What's the Deal With Higher Rates?

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 |  About: iShares Core Total U.S. Bond Market ETF (AGG)
by: James Picerno

The Federal Reserve is forging ahead with its quantitative easing strategy for monetary policy. Although there's a sea of critics who think the central bank should rethink QE2, there was no mention of the debate in yesterday's FOMC statement, which explained:

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to continue expanding its holdings of securities as announced in November.

Inflation is, in fact, holding steady, or at least expectations of inflation are stable, as measured by the yield spread between the nominal and inflation-indexed 10-year Treasuries. By this benchmark, the outlook for inflation is roughly 2.2%, based on yesterday's Treasury yields. That's more or less unchanged versus the tight range of the last two months.

Click charts below to enlarge

But while the market's outlook for inflation is relatively calm, the yield on the 10-year note is climbing, reaching nearly 3.5% yesterday. That's up sharply from 2.4% in early October. The debate has shifted to whether this is a sign that the Fed's QE2 is a failure or success.

Economist Jeremy Siegel is firmly in the camp that higher rates are a sign of triumph. In yesterday's Wall Street Journal he writes:

The Fed's QE2 program has raised expectations of growth and inflation, sending long-term Treasury rates up. It has also lowered risk aversion, which implies rising long-term rates. The evidence for a decline in risk aversion among investors is the shrinkage in the spreads between Treasury and other fixed-income securities, the strong performance of the stock market, and the decline in VIX, the indicator of future stock-market volatility. This means that expectations of accelerating economic growth — and a reduction in the fear of a double-dip recession — are the driving forces behind the rise in rates.

But there are plenty of analysts who disagree. For instance, The New York Times reports that some economists are "skeptical, saying the rise in interest rates demonstrated the limited effectiveness of the Fed’s program to buy bonds in a bid to lower long-term interest rates and spur growth." That includes Chris Rupkey, chief financial economist at the Bank of Tokyo-Mitsubishi UFJ, who penned a note to clients yesterday that advises:

All the king’s horses and all the king’s men can’t push bond yields back below 3 percent again … There must be some disappointment at the F.O.M.C. that the purchases have not kept 10-year yields from rising so much, let alone decline.

Bernard Baumohl, chief global economist of the Economic Outlook Group, poses the operative question via today's Washington Post:

Did these rates move higher because the economy is getting stronger -- or because bond investors fear the Fed is about to err by continuing to pump too much money into an economy that is in the midst of accelerating? Our concern ... is that it's the latter.

Earlier this week, CNBC.com reporter Jeff Cox wrote:

Rising interest rates for now are generating views that the economic glass is half-full, even though the trend would seem to counteract aggressive monetary policy from the Federal Reserve.

Is optimism unfounded at this juncture? No, according to economist David Beckworth, who argues forcefully that higher rates at this point are a good thing:

Though it too soon to know for sure, the data seem to support the recovery interpretation of the rising nominal yields. Below is a figure showing the 10-year expected inflation rate and the 10-year real interest rate from the TIPs market. This figure shows that inflation expectations pick up first and eventually the real interest rate does too:

Ultimately, the debate will be settled by the numbers. The key variables are inflation, economic growth and interest rates. Inflation expectations are currently stable and relatively tame. So far, so good. That can change, of course, but for the moment this is the lesser threat in this trio.

The main focus has moved to interest rates and economic growth. Higher rates that are accompanied by an improving macro picture is a winning combination. The latest sign that the mending process is moving forward comes in yesterday's encouraging retail sales report. The labor market, however, is still sluggish and so there's plenty of incentive to wonder what comes next. If we don't see a stronger trend in job growth in the months ahead, higher interest rates will be a problem and there will be hell to pay.

For now, you can make a case for almost any scenario. But one side in this debate will be wrong. The only issue is deciding when the truth will out.

Disclosure: No position