The Outlook For Interest Rates

Includes: GOVT, PLW
by: Calafia Beach Pundit

Everyone knows that interest rates are going to rise in the future. So the real question is not whether they will rise, but when and by how much. Janet Yellen didn't change the consensus opinion regarding these questions much in her testimony today. The market thinks the Fed is almost certainly going to end the tapering of QE3 in October, and about six months later, give or take a few months, the Fed is expected to start raising short-term rates. They will probably do this by increasing-very slowly-the interest rate they pay on bank reserves, using reverse repo transactions, and by not rolling over maturing Treasuries and MBS.

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The above graph shows the Treasury yield curve at different points in time: April 2013 (the all-time low for the 10-yr Treasury yield), today, and two and five years in the future. The latter two are derived mathematically from the current Treasury curve. If you compare this graph to the one in my post last March ("How much are yields going to rise?") you can see that not much has changed of late. The Fed is expected to raise short-term rates in a very gradual fashion beginning next year, and five or so years from now rates are going to be topping out around 3½ to 4%.

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There's nothing very scary about this. As the graph above shows, for most of modern history 5-yr Treasury yields have traded well in excess of 3%. That 5-yr yields today aren't expect to rise above 4% for as far as the eye can see is pretty unusual from an historical perspective.

Interest rates aren't expected to rise by much because 1) the market doesn't think the U.S. economy has much chance of returning to its former growth glory, and 2) the market doesn't think that inflation has much chance of exceeding 2-3%. In other words, the bond market today seems fairly convinced that growth will be sluggish and inflation will therefore be tame for as far as the eye can see.

If you disagree with the assumptions behind the market's current consensus, then you can take actions to bet that interest rates will be either higher or lower than current expectations. For example, if you see more potential for growth and inflation, then bet that rates will rise faster than expected: lock in long-term borrowing costs today; keep the duration of bonds you own as short as possible; and avoid excessive leverage (or place hedges to protect against higher-than expected borrowing costs). Consider an increased exposure to real estate, since it should benefit from stronger growth and higher inflation, and it is not necessarily expensive today. Consider also an increased exposure to equities, since stronger growth and higher inflation should have a positive impact on future expected cash flows.

For my part, I acknowledge that I have been overly concerned about rising interest rates for most of the past 5 years or so. Being wrong for so long is humbling, but it is not a reason to shy away from worrying about a faster-than-expected rise in interest rates today. In the end, it's all about what happens to the economy and to inflation.

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I'm still an optimist on the economy, since I think the market's growth expectations are overly pessimistic. I think 5-yr real yields on TIPS tell us a lot about the market's underlying expectations for real economic growth. As the graph above suggests, the current -0.38% real yield on 5-yr TIPS points to economic growth expectations of perhaps 1% per year, which in turn is a bit less than we've seen in recent years. If the market were convinced that future growth would be a solid 3% a year, then real yields today would be a lot higher than they are now.

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I'm still more worried about inflation than the market is, since I think the market is being a bit too complacent about the inflationary potential of the Fed's massive balance sheet expansion and the Fed's ability to reverse course in a timely fashion. As the graph above shows, the market expects CPI inflation over the next 5 years to average a mere 2.1%, which is actually less than the 2.3% it's averaged over the past 10 years. I'm not predicting hyperinflation or anything like it, I'm just saying that expecting inflation as usual for as far as the eye can see despite the Fed's huge and unprecedented experiment in quantitative easing is a bridge too far for me.

There's nothing scary about expecting interest rates to rise more than expected. Rates aren't likely to surprise on the upside unless real growth expectations and/or nominal GDP expectations rise, and given the pessimism inherent in the market's current expectations, either one of those would be very welcome developments.

Interest rates are a good barometer of the market's expectations for growth and inflation. That they are still so low today means that the market holds little hope for any meaningful improvement in the outlook for the economy and/or any meaningful rise in inflation. We're living in a slow-growth, low-inflation world for now, and-as often occurs just before something hits us from left field-the market is extrapolating that today's conditions will prevail for as far as the eye can see.