Interest rates question

[DRumsfeld2000]

I would like to get some comments on where people think interest rates will go in the next 2-5years, both in the USA and Europe.

It appears that governments are going to try and increasingly tax citizens as much as possible to pay for the massive debt they have created. These advanced economies are dependent on consumerism so this will have a downward pressure on spending, this will affect taxes and income governments will receive etc. The production cost of goods will remain under pressure due to technology but mainly due to low world demand which could equate to deflation.

Under deflation, which I think is the most likely scenario at present, would interest rates remain low despite government debt and the need to finance this? Can QE continue to finance government debt and overpower the bond markets to keep rates low?

[Chris]

Re: Interest rates question

What deflation? Isn't inflation still above the nominal, never mind real, interest rate? Deflation means death for an over-indebted government as the interest costs become increasingly larger and tax revenues fall.

If nothing goes wrong, I think the trajectory for interest rates will be.....nowhere.

[don]

Re: Interest rates question

Doug Nolan's Take on the Interest Rate Conundrum

There will be neither specifics nor a timetable. The Fed has pretty much painted itself into a corner. QE3, in particular, fueled dangerous Bubbles in equities and corporate Credit. Meanwhile, it ensured another two years of global (largely Asian) over- and mal-investment. Today and going forward, the Fed will have little clarity as to the soundness of the financial markets or real economy. It will have minimal grasp on prospective inflation rates. So long as the financial Bubble inflates, economic output will appear OK. Yet market Bubbles guarantee intractable financial and economic fragility. Market tumult would, in short order, darken economic prospects. Very few appreciate today’s dilemma.

May 8 – Bloomberg (Simon Kennedy and Ilan Kolet): “The global economy is rebooting for ‘Great Moderation 2.0.’ Barely five years after the worst financial turmoil and recession since the Great Depression, the U.S. and fellow advanced nations are showing a stability in output growth and hiring last witnessed in the two decades prior to the crisis, in an era dubbed the ‘Great Moderation.’ The lull points to a worldwide economic expansion that will endure longer than most. Volatility in growth among the main industrial countries is the lowest since 2007 and half that of the 20 years starting in 1987… Investors also are becalmed, with a risk measure that uses options to forecast fluctuations in equities, currencies, commodities and bonds around the weakest level in almost seven years… Such calm finally is providing a support for equities over bonds and giving companies and consumers long-sought clarity to spend.”

What an incredibly fascinating time to be a “top down” analyst – of economics, global markets and geopolitics. And as an analyst of Bubbles, these days it’s too often “Déjà vu all over again.” “Tech Bubble 2.0” resonates. “Great Moderation 2.0” analysis, well, it suffers from the same misconception as the original: complete disregard for the impacts and future consequences of flawed policies and resulting Credit and asset Bubbles. With going on six years of unprecedented growth in Federal Reserve Credit and global central bank holdings, analysts should be especially cautious when it comes to extrapolating the deceptive appearance of financial and economic stability.

From an analytical perspective, I’ll dismiss “Great Moderation” chatter and focus instead on the reemergence of “Conundrum.” Recall that chairman Greenspan introduced “Conundrum” into market lexicon back in 2005. Confounding the Federal Reserve (officials and models), long-term yields trended lower in the face of Fed rate increases.

From my perspective, there was No Conundrum in 2005. I addressed this topic in a May 2005 CBB, “Conundrums,” and again in June 2006 with “No Conundrum, Again.” The Fed had increased short-term rates from 2% to 4% between December 2004 and November 2005 with minimal impact on long-term Treasury yields and mortgage rates. I saw no mystery. Committing another major policy blunder, the Fed had held rates too low for too long. And in the midst of an increasingly speculative Mortgage Finance Bubble backdrop, timid Fed rate increases completely failed to restrain leveraged speculation. Financial conditions were remaining extraordinarily – dangerously - loose.

I want to bring in some data. Mortgage Credit growth averaged about $270 billion annually during the decade of the nineties (no slouch period for Credit growth!). Total Mortgage debt began growing at doubled-digit rates in 2002 as the Fed aggressively reflated (post-“tech” Bubble). Surging annual mortgage debt growth surpassed $1.0 Trillion for the first time in 2003. It then inflated to $1.27 Trillion in 2004 and hit an all-time record $1.45 Trillion in 2005.

It was my view at the time that long-term Treasuries, agency debt and MBS were beneficiaries (downward pressure on yields) of an increasingly unstable Bubble backdrop. Essentially, the marketplace was discounting the unsustainability of both rapid system Credit growth and an unsound economic expansion. Indeed, I argued at the time that this dynamic was dysfunctional. In a key “Terminal Phase” Bubble Dynamic, liquidity and general speculative excess sustained the mispricing (and gross over-issuance) of mortgage Credit and prolonged the general Bubble period.

