An Interesting Take on Interest Rates
by Rob Kirby, Kirby Analytics. October 31, 2005
With Ben Bernanke being nominated as "the man" to replace Sir Alan Greenspan [pending confirmation] – and the FOMC set to meet Nov. 1 to render their latest decision regarding interest rates - I felt it might be fitting to take a close look at the fixed income complex given that one of the most important tasks of the Fed Chairman is to shape and implement the nation's interest rate policy.
While the FOMC is widely expected to raise interest rates [.25 basis points to 4.00%] to "remove excess accommodation" for the 12th successive time when they meet on Tuesday – there has been growing speculation that the "language" which accompanies Fed Rate Decisions is likely to change soon,
"While there has been no indication that the Federal Open Market Committee will change its judgment that monetary policy remains 'accommodative' and that it will continue to raise rates at a 'measured' pace, there is a widespread feeling that part of the statement will need to change soon."
The speculation here being – the higher the Fed ratchets up short term interest rates [the overnight borrowing rate for banks or "Fed Funds Rate"] – the closer they must be to one of the more opaque terms in monetary lingo know as "neutrality."
"In principle, the degree of stimulus would diminish to zero - the Fed would move monetary policy to neutral – just at the point when the economy settles on to its long-run sustainable growth path, much like a boat gliding to a stop alongside a pier."
Because monetary stimulus is said to affect the economy with "a lag" – achieving true neutrality in monetary policy can be and often is a daunting task. While raising interest rates does perform the desired effect of "slowing" the economy through lessened credit demand – in some cases it can also act to "shut down" the carry trade. This occurs when short term rates are "driven" to levels where they exceed long term rates producing an "inverted yield curve." Inverted yield curves are historically known to be harbingers of recessions. The carry trade is best thought of as lending long dated [maturity] money at a high interest rate and "funding" the loan with cheaper short term money [the overnight or Fed Funds rates in many cases for banks].
Shutting down the carry trade can have undesired and sometimes systemically dangerous side effects. If banks and or hedge funds are heavily invested [or leveraged] in the carry trade – a sudden move to an inverted yield curve can create a "stampede effect" of market participants trying to "unwind" their positions. Also, historically many financial institutions have counted on this "bread and butter" transaction as what is generally perceived to be a low risk way to bolster their balance sheets and generate profits. Ending this gravy train type of trade could have negative impacts on banks and finance company's balance sheets – not likely a desired outcome of monetary policy makers.
This brief explanation of interest rates and the carry trade should give folks some understanding as to why the Fed has chosen to remove the excess accommodation [ridiculously low rates] at a "measured pace" – and not aggressively as some pundits would choose. In a highly leveraged and indebted economy, one must be careful not to upset the proverbial apple cart.
So this brings us to the here and now – with many Fed officials clamoring for still higher rates and at the same time a growing chorus of bond mavens [like Pimco's Bill Gross] saying "enough."
The Fed has been on a mission for 15 months now to return money market interest rates to neutral and to impart a semblance of normality to the cost of borrowing. In analyzing this journey, PIMCO has for several years now focused on the real interest rate – Fed Funds minus inflation – as the most legitimate indicator of neutrality. Historically trading between 2% and 3%, which would imply a 4½ – 5½% range in nominal headline terms, we have suggested it will be different this time. Because the U.S. economy has evolved into a highly levered finance-based economy, it stands to our reason that this modern day version is more sensitive to changes in interest rates than those of years past.
Who's to argue with Bill Gross? Maybe he's "talking his own book," but heck, he is still the world's largest bond fund manager. Interesting times indeed... and least I forget to mention, the times – they are a changing!
Overseas equities firmed with Japan's Nikkei Index surging 259 to close at 13,606. North American markets also began the week on a positive note with the DOW up 37 to 10,440, the NASDAQ gained 30 to close at 2,120 and the S & P added 8.60 to close at 1,207. NYMEX crude oil futures lost 1.46 to close at 59.76 per barrel.
Interest rates closed virtually unchanged with the benchmark 10-year bond ending the day at 4.56% yield and the 5-year bond ended the day at 4.44%.
The U.S. dollar index closed up .47 to 89.93 with the YEN at 116.41, the EURO at .8341, the GBP at .5649, the CAD at 1.1812, the YUAN at 8.0832 and the RUBLE at 28.56.
Precious metals were slammed with COMEX gold futures ending the day down 8.00 to 465.60 per ounce while silver futures gave up .25 to close at 7.55 per ounce. The XAU gold bug index gained 1.01 to 107.81 and the HUI lost 1.41 to close at 222.79.
On tap for tomorrow, October Auto and Truck sales data are due to be released – expected 5.3M vs. prior 5.7M and 7.0M vs. prior 7.3M. At 10:00 a.m. the Census Bureau is due to release September Construction Spending – expected .5% vs. prior .4%. Also at 10:00 a.m., the ISM [Institute for Supply Management] is due to release their October data – expected 57.5 vs. prior 59.4. Then at 2:15 p.m. the FOMC is due to release their interest rate decision and policy statement.
Wishing everyone a ghoulishly pleasant evening and a happy tomorrow!
© 2005 Rob Kirby