot up.

  • A third theory is that investors are so convinced by the Fed's record as an inflation-slayer that they don't need higher rates on long-term bonds. Overall inflation is indeed much lower than it was a generation ago. But plenty of aspects of America's economy should spook even the most trusting admirer of Alan Greenspan (not to mention the Fed chairman himself). These include that worsening budget outlook and America's rising reliance on foreign capital.

  • Which leaves the last possibility: that the financial markets have temporarily mispriced the risks involved. Investors are too complacent about inflation and about America's enormous budget and current-account imbalances. If that theory is correct, long-term interest rates could rise sharply and suddenly.

I lean towards 1 or 4 but would tend to see elements of all the alternatives at work. I would lay out a thesis like this. Foreign central banks are distorting the market process for interest rates and risk premium by involvement in the UST bonds and agency assets. Asset managers also buy the "gloomy" economy scenario that Fed hikes are capped by the interest rate dependence of a liquidity induced recovery. The inflation picture is mixed with booming commodity markets and low capacity utilization rates. The last factor is that the markets are willing to discount the U.S. fiscal deficit and resulting trade imbalance because it has persisted since the Reagan years.

Whatever the causes of the yield curve flattening it is difficult to believe investors won't dump the long-end for the safety of the short-end at some point this year.

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