At the end of the day, one could say bond prices had it “right” and stocks had it “wrong.” It’s so good to be a bond. During the Bubble period, low bond yields spurred destructive excess that came back to crash stocks – while the inevitable bust proved absolutely delightful for Treasuries and agency securities.

So I am monitoring the 2014 decline in Treasury and global sovereign yields with keen interest. Of late, there’s been some concern that declining long-term yields might be signaling issues thus far ignored by bullish equities investors (with the S&P500 a smidgen below record levels). From my experience, the bond market tends to be a much more effective discounter of fundamental prospects (and macro inflection points!) than equities. For sure, equities tend to turn wild late in the speculative cycle. It’s worth noting that 10-year Treasury yields traded to almost 5.30% in June 2007 and then sank almost 150 basis points in five months – while the S&P 500 defied a faltering Bubble to trade to record highs in October 2007.

After ending 2013 at 3.03%, 10-year Treasury yields have declined 41 bps y-t-d. Sovereign yields have collapsed throughout Europe and have generally retreated around the globe. What’s behind the decline? Are there potential ramifications for stocks and the global economy? These are critical questions, especially considering the bullish consensus view of accelerating U.S. and global growth.

Some thoughts. First of all, I’m rather convinced that we’re in the “Terminal Phase” of the global government finance Bubble that began inflating more than five years ago. Credit and speculative excesses have exacerbated global distortions – including problematic wealth distribution and economic maladjustment (certainly including mounting over-capacity for too many things). For now, there are some disinflationary tailwinds exerting modest downward pressure on consumer price aggregates. Bond prices are supported by meager CPI gains throughout the developed world. I believe “safe haven” government debt markets are further supported by the unsustainability of various Bubbles, certainly including U.S. stocks, corporate debt and global risk assets more generally.

It’s also my view that a rapidly deteriorating (faltering global Bubble-induced) geopolitical backdrop has begun to bolster safe haven demand for Treasuries and sovereign debt. I fear the “Ukraine” crisis marks an unfortunate end to an era of general global cooperation and integration – with the troublesome return of “Cold War” tensions and risks. Myriad risks encompass economic, financial and military. And it is difficult for me to envisage rapidly escalating tensions in the South China Sea and East China Sea as mere coincidence. Russian and Chinese governments appear determined. Both seem to be implementing plans – replete with belligerent war-time propaganda and disinformation. The U.S. is portrayed as the villain – and things seem headed in the direction of an acrimonious bipolar world. There are major potential economic ramifications that go neglected in the midst of bull market exuberance.

I will not claim to be an expert in geopolitics. My macro expertise is more in the realm of Credit, financial flows, Bubbles and associated financial and economic fragility. But these days I discern an extraordinary interplay between geopolitical and the markets. If I’m on the right track with the geopolitical, the world is quickly becoming a more dangerous place. Geopolitical risks compound the vulnerabilities associated with mounting “Terminal Phase” Bubble excesses.

Egregious Fed and central bank monetary inflation has ensured mispricing for tens of Trillions of dollars of financial assets. In particular, I fear central bank policies have incentivized enormous amounts of speculative leverage (certainly including myriad global “carry trades”). This means the leveraged speculator community is once again a source of major instability. And I fear the ETF complex – having doubled in size in four years – is another avenue of potential fragility. As I’ve posited previously, a strong case can be made that the scope of trend-following and performance-chasing finance currently fueling market Bubbles is unprecedented. The consensus view dismisses the notions of speculative excess, Bubbles and fragility.

And here’s where things get really interesting. Whether things blow up soon or not (in Ukraine or the China Seas), newfound geopolitical uncertainties have unexpectedly elevated market risk. I believe the more sophisticated market operators have likely begun to take some risk off the table. De-risking/de-leveraging wasn’t much of an issue when the Fed was adding $85bn of monthly market liquidity. But with the Fed now in the waning months of its QE operations, the markets are increasingly susceptible to a bout of “risk off.” If the hedge funds are turning more risk averse, this would likely mark an impending inflection point in terms of overall marketplace liquidity.

