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Paratrade Systems Weekly Research News

2 Sep

Are interest rates unnaturally low?

There are a plethora of famous investment managers and newsletter writers who like to argue that interest rates are far too low. They assert that the Fed has grossly mismanaged their stimulus program and this will all end in tears. This may well be true since another crisis would demand more rate cuts and it’s hard to cut them when they’re already at zero.

The question becomes – have rates fallen far more than fundamental factors would have pushed them without the Fed’s actions. To study this we have to divide the time frame into two parts:

  • 2008-2010  When the economic meltdown demanded extreme action. Few people argued then (or now) that they went too far given the circumstances.
  • 2011 – Present  After the economy found some footing, the Fed may have continued on in panic mode too long. T/F?

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We can see here the two primary indicators of inflation risk set (upside down) as cumulative volatility adjusted price change. In 2012 – early 2013 these factors were essentially flat and so were bond prices.

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We can see here the two factors combined. The bond rally seems consistent with the drop in inflation that we saw in 2014. It was a huge move and long rates fell justifiably. What’s new is that the rise in this inflation measure over the last six months has not been met with weaker bond prices.

There is of course another factor (there are certainly more) that we need to consider: foreign bond yields.

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European economic stagnation is not very new and the actions of the ECB to buy bonds came rather late in the day. They were inspired by our own QE and the mess in the PIIGS countries. Such buying has created a veritable bond shortage in Europe so it is fair to ask – where will international investors turn if they have no yield in Japan or Europe? The problem is less about irresponsibility on the part of the Fed but rather about global policy.  Is the BOJ negligent for setting rates at zero during their time of protracted stagnation? Has it lead to inflation there?
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If inflation continues to rise and the divergence we see in chart #2 grows then the Fed will be forced to reverse course. They may be too late to control the fire but who wouldn’t like a little inflation – everyone knows it’s easier to fix inflation than deflation.

We may have finally arrived at a distinct juncture where inflation is rising and the Fed is scared to do the right thing. My guess is that the global labor and oil glut isn’t going to disappear anytime soon so worrying about inflation is rather pointless.[/cs_text][/cs_column][/cs_row][/cs_section][/cs_content]

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