The Independent Market Observer

4/15/14 – What Happens When Interest Rates Rise? Part 2: What’s Keeping Rates Low, and What Happens When It Stops?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Apr 15, 2014 1:30:00 PM

and tagged Commentary

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Yesterday, we discussed what the natural rate of interest should be, arriving at about 5 percent on a nominal basis, assuming 2-percent inflation. That seems like a reasonable number over time, given that the Federal Reserve has committed to an inflation target of 2 percent. But with interest rates currently at much less than 3 percent, there’s clearly a gap between what the rate should be and where it is now.

The question for today is, What is keeping that gap open, when will it close, and what happens then? (For those who read yesterday’s post, that’s questions 2, 3, and 4.)

You’d think this would be an easy question to answer. After all, the Fed is spending trillions of dollars to buy securities specifically to keep rates down. Surely they have a detailed explanation for how that works, the extent of the effects, and what happens when they pull back. Right?

Wrong. A commentary from the Cleveland Fed breaks out the components that make up interest rates. Explanations for low rates include low expected inflation, a decline in the real interest rate to just about zero, and the higher rate that is required for longer time periods, known as the time premium. Absent is any discussion of the effects of quantitative easing.

A discussion of QE from the St. Louis Fed defines and defends it, with a lot of “may affect” rather than “does affect,” finally concluding that the Fed’s program has reduced rates by about 75 basis points, or 0.75 percent, through a lower term premium. For our purposes, we can ignore the details and surmise that, without the Fed’s stimulus, rates would be that much higher—2.65 percent plus 0.75 percent, for a rate on the 10-year Treasury of 3.4 percent. This is still below the 5 percent we would expect.

The remaining gap therefore comes from low expected inflation and a decline in the real interest rate. The real rate, per the Cleveland Fed paper, dropped from at least 1 percent to 0 percent. When that normalizes, which seems to be happening, the 1-percent shift will be added back to the Treasury rate. Inflation expectations are quoted as declining by about 0.5 percent. So, if we add these two factors to current rates and the QE adjustment, we’re right around the 5 percent we would expect.

Given this framework for understanding how interest rates will adjust, we can now consider the time frame. The Fed is currently tapering the stimulus, reducing its bond buying on a regular basis, and this should conclude by the end of the year. If the Fed’s research is right, that should increase rates by 75 bps by the end of the year. The adjustment for inflation is somewhat more speculative, but economists are now projecting an increase by the end of the year as well, probably by more than the 50 bps quoted in the Cleveland Fed commentary. Combined, this gives us a very reasonable upward rate movement of at least 1 percent by the end of the year—big stuff, in the world of finance. Any increase in the term structure is even more uncertain, but would come on top of these changes.

All of this is speculative, of course, but it gives us some context for understanding why rates are low, what is keeping them there, and how and when that will change. With the Fed’s continued tapering and the slow increase of inflation, and if investors start to require more compensation for risk, all factors are pointing toward higher rates in the medium-term future. This will be important for all investors, and tomorrow we’ll talk about what it means for our investments.

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