The Fed Cannot Keep Long-Term Interest Rates Down

Includes: IEF
by: John M. Mason

The Federal Reserve cannot keep long-term interest rates down. It just cannot control the long-term end of the market for a significant period of time if market participants want it to go elsewhere.

Right now, flows of funds are moving toward Europe and away from the United States. The Federal Reserve cannot control this flow.

The economy of Europe seems to be recovering and confidence appears to be rising in the eurozone. Even though officials in Europe, as usual, just seem to be "muddling" through all of the relevant structural issues facing the continent, the economy seems to be getting better.

The news out of Paris this week was that the eurozone posted a 0.3 percent increase in real GDP growth in the second quarter this year, signaling an end to the recession of more than two years. "Bolstered by stronger consumption and investment in Germany as well as growth in France, Europe broke out of recession in the second quarter, ending its longest postwar contraction …"

This is good news. It is not great news. The economic recovery, if it continues, is expected to remain a weak one … not unlike that being experienced by the United States. There are still a lot of structural issues remaining that will continue to have a dampening effect on the economy. But, the recovery appears to be taking place.

European officials still have a lot of work to do on the two main problem areas concerning the euro hanging over any recovery, and, these officials show no signs of any real leadership in resolving them as they continue to kick the can down the road. No full recovery can occur without some formal political union of the eurozone and without the creation of some kind of European-wide banking system.

Yet, the economic recovery seems to have started and confidence in the financial situation seems to be growing. And, this is continuing to cause funds to flow back into Europe from "safe havens" like the United States. This flow of funds seems to have begun in early May of this year.

My benchmark on this movement is the yield on the 10-year United States Inflation-adjusted bonds. On April 26, 2013, the yield on this security closed at a NEGATIVE 0.723 percent!

The flow of funds from Europe and into United States financial markets had been such that the yield on this security began dropping from around 2.00 percent in the middle of 2009 and turned negative in the second half of 2010. With only a slight reprieve in early 2010, the yield continued to fall until the spring of 2013.

In early May the yield on the 10-year TIPS security began to rise as confidence in the eurozone increased and crossed into positive territory on June 11, 2013. It continued to rise throughout June and July. On Friday, August 16, the yield on the 10-year TIPS closed at 0.650 percent! The rise in yield from April 26 was almost 140 basis points or 1.40 percentage points! And, this rise occurred while the Federal Reserve was in full "quantitative easing" mode!

The rise in the yield of the regular, 10-year Treasury security was basically a parallel rise. On April 26, 2013, the yield on the 10-year Treasury was 239 basis points above the yield on the 10-year TIPS. At the close of business on August 16, the yield on the 10-year Treasury was 224 basis points above the TIPS. In essence, the inflationary expectations of the market built into the nominal yield remained virtually unchanged over this three and one-half month period.

The explanation for the rise in yields was the flow of "risk averse" money from the United States back into Europe due to the growing confidence in European markets. The earlier flow into the United States, beginning in 2009, was a flight of money from Europe into "safe havens." It created abnormally low interest rates in spite of what the Federal Reserve was doing at the time.

Now, the flow of these risk avoiding funds out of the United States and back into Europe is a result of what is happening in the eurozone and not a result of what the Federal Reserve is doing in the United States. The Federal Reserve cannot control these funds and the flow of these funds is going to dominate the level of long-term interest rates in both the European and the American financial markets.

As I have been forecasting for some time now, these fund flows are going to continue to dominate the longer-term end of the interest rate spectrum for some time. And, these flows of funds will dominate the longer-term end of the market despite whatever the Federal Reserve does.

If the Federal Reserve does begin to "taper" its purchases of Treasury securities and mortgage-backed securities, it will only add a little to the rise in longer-term yields. This contribution to the rise in interest rates will only add on to the pressures for rates to rise resulting from the international flow of funds.

This movement will be nothing more that the reverse side of the drop in U.S. Treasury yields when the money from European markets began flowing into the United States in the middle of 2009, a time when the Federal Reserve was engaged in earlier efforts at quantitative easing which may have had a modest impact on falling long-term Treasury yields.

As before, I will not be surprised if the yield on the 10-year TIPS rises into the 1.00 percent to 1.50 percent range over the next several months. And, if inflationary expectations remain the same as they are today, about 220 basis points, the yield on the regular, 10-year Treasury security should rise in the 3.20 percent to 3.70 percent range.

I don't see any reason at the present time to expect that "inflationary expectations" will rise "over the next several months." This movement in yields will take place, in my mind, regardless of what the Federal Reserve does with respect to its purchase of Treasury securities and mortgage-backed bonds.

A consequence of this rise in longer-term rates will be for interest rates on mortgages to rise as well as for all longer-term yields to increase. Looking further into the future, I feel that the yield on 10-year TIPS to rise into the 2.00 percent range, which will bring the yield on the regular 10-year bond above 4.00 percent. Wow! We haven't seen anything like this for a long time!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.