Thursday, January 31, 2013

interest rates and the economy

What determines the level of the 10 year note yield (top chart)? I'd say that this yield depends on investor expectations about two things: the real rate of growth in the economy and the rate of inflation over the next 10 years. We can simplify this idea even further by saying that the level of 10 year note yields should roughly equal investor forecasts of the average annual rate of growth in NOMINAL (no inflation adjustment) gross domestic product  over the next 10 years.

As you can see in the chart investors are expecting nominal GDP to grow at about a 2% annual rate for the next 10 years. Since people expect inflation rates of at least 2% as far as the eye can see, this level of interest rates suggests that investors think that the real economy will not grow at all during the next 10 years!

You can get another read on this expectation by looking at the yield on the 10 year TIPS (inflation protected treasury notes) which were auctioned at a rate of a NEGATVE 0.63% a few days ago. People who bought these notes are paying the US treasury to take their money and spend it!!!  From a purely mechanical point of view the difference between the yields on the 10 year note and the 10 year tips represents investor's expectation of the rate of inflation over the next 10 years. In this case the difference is 2.60%. Put another way, the 10 year TIPS yield suggests that investors think the real economy will shrink by 0.60% per year over the next 10 years while inflation averages 2.00% per year! Of course there is probably a fairly big risk premium built into the negative TIPS yield so the forecast is not really as pessimistic as this. Even so I still think this is an incredible forecast for the US economy.

Is this forecast likely to be close to the mark? I don't think so. I think people are grossly underestimating the likely effects of the Fed's quantitative easing policy and the Fed's commitment to pursue that policy at least until the US unemployment rate drops below 6.5% (it is currently 7.8%). The Fed's policy is having an effect on the Euro which is steadily rising against the dollar (middle chart). The Euro is above it rising 200 day moving average as well as above its rising 50 day moving average, a bullish configuration if there ever was one. The market is pricing in not just the survival of the Euro currency but also the fact that the Fed's monetary policy is relatively loose compare with that of the European Central Bank. Liquidity in the US is increasing relative to Europe's. This will inevitably lead to a pick up in US economic activity relative to that of the EU and a further advance in the Euro against the dollar.

The market thinks that the Fed will also be getting help from the Japanese central bank in pushing upward world economic activity. The bottom chart shows the yen priced in dollars. This bear market in the yen is a forecast of a big expansion in yen liquidity relative to dollar liquidity (which of course is itself increasing). This would be an enormous change in policy by the Bank of Japan (if it occurs) and will have very positive effects on the Japanese and the world economies.

All in all I think the market forecast of only 2% annual growth in nominal US GDP over the next 10 years is plain silly. My own guess is that this number will come in closer to 5% or even higher. If I am right 10 year note yields are in the early stages of an advance which will last several years. You can see that the 50 day moving average of this yield has finally climbed above the 200 day moving average, the first time this has happened in years. This I think is a harbinger of a long term bear market in bond prices.


bmgh said...


Excellent post!
As usual... whenever you write away from the daily gyrations of the ES... you write outstanding stuff.

Many thanks for sharing.


Graph1159 said...

Hi Carl,
Very thorough analysis! I hear a lot of people predicting the soon collapse of the dollar and hyperinflation in the U.S. economy. It would be interesting if you made a post explaining why (at least in the near term) you do not think this would happen.