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The Risk in Long-Term Interest Rates & Stagflation.

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"There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world's productive capacity is being tapped to satisfy
global demands for goods and services.

Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of investment. The favourable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of
lower inflation in the years ahead and lower inflation risk premiums.

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But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of
world bond markets remains a conundrum.

Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge
the forces underlying recent experience."


Testimony of Chairman Alan Greenspan
Federal Reserve Board's Semi-Annual Monetary Policy Report to the Congress
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate February 16, 2005
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Abstract:

This paper explains the recent rise in long-term interest rates and inflation expectations.

There have been a lot of concerns about the recent rise of long-term interest rates and inflation expectations.

Some have been calling philosophy at the rescue to explain that raise (Brad de Long: A Socratic Dialogue: Fearing the Collapse of U.S. Treasury Bond Prices.

As an economist, I prefer to call Fischer Sheffey Black and his valuation of option prices.

These concerns are ill placed:

Long-term interest rates are compounded options of short-term interest rates.

The only way the fair value of long-term interest rates could rise would be if the FED would hike short-term interest rates or the implied volatility of short-term interest rates goes up.

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If we look at the volatility of interest rates we get the whole story:

Chart of the Volatility of the Yield of the 30 Years US Treasury Bond
Chart of the Volatility of the 13 Weeks Treasury Bill:
The increase in Long term yields are entirely explained by the increase of their volatility!

Because of the high volatility of long term interest rates, according to my definition, (Plea for a New World Economic Order, Chapter II) and contrary to the common belief, the yield curve is inverted, which explain why mineral prices are going up.

In fact what history told us is that the only way we get inflation is when, thanks to the inversion of the yield curve, mineral prices go up (confer my article about the Stagflation Paradox Commodity Conundrum Solved: The Hidden Parameter in Interest Rates).

A stagflation is driven by mineral prices and exhibit a deficit in supply in the sole arena of mineral prices.

It is thus perfectly possible that following the steps of Chairman Paul Volcker at the end of the 70's and beginning of the 80's, Chairman Benjamin Shalom Bernanke hike the short-term rates in a recession. It is however, according to me, not probable and any way would occur in a distant future. And there are not many fools like Paul Volcker.

Given that the volatility of long-term interest rates is showing some signs of cooling off very soon long-term rate will drop down.

Monetarist ideology takes the Money Supply as one. But when the FED pumps money it increases the Investments (and Supply) and marginally increase Consumption (Demand). So the increase in money supply increase more Supply than Demand and causes deflation on a medium term. (When the new productive capacities are put to work.)

"The third major uncertainty in the economic outlook relates to the behavior of long-term interest rates. The yield on ten-year Treasury notes, currently near 4-1/4 percent, is about 50 basis points below its level of late spring 2004. Moreover, even after the recent widening of credit risk spreads, yields for both investment-grade and less-than-investment-g... corporate bonds have declined even
more than those on Treasury notes over the same period.


This decline in long-term rates has occurred against the backdrop of generally firm U.S. economic growth, a continued boost to inflation from higher energy prices, and fiscal pressures associated with the fast approaching retirement of the baby-boom generation.

The drop in long-term rates is especially surprising given the increase in the federal funds rate over the same period. Such a pattern is clearly
without precedent in our recent experience.


The unusual behaviour of long-term interest rates first became apparent last year. In May and June of 2004, with a tightening of monetary policy by the Federal Reserve widely expected, market participants built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with an initial rise in the federal funds rate.

Accordingly, yields on ten-year Treasury notes rose during the spring of last year about 1 percentage point. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In March of this year, long-term rates once again began to rise, but like last year,market forces came into play to make those increases short lived.

Considerable debate remains among analysts as to the nature of those market forces.

Whatever those forces are, they are surely global, because the decline in long-term interest rates in the past year is even more pronounced in major
foreign financial markets than in the United States.


Two distinct but overlapping developments appear to be at work: a longer-term trend decline in bond yields and an acceleration of that trend of late. Both developments are particularly evident in the interest rate applying to the one-year period ending ten years from today that can be inferred from the U.S. Treasury yield curve. In 1994, that so-called forward rate exceeded 8 percent. By mid-2004, it had declined to about 6-1/2 percent--an easing of about 15 basis points per year on average. Over the past year,that drop steepened, and the forward rate fell 130 basis points to less than 5 percent.

Some, but not all, of the decade-long trend decline in that forward yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real term premium that seems due to a moderation of the business cycle over the past few decades. This decline in inflation expectations and risk premiums is a signal development. As I noted in my testimony before this Committee in February, the effective productive capacity of the global economy has substantially increased, in part because of the breakup of the Soviet Union and the integration of China and India into the global marketplace. And this increase in capacity, in turn, has doubtless contributed to expectations of lower inflation and lower inflation-risk premiums.

In addition to these factors, the trend reduction worldwide in long-term yields surely reflects an excess of intended saving over intended investment. This configuration is equivalent to an excess of the supply of funds relative to the demand for investment.

What is unclear is whether the excess is due to a glut of saving or a shortfall of investment. Because intended capital investment is to some extent driven by forces independent of those governing intended saving, the gap between
intended saving and investment can be quite wide and variable.


It is real interest rates that bring actual capital investment worldwide and its means of financing, global saving, into equality. We can directly observe only the actual flows, not the saving and investment tendencies. Nonetheless, as best we can judge, both high levels of intended saving and low levels of intended investment have combined to lower real long-term interest rates over the past decade."


Chairman Alan Greenspan
Federal Reserve Board's Semi-Annual Monetary Policy Report to the Congress
Before the Committee on Financial Services, U.S. House of Representatives July 20, 2005

Bond traders tend to have a very short memory (I have been one in a previous life.) I will remind them that when Chairman Alan Greenspan and then Chairman Benjamin Shalom Bernanke hiked the short-term rates from 1% to 5.25% they succeeded in rising long-term rates only by a mere 1.25% (at a time when the economy was in a much better shape than today.).

So the risk in long-term interest rate is the dreaded Keynes' Liquidity Trap.

Unless, of course, the rich get poorer relatively to the poor.

One question remains: Are We in a Liquidity Trap Yet? and its necessary collateral: Is a Crash Already in the Cards? The answer is in my next article.


 

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blog.yield-curve.net
Shalom P. Hamou Tel Aviv, Ramat Aviv, Israel I am the youngest economist at My Yield Curve. Since spring of 1994 I have been working on economic depressions. I am writing The Tract The Religious Interpretation of (more...)
 

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