Real Interest Rates "Historically" High or Low? Bond Market Legs?
In a Daily Reckoning article, Jim Rickards states This Bond Bull Market Still Has Legs.
Rickards' article contains some interesting anecdotes regarding bond trading and his relationship with the Fed. And it contains none of the "act now" hype typical of DR articles. It's well worth a read.
Here is the set of paragraphs that caught my attention.
Rates of 13% when inflation is 15% are actually stimulative. Rates of 3% when inflation is 1% are actually contractionary. In these examples, 2% is a “high” rate and 13% is a “low” rate once inflation is factored in. [No problem with this paragraph.]
The situation today is much closer to the latter example. [Really?]
The yield to maturity on 10-year Treasury notes is currently around 2.7%, the highest since the yield briefly touched 3% at the end of 2013. Inflation as measured by the PCE core deflator (the Fed’s preferred measure) is currently about 1.5% year over year. Using those metrics, real interest rates are about 1.2%, relatively high by historic standards. [Whoa!]
Let's put that thesis to a chart test.
10-Year Treasury Yield Minus PCE (Excluding Food and Energy)
10-Year Treasury Yield Minus PCE
I have two problems with Rickards' statements.
- Whether one uses core PCE (excluding food and energy) or full PCE the spread is not historically low.
- Neither chart represents "real" rates. The following charts do.
Fed Funds Rate Minus PCE (Excluding food and Energy)
Fed Funds Rate Minus PCE
The above two charts represent "real" interest rates as commonly understood. And both are negative.
Rates are even more negative if one factors in housing prices as I believe should be done.
Moreover, look at the unprecedented length of time the Fed held rates negative. When Fed Chair Janet Yellen repeatedly stated "real interest rates are accommodative" she wasn't fooling.
When the bubbles blow up, the accolades for Yellen will vanish.
That said, I believe Rickards has things correct when he states "This Bond Bull Market Still Has Legs."
Asset Deflation Coming Up
When recession hits, asset deflation will return with a vengeance. Bank loans based on asset prices rising will force losses. Consumer defaults will rise. Consumer spending will tank.
Add those up and we are likely to see outright price deflation once again. Regardless, the Fed will come in and do what they always do, cut rates. The lemmings in Europe will follow. Those events would be good for gold.
Looking ahead, here's the crucial question: Will stocks respond to QE4 the same way as before or will the earnings recession deflate that boat too? I expect the latter and it will be extremely painful for the dip buyers.
Meanwhile, Hold the Champagne and Truffles: Yellen's Story Not Yet Written. Also ignore the inflation hype. It's another premature scare.
Mike "Mish" Shedlock