In my last post on equity risk premiums and the market, I argued that the equity markets have been priced on the presumption that the Fed has the power to control where interest rates will go in the next few years. Wednesday’s press conference by Ben Bernanke was a perfect example of how the Fed has become the center of the equity market universe and how every signal (intentional, implied or imagined) of what the Fed plans to do in the future causes large market gyrations.
Fundamentals and History
As with any asset, the treasury bond market sets prices (and yields) based upon demand and supply, with perception, expectations and behavioral factors all playing a role in the ultimate price (and rate). Holding all else constant, then, it seems obvious that the Fed with its bond buying program can change the dynamics of the market, increasing bond prices and lowering long term rates.
Without contesting the basic economics of the demand/supply argument, it is worth noting that even with treasury bonds, there is an intrinsic value relationship that should govern the level of interest rates. In particular, the risk free interest rate can be decomposed into two components: the expected inflation rate in the currency in question and an expected real interest rates:
Note that the actual inflation rate in each year and the real GDP growth in that year are aggregated to yield the fundamental interest rate. Thus, in 2006, the actual inflation rate was 2.52% and the real GDP was 2.38%, yielding a fundamental interest rate of 4.90%. Comparing it to the ten-year treasury bond rate that year of 4.56% yields a gap of -0.34% (T.Bond rate - Fundamental interest rate). There are two conclusions I would draw from this graph.
In January 2013, the treasury bond rate at 1.72% was about half the fundamental growth rate of 3.43% (Inflation in 2013 of 1.76% + Real GDP growth of 1.67% = 3.43%). Not only is the gap of 1.71% high by historical standards, but the ratio of the T.Bond rate to the Fundamental interest rate was close to historic lows (the lowest was 2011, when the T.Bond rate was 40% of the fundamental interest rate). If you are interested, you can download the raw data on interest rates, inflation and real GDP growth and come to your own conclusions.
Put in more intuitive terms, based on the historical data, a cut in the Fed funds rate of 1% decreases the gap between the T.Bond rate and the fundamental growth rate by 0.53%. There are two sobering notes worth emphasizing. The first is that the Fed funds rate currently is close to zero and that effectively implies that its use as tool to make T.Bond rates decrease relative to fundamental growth rates is limited. (I know that the Fed has been much active with the other tool in its war chest, bond buying, but that tool too has its limits). The second is that the Fed is not as powerful at setting interest rates as most investors think. Only 14.33% of the variation in the gap can be explained by the Fed funds rate and changes in real growth & inflation have far bigger impacts.
If the T.Bond rate does rise next year towards the fundamental interest rate, it will ironically make investors attribute even more power to the Fed, since it will coincide with the winding down of the bond buyback by the Fed. The Fed, we will be told, allowed long term interest rates to rise by using it extensive powers. Here is what I believe. Thus, if the economy improves, interest rates will rise, with or without the Fed buying bonds and if the economy falters, interest rates will stay low, with our without the Fed buying bonds.
There are two things to note about these scenarios. The first that some of these scenarios are more likely than others, though I am sure that opinions will vary about which one. For instance, the soft landing scenario, favored by many economists/investors today, sees moderate growth with low inflation, one that is negative for bonds (because interest rates will start creeping back towards the fundamental growth rate) and mildly positive for stocks. I think that the high real growth/deflation scenario is unlikely, since it is difficult to see the economy growing at a robust rate and prices falling at the same time (especially given monetary policy over the last few years). I also have to believe (and perhaps hope is winning out here) that the negative real growth/deflation scenario has a low chance of occurring, and it would be very negative for stocks, though it will help bond holders. The second is that there are far more scenarios which are negative for bonds than positive, a direct result of interest rates being at historic lows and the Fed running low on ammunition.
The Fed speaks and markets react
Ben Bernanke’s press conference was at the end of the meetings of the Federal Open Markets Committee (FOMC) and it provided an opportunity for the market to observe the Fed’s views of the state of theeconomy and its plans for the foreseeable future. The Fed’s optimistic take on the economy (that it was on the mend) and Bernanke’s statement that the Fed could start winding down its bond buying program (and by extension, its policy of keeping interest rates low) was not viewed as good news by the market. The reaction was swift, with stocks collapsingin the two hours of trading after the Bernanke news conference and rippleeffects spreading to other global markets over night.
Implicit in this reaction is the belief that the Fed is an all-powerful entity that can choose to keep interest rates (short term and long term) low, if it so desires, for as long as it wants. While this belief in the Fed’s power to set interest rates is touching, I think it is at war with both history and fundamentals. In fact, if there is blame to be assigned for the market collapse, it has to to rest just as much on investors who have priced contradictory assumptions into stock prices as it does on the Fed for encouraging them to do so.
