No, it’s not one of those headlines that promise to share “something weird” or proclaim “you’ll never believe what happened next”. Well, actually some people might find it hard to believe this one.
In order to keep the time of those who are already up to date with this week’s economic data and interest rate movements, we are going to talk about the paradoxical drop in rates despite decades high inflation. Everyone, read on!
Inflation is one of the Deadly enemies interest rates. Here’s why:
- Rates are determined by the amount of money investors are willing to pay for bonds / loans. Basically, investors give you a large amount of money and you make payments (with interest) over time.
- Inflation makes dollars less valuable (or, in other words, it makes “stuff” cost more).
- But the value of your monthly payment stream never increases because it’s been agreed upon from the start.
- As such, inflation makes your monthly payments less valuable over time (or less able to buy “stuff”).
- Therefore, if the investor sees inflation on the rise, they could raise rates today in order to squeeze a similar value out of your payment stream.
To take this example to the extreme, let’s say I lend you $ 100 and you make 11 installments of $ 10. I take each $ 10 payment and treat myself to the 3 taco combo at the taco truck once a month. Now let’s say that due to inflation, the taco truck raises prices to $ 15. I have 2 choices. I can either get the 2 taco combo (and who wants to do that ?!) or I can increase the interest rate on your loan so that the new monthly payment is $ 15.
While he may or may not be driven by an insatiable thirst for affordable tacos, he is exactly this dynamic which explains the long-standing correlation between inflation and rates. Of course, inflation is not the only concern for rates, but it is always a consideration. The following chart shows 10-year Treasury yields (the most popular benchmark for long-term interest rates) and basic consumer prices (the most popular measure of consumer-level inflation. ).
In fact, the most recent data is missing in the graph above. This week brought a new installment of the monthly Consumer Price Index (CPI). Much like last month’s report, it was a shock, both in terms of the height of the number in outright terms. and compared to expectations.
You would expect interest rates to pay at least some kind of pay attention to such things, and you would be right! But the attention was both minimal and temporary. The following chart shows how 10-year Treasury yields have traded moment-to-moment this week. In fact, they climbed higher as soon as the inflation data was released, but it didn’t last very long.
What is happening with the paradoxical reaction? While the average headline of the news suggested that this inflation “was not enough” to derail the Fed’s low rate policies, the real motivation is much more esoteric. It is an imbalance of commercial positions in the bond market and the subsequent exploitation or punishment of this imbalance.
In market jargon, it is a short press. This happens when a majority of traders bet on higher rates. They make these bets by selling bonds short. Short selling is about selling at today’s prices and buying back in the future at lower prices (side note: prices and yields / rates move in direction lower price = higher yields / rates).
If prices go up instead of down, there is a certain line in the sand where these traders will buy bonds to close their position and avoid further losses. In doing so, they are only pushing the price up (or lowering rates), likely forcing more short sellers to cover their losses by buying bonds. Call it a domino effect, a snowball, or a short squeeze. It all adds up to lower rates when that happens in the bond market.
Why are so many traders betting on higher rates? Well, it’s obvious, don’t you know ?! The Covid figures continue to drop. The economy continues to reopen. The Fed is increasingly believed to be considering cutting back on its bond purchases. And the list continues. Indeed, if we look at economic fundamentals, there are better arguments for a rate hike versus a rate cut.
Just one problem though: everyone knew those fundamentals were at the start of 2021, and much of the logical rate hike came in anticipation of the economic reality we are witnessing now. Additionally, the economy is still experiencing many growing pains as it heads to wherever it goes after covid. We won’t get a clearer picture of the destination until this fall, according to the Fed. This makes “lower rates” a classic contrarian trade for the time being.
Does this mean that the rates will be keep falling for the next few months?
Nobody knows. The prices are able to get down from here, but probably not exceptionally lower without further unforeseen shock. The rates are also capable of rising higher! But again, probably not exceptionally higher until we get a clear indication that the economy has shifted into high gear on a more sustainable basis. When that happens – or even if it seems to happen – that’s when we’re most likely to hear the Fed say that it is considering cutting bond purchases.
This habit will happen next week, but we might see some rate volatility nonetheless after the Fed’s last announcement on Wednesday. This is one of 4 Fed announcements along with updated Fed members’ forecasts (including the dot plot which shows Fed rate hike expectations). Between that and Fed Chairman Powell’s press conference, the Fed could send some sort of cutback message without putting it in writing.
Another joker to keep in mind is the increased discussion among Fed members about the role their bond purchases play in real estate valuations. If they conclude that the appreciation in house prices needs help to subside, they could adjust their purchase balances in favor of treasury bills. That’s a long time for next week’s meeting, but if Powell talks about it at the press conference, it would likely be bad for mortgage rates.
The press conference will begin at 2:30 p.m. EST next Wednesday.