Wednesday, November 01, 2006

Telling the Future with Interest Rates

Barry Ritholtz points us to a post in yesterday's WSJ Marketbeat about how the markets' optimism about the direction of the US economy seems to be changing.

I think they're right. As an illustration, let me show you two interest rate series that tell us something about market participants' expectations.

The red line in the picture below shows the difference in the yield curve between interest rates on 5-year government bonds and 3-month treasury bills. In the past few months that yield differential has moved decidedly negative, meaning that people are willing to accept a lower rate of interest when lending money for 5 years than they will accept to lend money for 3 months.

If you think (pretty reasonably) that the only reason you'd ever accept a lower rate of interest on a loan you were making for 5 years would be to lock in that rate for a long period of time in the face of falling interest rates, then this series tells us that the market expects interest rates to drop. (For more about what the yield curve tells us, see the blogosphere's resident expert on the subject, Jim Hamilton, or this handy primer from the NY Fed.)

Economists have developed models to gauge the probability of recession based on the yield differential. A neat tool over at Political Calculations (hat tip: Jim Hamilton) uses the predictive model of economist Johnathan Wright to calculate the probability of recession. If you plug today's interest rates into that calculator, it tells us that there's a 52% chance that we'll have a recession sometime in the next 12 months. That's a pretty high chance.

The green line in the chart tells us something else: what market participants expect inflation to be over the next 5 years. That series is calculated by subtracting the inflation-adjusted TIPS interest rate from the interest rate on the nominal 5-year government bond. (Yes, there's a little bit of error because the TIPS market is not very liquid, but it still gets us pretty close to average inflation expectations.)

The thing to notice in that series is how sharply inflation expectations have changed over the past few months. It seems likely that that reflects a new feeling in the market that the economy is about to slow down significantly. Of course, the series also shows how volatile those inflation expectations are (or how big of an impact liquidity issues have on the TIPS market, depending on your interpretation), so take that data with a grain of salt. But it still seems pretty clear that along with expectations of lower interest rates, the bond market seems to be expecting lower inflation sometime soon.

Put those two together, and this picture tells me that market participants think there's a pretty good chance of a dramatic slowdown in the US economy happening pretty soon. Reading the tea leaves of today's interest rates, the future looks a little bleak.

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