As with any asset, the treasury bond market sets prices (and yields) based upon demand and supply, with perception, expectations and behavioral factors all playing a role in the ultimate price (and rate). Holding all else constant, then, it seems obvious that the Fed with its bond buying program can change the dynamics of the market, increasing bond prices and lowering long term rates.
Without contesting the basic economics of the demand/supply argument, it is worth noting that even with treasury bonds, there is an intrinsic value relationship that should govern the level of interest rates. In particular, the risk free interest rate can be decomposed into two components: the expected inflation rate in the currency in question and an expected real interest rates:
Risk free rate = Expected Inflation + Expected real Interest rate
The real interest rate itself is a function of demand and supply for capital in the economy, which should be determined by expected real growth. As the economy becomes stronger, and real growth increases, real interest rates should also increase. If we make the assumptions that actual inflation in the most recent time period is equal to expected inflation and that the actual real growth in the most recent period is the expected real interest rate, you have an equation for what I will call a fundamental risk free interest rate:Fundamental interest rate = Actual inflation rate + Real growth rate
While the assumptions that underlie this equation can be contested (past inflation is not always the best predictor of expected inflation and actual real growth may not be a proxy for expected real growth), we can use the historical data to check how the actual interest rate on a long term treasury bond (the 10-year T.Bond) compare to the fundamental interest rate derived above:
Note that the actual inflation rate in each year and the real GDP growth in that year are aggregated to yield the fundamental interest rate. Thus, in 2006, the actual inflation rate was 2.52% and the real GDP was 2.38%, yielding a fundamental interest rate of 4.90%. Comparing it to the ten-year treasury bond rate that year of 4.56% yields a gap of -0.34% (T.Bond rate - Fundamental interest rate). There are two conclusions I would draw from this graph.
- Over the 1954-2012 time period, the actual T.Bond rate has moved, for the most part, with the fundamental interest rate, rising in the 1970s as inflation surged and dropping in the 1980s as inflation retreated. There have been gaps that open up between the treasury bond rate and the fundamental interest rate but they seem to close over time. In fact, when the T.Bond rate increases (decreases) relative to fundamental interest rate, the treasury bond rate is more likely to fall (increase) in the next period.
- Across the entire time period (1954-2012), the 10-year treasury bond rate averaged 6.11% and the fundamental interest rate average 6.83%, but breaking down into sub-periods suggest that there has been a shift in the relationship over time. In the 1954-1980 time period, T.Bond rates were 2.20% lower, on average, than the fundamental interest rates but in the 1981-2012 time period, the average treasury bond rate has been 0.52% higher than fundamental interest rates.
The Fed Effect
Does the Fed matter? Looking at the data on interest rates and fundamentals over time, the answer is undoubtedly yes. Over the last three decades, you can see the imprint left by consecutive Fed Chairs from Paul Volcker to Alan Greenspan to Ben Bernanke on inflation, real growth and T.Bond rates. To examine the relationship between Fed policy and T.Bond rate/fundamental interest rate difference, I focused on the one number that the Fed truly controls, the Fed Funds rate, as an indicator of whether the Fed is adopting a looser or tighter monetary policy, and look at the relationship between the Fed funds rate and the gap between the T.Bond rate and the fundamental interest rate:
Looking at the graph, it seems clear that increases (decreases) in the Fed funds rate have caused the gap between treasury bond rates and fundamental interest rates to move in the same direction. In fact, running a regression of the change in the Fed funds rate each year against the change in the gap (T.Bond rate - Fundamental interest rate) in the next year yields the following:
Change in the gap in year t = - 0.0001% + 0.5333 (Change in the Fed Funds rate in year t -1)
(0.03) (3.25)
R squared = 14.33%
Put in more intuitive terms, based on the historical data, a cut in the Fed funds rate of 1% decreases the gap between the T.Bond rate and the fundamental growth rate by 0.53%. There are two sobering notes worth emphasizing. The first is that the Fed funds rate currently is close to zero and that effectively implies that its use as tool to make T.Bond rates decrease relative to fundamental growth rates is limited. (I know that the Fed has been much active with the other tool in its war chest, bond buying, but that tool too has its limits). The second is that the Fed is not as powerful at setting interest rates as most investors think. Only 14.33% of the variation in the gap can be explained by the Fed funds rate and changes in real growth & inflation have far bigger impacts.
