Selasa, 25 Juni 2013

Putting higher interest rates in perspective

As I detailed last week, the dramatic rise in nominal and real yields since the end of April marks a big change in the market's expectations for the future of the U.S. economy. Two months ago, the market believed the economy would be so weak that the Fed would be unable to raise short-term interest rates for the next two years. Today, the market expects the economy to be doing well enough to allow the Fed to raise short-term rates to about 1% two years from now. As a result, interest rates all across the yield curve have jumped, and it's all because the market has gained confidence in the economy's ability to grow. It's hard to see how this can be interpreted as a negative for the equity market, or for the housing market, since even after the expected rate increases occur—if indeed they do—interest rates would still be relatively low from an historical perspective.


The chart above shows the Treasury yield curve as it stood at the end of last April, as it stands today, and as the market expects it to be in two years. 5-yr Treasury yields were 0.7% two months ago, and are now expected to climb to 2.7% over the next two years. 10-yr Treasury yields were 1.7% and are now expected to be 3.3% in two years. These are significant changes, but they are hardly life-threatening from the economy's perspective.

As the chart above shows, a 3.3% yield on 10-yr Treasuries would still qualify as an extraordinarily low yield from an historical perspective. 

As the chart above suggests, the current -0.2% real yield on 5-yr TIPS is only now approaching levels that might be consistent with the economy growing by a tepid 2% per year for the next several years—at about the same rate that it has grown over the past several years. What stands out in this chart is just how low real yields had fallen two months ago. The bond market was exceptionally bearish on the economy's prospects last April, and now it is much less pessimistic. But it is still far from being optimistic.

Today's interest rates, which embody expectations of higher interest rates to come, are not likely to pose a threat to the U.S. economy. They have presented a problem, however, for investors who thought that interest rates would remain close to zero for a very long time. 

The jump in Treasury yields has boosted mortgage rates by almost a full point, as seen in the chart above. Does this threaten the housing market? I doubt it. In the entire history of the U.S. mortgage market, rates have only been lower than they are today for the preceding year. Prior to 2012, rates have never been lower than they are today. 

Today's release of the Conference Board's measure of consumer confidence marked a new high for the current recovery. This is consistent with the action in the bond market: people are feeling a bit more comfortable now about the future prospects for the U.S. economy. 

UPDATE: According to ICI, taxable bond funds this month have experienced their biggest net outflow in over four years. Big things are indeed happening; the bearish case for the economy—which calls for very low interest rates for as far as the eye can see—has been dealt a serious blow.

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