Wednesday, June 13, 2007

Action in Long-Term Interest Rates

Long-term interest rates have been in the news in the US financial world in recent days. For example:
Bond Yields Soar, Driving Shares Down

The cost of borrowing headed higher yesterday and drove the stock market down sharply.

Yields on the 10-year Treasury note — a key benchmark that influences nearly all long-term interest rates, including home mortgages — hit a five-year high, climbing to 5.248 percent yesterday, up from 5.154 percent late Monday as investors sold off notes and bonds.

Treasury yields, which have been rising steadily since the end of April and have started to weigh on the stock market, quashed an early afternoon stock rally. The Standard & Poor’s 500-stock index, a broad gauge of the market, closed down 1.07 percent, or 16.12 points, to 1,493 points; and the Dow Jones industrial average dropped 1 percent, or 129.95, to 13,295.01 points.
First, a little perspective. Yes, the rise in long-term interest rates in recent weeks has been fairly impressive. But as the following chart illustrates, this sell-off in the bond market is not much different (so far) from a number of previous short-lived surges in interest rates, and could just as easily be reversed over the coming months. In the grand scheme of things, long-term interest rates in the US are still substantially below where they were during the last economic expansion.

That said, there are a couple of interesting things to note about the current phenomenon. First of all, the recent rise in long-term rates - together with a bit of a fall recently in short-term rates - means that the yield curve has abruptly become "un-inverted". In other words, short-term interest rates are now no longer higher than long-term rates, in contrast to the situation for most of the past year. There are a number of different possible interpretations for this change, including the possibly contradictory beliefs that the Fed is soon going to have to start reducing interest rates to prop up economic growth, or that the economy is poised for a rebound that would increase the demand for loanable funds.

A second point of interest is that the current run-up in long-term interest rates is entirely due to a rise in real interest rates, rather than a rise in inflation expectations. Using the 10-year inflation-indexed bond to serve as an estimate of the real interest rate, we can estimate inflation expectations as the difference between that real interest rate and the nominal bond yield (a procedure that has a few minor problems with it due to liquidity issues in the TIPS market, etc., but one that still conveys the general idea). Doing that reveals that financial market participants still (on average) expect inflation over the next 10 years to be in the neighborhood of 2.3%-2.5% - right where those expectations have been for years. The real interest rate, on the other hand, has jumped by almost three-quarters of a percentage point in the past few weeks, as the following chart shows.

One big question on a lot of people's minds is how big the China factor may be. If this movement in US interest rates is indeed being driven largely by concerns about China's economy, then this could be an important moment in US financial history, i.e. the point in time when we really started seeing China's direct influence on US interest rates. Of course, given how difficult to gauge why financial market participants are doing the things that they're doing, we may never know for sure if that's the case.


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