So can the Fed really “control” interest rates and keep long term rates from rising? I may not have much company on this one, but I think that the Fed's power comes primarily from the perception that it has power and not from its direct control over the interest rate mechanism. This may seem like heresy in a market that views the Fed both as the arbiter of interest rates and the protector of the bull market, but if long term interest rates start rising, I don’t think that the Fed can do much to stop them. In fact, as I watch investors look to Ben Bernanke to save them, here is the scene that plays out in my mind, from the Wizard of Oz. For those of you who may still be unfamiliar with the classic, here is a quick recap. A tornado plucks Dorothy from her home in Kansas and dumps her in Oz (and right on top of the Wicked Witch of the East). When Dorothy seeks help to get home, she is advised to seek out the powerful Wizard of Oz, and on her way to meet him, she gathers together a motley crew of needy characters (the Scarecrow, who needs a brain, the Tinman, who desires a heart and the Cowardly Lion, who is searching for courage). When they get to the Wizard's lair, here is what they find:
Is that Ben Bernanke I see behind the curtain and is that contraption the Fed's vaunted interest rate setting machine?If the T.Bond rate does rise next year towards the fundamental interest rate, it will ironically make investors attribute even more power to the Fed, since it will coincide with the winding down of the bond buyback by the Fed. The Fed, we will be told, allowed long term interest rates to rise by using it extensive powers. Here is what I believe. Thus, if the economy improves, interest rates will rise, with or without the Fed buying bonds and if the economy falters, interest rates will stay low, with our without the Fed buying bonds.
The way forward
As my last two posts on the market indicate, my biggest concern with markets right now is that investors may be pricing inconsistent assumptions about the macro environment. In other words, investors are pricing stocks on the assumption that the US economy will return to growth, while interest rates stay low. While each assumption can be defended separately, I don’t see how they can co-exist, no matter what the Fed or any other entity may tell us.
As investors, therefore, we have to think through the possible scenarios and adjust our portfolios accordingly. Here is my very crude attempt to delineate the possible scenarios, with permutations of real growth/inflation:
Real Economic Growth | |||
High | Moderate | Low/Negative | |
High | Negative for bonds Mildly positive for stocks | Negative for bonds Negative for stocks | Negative for bonds Negative for stocks |
Moderate/Low | Negative for bonds Positive for stocks | Negative for bonds Mild positive for stocks | Neutral/ Positive for bonds Negative for stocks |
Deflation | Neutral for bonds Positive for stocks | Neutral for bonds Negative for stocks | Positive for bonds Negative for stocks |
There are two things to note about these scenarios. The first that some of these scenarios are more likely than others, though I am sure that opinions will vary about which one. For instance, the soft landing scenario, favored by many economists/investors today, sees moderate growth with low inflation, one that is negative for bonds (because interest rates will start creeping back towards the fundamental growth rate) and mildly positive for stocks. I think that the high real growth/deflation scenario is unlikely, since it is difficult to see the economy growing at a robust rate and prices falling at the same time (especially given monetary policy over the last few years). I also have to believe (and perhaps hope is winning out here) that the negative real growth/deflation scenario has a low chance of occurring, and it would be very negative for stocks, though it will help bond holders. The second is that there are far more scenarios which are negative for bonds than positive, a direct result of interest rates being at historic lows and the Fed running low on ammunition.
My personal investing foibles should be of little interest to you, but I have tried to build in some degree of protection into my overall portfolio, especially against interest rate changes. A few weeks ago, I invested in ProShares UltraShort 20+ year (TBT), an ETF that sells short (with leverage) on long term treasuries; it is one of many ETFs that offers this choice. (As some of my readers have pointed out, the ultrashort funds come with baggage. For those who prefer a more predictable play, go with TBF, which also shorts the treasury bond, but without leverage). I did not buy full protection against interest rate changes, since that would have required me to invest a huge amount of my portfolio in this ETF and because I don't attach a high probability to the most disastrous scenarios for bonds. The partial protection that I did buy has worked as advertised.
That may not be your preference, either because your assessment of the likelihood of the scenarios will be different from mine or because you feel that there is a different asset class (gold, emerging market equities etc.) that will provide you better protection. In my view, the one scenario that is unlikely to unfold, no matter how much you wish it to be true, is the one where real economic growth (2-2.5%) returns, inflation stays at moderate levels (2-2.5%) and the 10-year treasury bond rate stays at 2%. I understand that the Fed is doing a difficult job (that the executive and legislate branches have shirked), that it is well intentioned and has some very smart policy makers, but when you fight markets and fundamentals, you have to capitulate at the end. No one is bigger than the Market, not even Ben Bernanke.
That may not be your preference, either because your assessment of the likelihood of the scenarios will be different from mine or because you feel that there is a different asset class (gold, emerging market equities etc.) that will provide you better protection. In my view, the one scenario that is unlikely to unfold, no matter how much you wish it to be true, is the one where real economic growth (2-2.5%) returns, inflation stays at moderate levels (2-2.5%) and the 10-year treasury bond rate stays at 2%. I understand that the Fed is doing a difficult job (that the executive and legislate branches have shirked), that it is well intentioned and has some very smart policy makers, but when you fight markets and fundamentals, you have to capitulate at the end. No one is bigger than the Market, not even Ben Bernanke.
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