I suspect the markets have already entered a period of unusually high risk. What the bulls see as “healthy rotation,” I view as confirmation of incipient risk aversion, greed transforming to fear, and the overall “inflection point” thesis. With QE winding down, there is impetus for the leveraged speculators to push forward with de-risking while Fed liquidity remains available. Bullishness is so entrenched that any serious market retreat would catch most by surprise. A scenario where the hedge funds bound for the exits as a spooked public clicks the sell button on ETF holdings doesn’t these days seem like such a longshot.

Yet I over-simplify things. The geopolitical backdrop has surely turned incredibly complex and nuanced. I believe Russia and China have increasingly serious issues with U.S. dominance over global finance. Both have serious domestic problems that might incentivize them to act out – and perhaps even act out as partners.

At the same time, the U.S. and the West are hoping financial and economic sanctions (as opposed to military confrontation) will alter Putin’s behavior. A weak ruble and faltering Russian stocks and bonds are seen as pressuring Putin and his inner circle. As things unfold, I would expect officials from Russia and China to demonstrate resolve of steel against Western pressure (financial and otherwise). And it would seem reasonable that the performance of Western stock and bond markets now also plays into the new Cold War calculus. It would appear an especially inopportune time for a bout of serious market tumult. From a game theory perspective, perhaps this even reduces the odds of a near-term market blowup. Personally, I wouldn’t want to bet on stability.

It was another interesting week in the markets. In the category “careful what you wish for,” Mr. Draghi finally seemed to get some traction with a weaker euro. The euro declined 1.1% against the yen this week to the lowest level in two months. It is worth recalling that euro weakness versus the yen back in late-January corresponded with a fleeting bout of market “risk off.” How big is the yen carry trade – borrowing in cheap yen to speculate in higher-yielding European stocks and bonds? Might this be an important trade that risks pushing the leveraged players into a more urgent de-risking/de-leveraging mode?

[coolhand]

Re: Interest rates question

I would like to get some comments on where people think interest rates will go in the next 2-5years, both in the USA and Europe.

It appears that governments are going to try and increasingly tax citizens as much as possible to pay for the massive debt they have created. These advanced economies are dependent on consumerism so this will have a downward pressure on spending, this will affect taxes and income governments will receive etc. The production cost of goods will remain under pressure due to technology but mainly due to low world demand which could equate to deflation.

Under deflation, which I think is the most likely scenario at present, would interest rates remain low despite government debt and the need to finance this? Can QE continue to finance government debt and overpower the bond markets to keep rates low?

Who needs QE to keep rates low when you have interest rate derivatives? Google "interest rate derivatives" and look at when their growth really exploded.

If you own a 10-year UST yielding 2.5%, if you buy an interest rate swap protecting you against rising rates, do you care if rates rise?

If you can borrow money at LIBOR and the swap only costs a few bps, how many times do you lever up your equity (borrow sub-1% to lever up 10x; buy interest rate swaps for a couple bps; buy UST's with the 10x levered pile of cash). Voila! You just earned a 20%+ ROI truly risk free...

This is how derivatives create demand for UST's...this is theoretical of course...but I am all ears if anyone else has a better explanation for why derivatives rose from < $100T to $800T in only 15 yrs all while global sovereign debt hit 300 yr highs while interest rates on that debt hit 300 yr lows

[DSpencer]

Re: Interest rates question

Who needs QE to keep rates low when you have interest rate derivatives? Google "interest rate derivatives" and look at when their growth really exploded.

If you own a 10-year UST yielding 2.5%, if you buy an interest rate swap protecting you against rising rates, do you care if rates rise?

If you can borrow money at LIBOR and the swap only costs a few bps, how many times do you lever up your equity (borrow sub-1% to lever up 10x; buy interest rate swaps for a couple bps; buy UST's with the 10x levered pile of cash). Voila! You just earned a 20%+ ROI truly risk free...

This is how derivatives create demand for UST's...this is theoretical of course...but I am all ears if anyone else has a better explanation for why derivatives rose from < $100T to $800T in only 15 yrs all while global sovereign debt hit 300 yr highs while interest rates on that debt hit 300 yr lows

If the interest rate swaps are so cheap would this imply the seller believes it is extremely unlikely that rates will rise? Does that logic make sense or is there something I'm missing?

[seobook]

Re: Interest rates question

If the interest rate swaps are so cheap would this imply the seller believes it is extremely unlikely that rates will rise? Does that logic make sense or is there something I'm missing?

It could also be the seller either...

• is highly motivated by quarterly bonuses associated with the still dancing "free money" today & has little to no concern for future losses
• figures they will be bailed out

[coolhand]

Re: Interest rates question

If the interest rate swaps are so cheap would this imply the seller believes it is extremely unlikely that rates will rise? Does that logic make sense or is there something I'm missing?

