No, this isn’t one of those click-bait headlines promising to share “a strange trick” or proclaiming, “You will never believe what happened next”. Well, in fact, some people may find it difficult to believe this.
To respect the time of those who are already up to date on this week’s economic data and interest rate movements, let’s talk about the paradoxical decline in interest rates in a moment Decades high Inflation. Everyone else, read on!
Inflation is one of the Mortal enemies of interest rates. Here’s why:
- The interest rates are based on the amount of money investors are willing to pay for bonds / loans. Basically, investors give you a large chunk of the money and you make payments (with interest) over time.
- Inflation makes dollars less valuable (or, in other words, “stuff” costs more).
- But the value of your monthly cash flow never gets bigger because it’s agreed in advance.
- Hence, inflation makes your monthly payments less valuable (or less able to “buy” stuff) over time.
- So if the investor sees inflation rising, he can raise interest rates today to get a similar value from your cash flow.
To take this example to the limit, let’s say I loan you $ 100 and you make 11 payments of $ 10. I take every $ 10 payment and treat myself to the 3 taco combo in the taco truck once a month. Now let’s assume that the taco truck raises prices to $ 15 due to inflation. I have 2 options. I can either get the 2 taco combo (and who wants that ?!) or I can raise the interest rate on your loan so that the new monthly payment is $ 15.
While it may or may not be fueled by an insatiable craving for affordable tacos, it is exactly This dynamic explains the longstanding correlation between inflation and interest rates. Granted, inflation isn’t the only concern for interest rates, but it is always a consideration. The graph below shows 10-year government bond yields (the most popular benchmark for longer-term rates) and core consumer prices (the most popular measure of consumer-level inflation).
In fact, the graph above is missing the latest data. This week brought a new edition of the monthly index of consumer prices (CPI). Much like last month’s report, it was a shock, both in terms of how high the number was in absolute terms and compared to expectations.
You would expect interest to be paid at least some Pay attention to such things and you are right! But the attention was both minimal and temporary. The next chart shows how 10-year Treasury yields are trading moment-to-moment this week. They actually went higher than the inflation data came out, but that didn’t last very long.
What about the paradoxical reaction? While the average headlines suggested that this inflation was “not enough” to derail the Fed’s low interest rate policy, the real motivation is much more esoteric. It has to do with an imbalance in trading positions in the bond market and the subsequent exploitation or punishment of that imbalance.
In market jargon it says a short press. This happens when the majority of traders bet on higher prices. They make these bets by shorting bonds. When selling short, you sell at today’s prices and buy back at lower prices in the future (side note: prices and yields / rates move in opposite directions, i.e. lower prices = higher yields / rates).
When prices rise rather than fall, there is a certain line in the sand where these traders buy bonds to close out their position and avoid further losses. That way, they only drive up the price (or lower interest rates), which is likely to force more short sellers to buy bonds to cover their losses. Call it a domino effect, a snowball, or a short press. Everything adds up lower rates when it happens in the bond market.
Why do so many traders bet on higher prices? Well it’s obvious don’t you know ?! Covid numbers continue to decline. The economy continues to open. The Fed is increasingly considering reducing its bond purchases. And the list goes on. Indeed, when we examine economic fundamentals, there are better arguments for rising rates than falling rates.
But only one problem: Everyone knew these fundamentals were in place in early 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 a lot of growing pains as it makes its way wherever it goes after Covid. According to the Fed, we will not have a clearer picture of the target until autumn this year. That makes “lower interest rates” a classic contrarian business at the moment.
Does that mean the prices keep falling for the next months?
Nobody knows. Prices are able to pulling down from here, but probably not out of the ordinary lower without a new, unforeseen shock. Prices are also able to move higher! But probably not that much higher there, either, until we get a clear indication that the economy has shifted into higher gear in a more sustainable manner. If that happens – or even if it looks like it – then the more likely the Fed will say it wants to scale back bond purchases.
The habit next week, but we could still see some volatility in rates following Wednesday’s latest Fed announcement. This is one of 4 Fed announcements accompanied by updated Fed member forecasts (including the “Scatter Chart” showing Fed rate hike expectations). Between that and Fed Chairman Powell’s press conference, the Fed could send some kind of rejuvenating message without actually writing it down.
Another placeholder One thing to consider is the growing discussion among Fed members about the role their bond purchases play in real estate valuation. If they conclude that home price spikes need some cooling off, they could balance their purchases in favor of government bonds. That’s a vision for next week’s meeting, but if Powell speaks to him during the press conference, it would probably be bad for mortgage rates.
The press conference begins next Wednesday at 2:30 p.m. Eastern Time.