Interest Rates Gone Wild?
Yields began rising in early April, with the earliest indicator coming from the interest rate on 5-year Treasury Inflation-Protected Securities.
Many observers didn't notice what was happening at first. Until we started getting into May, the yields on longer-term TIPS were little changed while the interest rates on bonds that aren't indexed to inflation were actually declining.
Things got more interesting as Ben Bernanke gave hints about "tapering" the Federal Reserve's asset-purchase program. Since then, rates have increased everywhere and emerging-market assets have been selling off. Between May 17 and the Fed's recent meeting on June 18, the price of Hungary's local-currency 10-year benchmark bond has declined by more than 10 percent, while the Athens Stock Exchange General Index plunged by about 20 percent.
The recent episode of market turbulence began right after the Federal Reserve released its latest economic forecasts and policy statement on Thursday. (Turmoil in the Chinese interbank lendingmarket have also played a role, althoughanalystsdisagree how important it is for the global economy. Some also argue that the volatility in China wascausedby rising rates in the U.S., rather than the other way around.)
As I discussed in my initial reactionto the Fed's meeting two days ago, the markets may have been responding to the improved unemployment forecast. The Fed has promised to keep short-term interest rates around 0 percent until sometime in 2015. In the long run, the Fed seems to think that short-term interest rates ought to average about 4 percent. That means that the interesting action is mostly going to occur in the spaces in between, which roughly means the years 2015 through 2018.
This was evident in the disproportionate reaction of 5-year interest rates and eurodollar futures. Since the beginning of April, the U.S. 5-year real interest rate went from -1.8 percent to -0.3 percent. A third of that increase occurred just since Wednesday afternoon. Similarly, the federal funds rate implied by eurodollar futures for June 2018 rose from 3 percent to 3.5 percent in the space of two hours. That's a lot.
Although eurodollars seem to have stabilized since the end of Wednesday, bond yields (both real and nominal) have kept rising. The benchmark 10-year Treasury note crossed the psychologically meaningful (but economically irrelevant) threshold of 2.5 percent for the first time since the beginning of August 2011. It helps to know that 10-year bonds were yielding as much as 3.5 percent a little earlier in 2011, although the recent spike is still remarkably rapid.
These adjustments are desirable. It would be far worse if rates had stayed at levels consistent with a Great Depression scenario right up until the Fed began to tighten. Moreover, if things start to get out of hand, the Fed can sway markets thorough speeches by members of the Fed's Open Market Committee or adjusting official statements about the timing of rate increase. Another option would be to increase the pace of asset purchases. Those measures may not do much for the real economy, but they might do wonders for the bond market.
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Matthew C Klein