How large is the rate risk? And where is the inflation?

Quantitative Easing represents the monetary policy of the Federal Reserve, whereby it purchases securities, mainly longer dated U.S. Treasury and mortgage-backed bonds, in order to move longer term interest rates lower toward short term interest rates.  While no one can be certain as to the aggregate effects of this policy on interest rates, one can use history to at least derive an estimated measure of QE’s impact.

Historically, the Federal Reserve has implemented and communicated its interest rate policy via the setting of the Federal Funds Rate and the Discount Rate.  Over long periods of time, the Federal Funds Rate and the inflation rate as measured by CPI have tracked each other closely.  This can be seen in the charts of the CPI and Fed Funds rates since 1914.  While there are obviously leads and lags, over time these two times series have matched.

The Market Perspective

From a market perspective, the equivalence between short term rates and inflation makes sense, as investors should not willingly suffer guaranteed real purchasing power losses except for short periods of time.  In fact, the only periods during which investors willfully accepted short term purchasing power losses were the periods surrounding major wars: World War I, World War II, and the Korean War, as well as the most recent period from Nov ember 2009 through today.  During these periods of negative interest rates, the CPI has averaged an annualized gain of 5.25%.  This 5.25% rate is 1.50% higher than the average inflation rate for the entire period.

Given this data, the question arises, if we are running negative interest rates, why is the inflation rate holding below 2% if the average during these periods has been 5.25%?  We believe there are several answers to this question:

  • The inflation has largely been contained within asset markets rather than goods markets. Inflation tends to manifest itself where governments incrementally choose to spend money.  Historically, as one can see, this spending has been on goods markets for war events, however, the big spend now is likely to be in healthcare which will hit in full force in 2014.The private sector is still working to repair income statements and balance sheets that were hit with job losses, housing price declines, higher taxes, and higher medical costs since the last recession.
  • Demographics. There is no question that due to the baby boomers, the country is going grey.  As can be seen in the Census Bureau’s Consumer Expenditure Survey, older people only spend increasing amounts of money on one category – healthcare.  Thus, the demographics of the country are essentially flat to deflationary for most categories.

Short Term Rates

If short rates are tethered to the inflation rate, then it makes logical sense that long term interest rates are also tied to short term interest rates.  In fact, one can see this is true by charting 10-year Treasury yields versus the Federal Funds Rate.  While this spread can move extremely wide, over long periods of time the slope of this curve has been about 80 bps or 0.80% as illustrated in the chart below with a standard deviation of 2.74%.  This would suggest a trading range of 1.80% to 2.80% for longer term treasuries.  In addition to the spread, another level an investor might consider is the realized 10-year inflation rate, which is also pictured as the smooth line.  The 10-year average inflation rate even with two large recession periods is 2.48%, therefore, long term bond investors might reasonably seek at least this rate in order to maintain their purchasing power.

Putting this all together then, one can argue that the Federal Reserve is 100 bps (1.0%) too low on short term rates and too aggressive with its asset purchases.

If investors are losing 1.0% a year on their short term investment, then logic dictates that investors will seek offsetting compensation where the Federal Reserve has less influence, in long term rates.  If one is -1.0% per annum on short rates then logic would suggest long rates might overshoot averages by a similar 1.0% to offset these losses.  Bernanke stated during his recent press conference that he was confused by the rise in long term rates, after the Fed had removed $3 trillion in long term bond supply; however, the removal of the Fed’s “flow” of purchasing is enabling free markets to reset rates to levels consistent with rational compensation for the risk.

The risk to equity markets is that investors in the chase for yield have driven the dividend yield on the S&P 500 to be in line with the 10-year interest rate on bonds.  The S&P 500 currently pays a dividend of about $35.33.   Using this as a base line the following table can be derived.

10 Year Interest Rate

S&P 500 Dividends

Implied Level

1.8%

35.33

1962

1.9%

35.33

1859

2.0%

35.33

1766

2.1%

35.33

1682

2.2%

35.33

1605

2.3%

35.33

1536

2.4%

35.33

1472

2.5%

35.33

1413

2.6%

35.33

1358

2.7%

35.33

1308

2.8%

35.33

1261

Our view regarding the current market environment is that there are no good short term places to hide as short term bonds look too low relative to inflation.  Long term bonds look too low relative to inflation and short term bonds, and stocks look pricey relative to long term bonds.  On a relative basis, stocks are implying about a 2.2% bond yield, and thus, if pushed it would appear that bonds are the most buying asset of the bunch at the moment, along with stocks at lower prices.

Allen R. Gillespie, CFA is a partner with FinTrust Investment Advisors, in its Greenville, SC office.  For more information, call 864-288-2849 or email agillespie@fintrustadvisors.com.

Menu