No, your logic is dead on, which is the problem... Interest rate swaps in small amounts are fine, useful even. When the global derivatives market hits $800T, with interest rate swaps roughly 50-65% of that, that is where the problem hits. If rates rise a bunch, in theory someone net loses and someone net wins. When we are talking about a base of $800T, it doesn't take much of a loss to wipe out the capital of a TBTF bank.

If just one TBTF bank goes under (like Lehman), then you have what amounts to a fire in an ammunition dump. The "gross" derivative exposure becomes "net" as suddenly one counterparty can't backstop any of it.

So no TBTF's will ever be allowed to go under again. And in the insurance business, writing policies to pay when you can't possibly have the capital to cover eventual claims is called fraud. In banking, they are called interest rate derivatives.

Regardless, what is important is understanding that a) it artificially lowers borrowing costs on sovereign debt regardless of debt levels or economic fundamentals (see US, Japan, UK); b) thinking about interest rate movements in classical terms without factoring derivatives is likely to lead to wrong conclusions (see what US rates have done since the US downgrade in 2011); c) the handful of TBTF banks that hold these things will be protected from on high by the governmental equivalent of the Almighty Himself.

Translation: There will be no inflation, nor will there be any spike in rates. But the price of everything you need will get much more expensive. This has already begun (see healthcare premiums, Rx prices, food, energy, housing, etc.)

It suggests the long term way to benefit is by shorting US debt the "finance 101 way": Borrow the money & buy productive assets. And as EJ has long noted, hold some gold, b/c no one knows when this game will end, but when it does, you're going to want some protection.

[lektrode]

Re: Interest rates question

..... the handful of TBTF banks that hold these things will be protected from on high by the governmental equivalent of the Almighty Himself.

Translation: There will be no inflation, nor will there be any spike in rates. But the price of everything you need will get much more expensive. This has already begun (see healthcare premiums, Rx prices, food, energy, housing, etc.)

It suggests the long term way to benefit is by shorting US debt the "finance 101 way": Borrow the money & buy productive assets. And as EJ has long noted, hold some gold, b/c no one knows when this game will end, but when it does, you're going to want some protection.

this provokes another question, coolhand (at least in my little brain) - since there appears to be no POLITICAL will in congress to either CUT SPENDING nor raise taxes - never mind even attempt to come up with an 'honest' budget - nor any kind of a coherent plan to CREATE JOBS??? (or maybe even create the conditions that might lead to CONFIDENCE within the non-cronyist private sector so that they/jobs might be created the old fashioned way, by the productive economy)

what appears to be happnin is the political class is enabling the financial terror brigade to 'raise revenues' by depriving those of us WHO DIDNT spend/borrow themselves into oblivion - by depriving - nay, ROBBING us of INTEREST INCOME on our hard-earned - and TAXED - saved-net incomes

since they cant get it 'honestly' by taxation, they - the poltical class/beltway bozos -
are STEALING IT WITH INFLATION.

the only other question then becomes: just what productive assets would make sen$e in the face of DENIAL of inflation, risk of outright collapse of the financial system, which will likely result in a huge uptick/spike in JOBLESS NUMBERS ?

[aaron]

Re: Interest rates question

Ej said that QE has a time delay. Based on the amount printed, we could even see rates under 2% . In other words, these current falling interest rate are the effects of qe3 from last year.

[charliebrown]

Re: Interest rates question

This raises some questions ...

1) This sounds like a great deal, can we get in on it? As a retail person, can I buy a bunch of 10yr treasuries that may yield 2.5 - 3%, then buy one of these
interest rate derivatives and net 2% - 2.5% with very low risk?

2) I have a stable value fund in my 401k. It holds corporate debt and an insurance wrapper to protect against interest rate rise. I think it is paying out about 1.8% now.

If the credit markets blow up again, I'm thinking of 1) taking a loan on my 401k to reduce the balance, 2) move from the stable value fund
to a regular bond fund when the pain to the insurance contract is at a maximum. Hopefully at that point, most of the price damage to the
bond portfolio will be done, and I can sneak out before exchanges out of the stable value fund are suspended because the insurance cannot pay out.

Boy the crap you have to think about to keep your head above water now a days ....

[Southernguy]

Re: Interest rates question

Ej said that QE has a time delay. Based on the amount printed, we could even see rates under 2% . In other words, these current falling interest rate are the effects of qe3 from last year.

There is a graph somewhere that illustrates this. To lazy to look for it.

[anayder]

Re: Interest rates question

Found it!

http://www.itulip.com/forums/showthr...263#post275263