Economics and Interest Rates

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Economics and Interest Rates

• Christopher Low, Chief EconomistFTN Financial

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What Drives the Bond Market

• Real yields determined by supply/demand for
  credit
• Inflation premium is best guess about future
  inflation
• In contrast, Fed Funds rate has no market
  component It is an attempt to steer growth and
  inflation
• Curve shape is determined by changes in real
  yields and/or Fed policy
• Historically, Fed is 90 of curve shape

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Anatomy of a Bond
Actual Inflation
Inflation Premium
TIPS Yield
RealReturn
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10-yr TIPS Treasury Spread
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5-yr TIPS Treasury Spread
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5-yr Forward 5-yr Spread
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Policy Lag and GDP
2 qtrs
5 qtrs
6 qtrs
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Policy Lag and Core Inflation
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Policy Lag and Core Inflation
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Economic Growth

• Inflation falls when the economy grows below
  potential
• Inflation rises when the economy grows above
  potential
• Potential GDP is a guess, based on availability
  of capital and labor

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GDP and Potential GDP (CBO)
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GDP Components
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Contrib. to GDP Growth Since 2000
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Payroll Employment Growth
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Housing-Related Payroll Growth
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Unemp Rate and NAIRU (CBO)
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Non-Defense Cap Goods, Ex-Aircraft, Orders,
yr/yr
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Auto Sales
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Housing Starts
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New Home Sales
-23.2
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Existing Home Sales
-15.0
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Single-Family House Listings
82.2
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New Single-Family Listings
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Median Home Price, yr/yr
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Home Equity Withdrawal
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House Completions vs Sales
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Inflation

• Containing inflation is the primary goal of Fed
  policy
• The bond market (usually) trades independent of
  the Fed
• Bond investors like it when the Fed is right.
  But, they really like it when the Fed is wrong,
  as long as it means too much tightening

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CPI and CORE CPI, yr/yr
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PCE and CORE PCE, yr/yr
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Core CPI, 3mo/3mo
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PPI and CORE PPI, yr/yr
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Silver and Gold, (yr/yr)
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Crude Oil, (yr/yr)
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GSCI Index, (yr/yr)
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Fed Policy

• Fed Policy artificially sets the short end of the
  curve.
• Balancing act between growth and inflation.

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Fed Funds Target Rate
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Real Fed Funds Rate
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Yield Curve
FF 2 3 5 10

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Fed at Turning Points

• The first tightening is usually a surprise to the
  market.
• The first ease is usually a surprise to the Fed.
• Fed tends to tilt against inflation
• Fed doesnt trust the curve as an indicator
  because it implies the Fed causes recessions.

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Bond Market after a Tightening

• Bond market leads from the long-end
• 10-yr yield often rallies as much before the
  first cut as after
• The eventual low in 10-yr yields comes before the
  last cut