deflation is more likely regardless of what you hear in the MSM. QE wasn't hyperinflationary as MSM spouted, QE is still here and is getting bigger.
Having sat on a rates desk, I can help. Interest rates on a bond are comprised of: real interest rate + risk premias + expected inflation Risk premias include things such as: premia on various debt issuers (credit risk), currency risks, etc. Real interest rates, in a vacuum, would be driven by long-term growth dynamics (think Solow-Swan) such as labor force growth, technology (productivity), and capital flows. In real life, they are driven by central bank policy. Why? Well, there is the "natural rate" of interest, which is where interest rates would be in a vacuum. And then there are mandates -- stable price inflation and low unemployment (at least in the US). Low unemployment rates correspond to economies that are growing faster than labor supply (or stable growth vs. shrinking supply). In real life, high income economies, are experiencing labor supply that is growing at an ever diminishing rate while productivity declines. In a vacuum, this means that interest rates move lower because opportunity cost is diminishing (growth is declining). Hypothetical scenarios: High growth economy --> interest rates higher due to rising opportunity costs. No growth economy --> zero interest rates (marginally negative due to storage costs). Negative growth economy --> interest rates lower due to falling opportunity costs. Now, think about economies moving through. Assume in time 1 an economy is in high growth, in time 2 economy is in negative growth, and in time 3 economy is in no growth. Interest rates would have moved up, down, and then marginally lower, sequentially. Now, in time 4, imagine a shock of negative growth again. Rates fall even further. So now you have rate theory 101 done. Let's move back to central banks. Because central banks are trying to actively manage an economy (from an inflation and unemployment standpoint), they must choose to SET the price of money either ABOVE or BELOW the natural rate of interest. When the rate is ABOVE the natural rate of interest, it means that the central bank is trying to slow an economy down ("hawkish", "tight"). When the rate is BELOW the natural rate, it means that the bank is trying to ease and economy higher ("loose", "dovish"). The problem is that the central banks must make these decisions without ever being able to observe the natural rate of interest. You can observe the markets response to central bank decisions by reviewing the slope of the yield curve. An upward sloping yield curve means that the market believes that the set rate is below the natural rate. A downward (or flat) sloping yield curve means that the market believes the interest rate is above the natural rate. Observing the term structure will help you identify the magnitude of the markets opinion vs. policy. Now, let's go back to decomposing yields on a bond. Interest rate = real rate + risk premias + expected inflation The real rate is the time value of money, which (in a vacuum) is based upon opportunity cost and growth. The way we can observe it is by finding the yield on a zero coupon US treasury bond and subtracting inflation. If the yield on the zero coupon bond is 1% and inflation is 1.5%, then the real rate is -0.5%. We are using a zero coupon UST bond because it has the least amount of risk premia, so we can just assume 0 for that variable. How to create an interest rate forecast? Take your real rate and add in your expected inflation rate through your term period. If you are looking at the 10-year bond, use what you think will be the average level of inflation over the next 10 years. For this example, let's say you think it will be 2%. That means your expected interest rate (10yr yield) is = real rate (-0.50%) + expected inflation (2%), which is 1.50%. This is what you think the natural rate would be. Compare your "real rate" with your "policy rate" to evaluate if the policy rate is easy or tight. Going back to your hypothesis, if interest rates are currently at 1.5% (on US 10 yr), where do you think rates should be? What is your level of expected inflation (averaged over 10 years)? When you compare US policy with other countries, are we looser or tighter?
Thanks for the excellent lesson on interest rates. I have a question, do you think the 'Natural' rate is: a) >0% b) =0% c) <0% it's been bothering me for a while
In my opinion, Japan is negative, US is positive, Eurozone is close to zero. Labor force + productivity aren’t expanding very quickly, and governments aren’t willing to really spend to expand labor demand/productivity. Biden’s proposals are a step in the right direction.
Thanks longandshort; that is a text book example of the informative commentary that makes this site great. That being said; do you mind if I ask if you are long or short and if so what duration?
I had bear steepeners on but closed them out last month. Do I think bonds could go lower? Yes, but the catalyst isn't very clear right now-- this might change if an infrastructure package passes. But right now, treasury refunding has peaked, so any shock in the interim (between now and voting on a bill) probably won't come from the supply side. On the demand end, our rates are very attractive to foreign buyers, pushing the dollar higher vs. peers.
It would be a yes from my end. I have always taken treasury bonds as a great investment purely because they’re safe and guarantee a fixed ROI. They’re in fact a part of my retirement plan. But before everything, I weight the risk tolerance with the bond’s default risk, yield, and most importantly, for how long my money will be tied up.
It's basically an inflationary trade. As prices get higher and the dollar weakens the $1000 or whatever coupon from a T-Bond is less and less valuable. Peeps start dumping them, and yields rise. Short $GOVT. Easy.