The Relationship between short & long term interest rates

 

1-      Short term policy rates- These are the rates which are determined by Central Banks and on which all other market rates take their cue. They include such rates as federal funds and discount rate in the US, the bank rate in the UK etc.

2-      Short term market rates-These are market set rates and are closely associated with short term policy rates, such as the infamous LIBOR (An interbank rate), short Guilt rates  in the UK or Treasury bills (T-bills) in the US etc. These usually refer to anything with maturities from 1 month to one year. Depending on the quality of the borrower these rates vary from the most secure T-bills & short Guilts, where both governments are perceived as almost riskless having an independent Central bank and therefore the ability to print ad infinitum and the riskiest junk corporates or peripheral government bills the likes of Greece, Portugal, etc. So the less risky implies they converge closest to the Federal funds rate whilst the riskiest diverge the most. For example if rate expectations are neutral, 1 month T-bill rates will be almost identical to the overnight Federal funds rate whilst I month USD interbank rates will be at a slight premium to Federal funds reflecting the additional risk premium of first class banks.

The key is that the market sets these rates based on the costs of borrowing on the short term policy rates. So for example if the market feels the Fed will be tightening credit by raising the federal funds rate in 2 months’ time then 3 month T-bills will be trading at a rate higher than the overnight federal funds rate to a level closer to where the market thinks rates will be raised by the Fed. The opposite would also occur should the Fed be expected to lower rates in 2 months’ time. In other words the market tends to discount presently rate expectations based on the dynamic forces affecting these rates on a daily basis.

3-      Medium & long term market rates- The market refers to these as yields not rates anymore. It applies to maturities from 2 to 50 years known as notes and bonds. For any instrument whether it’s a Treasury or corporate note or bond  will henceforth be priced by the market by discounting presently the total of interest or coupon payments this instrument will have and thus the price of such instrument will vary on the basis of such discounts. Should short term policy rates therefore go up, ceteris paribus, the market will re-price presently existing T-notes or bonds to reflect these higher interest rates in the future too. In fact the longer the maturity the greater the changes in price for a given yield change. Moreover, long term rate or yield expectations are not only dependent on short rates but more importantly on all market forces which may have an instrumental effect on interest rates in the future. For example if the USD continues to fall in this current economic environment the market may perceive an expansionary effect by the increase in US exports and may thus begin to drive yields higher in expectation of a rise in short term rates in the future. The same would apply if the government embarks in a highly expansionary fiscal policy. These are just two examples but the variants are endless and yields will change by the effect each variable will have on perceived future economic activity.  

 

So in conclusion, long term rates are clearly associated with short term policy rates but because long rates are market determined they are also independent of them. A case in point would be if for example the Fed decided to raise short rates at this juncture. A likely effect would be a short term spike in long yields as the market feared the start of a longer term trend but may fall to a level lower than prior to such a policy decision as the market judges it premature and growth disruptive.

 

Thus a market related sustainable higher trending yield and thus yield curve is a sign of expectations of stronger growth as well as higher inflation. The key is for this mix to favor growth.

Wealth Inequality & Growth a response to Paul Krugman

The financial bubble of the last decade created the housing bubble and along with it the financial crisis with its ramifications along all sectors of the economy and the world at large. Specifically in the US,  already overextended consumers had an unprecedented negative wealth effect to contend with both from a reduction in the value of more liquid assets such as stock holdings but more importantly the collapse in the value of their homes to such a level that more than 50% of all mortgage holders were effectively underwater on what constitutes most probably their biggest lifetime investment. In other words, if they were to liquidate at any time and sell their home they would be short on the amount owed to the bank. Interestingly, most (close to 85%) of these negative equity mortgages were being serviced and non delinquent indicating that owners were willing to adhere to mortgage payments on expectation ( I would contend) of an improvement in their home values.

More importantly however, is what this has meant to the underlying level of demand in the economy and what the government should have done to reinvigorate it. Understandably the FED and government gave precedence to the stability of its financial system as its first and foremost priority for without a solvent banking sector the US and the world for that matter would have experienced an apocalyptic depression. All emphasis then on the financial system which was successfully revamped and returned to health with the FED’S dramatic actions including aggressive QE, still with us today. It was hoped that the salvation of the money lending institutions would also have secured the necessary lending to households and businesses to remobilise the economy; to no avail. On the one hand the banks were in no mood to expand their balance sheet in an environment of conservative restructuring and a consumer already underwater and on the other a consumer faced with negative equity in a defensive mode with a focused purpose, to increase the savings rate and deleverage. It is evident that in such a setting unless balance sheet restructuring takes hold final demand will at best be weak.

How was inequality exacerbated from the above phenomenon? Saving stockholders at the expense of debtors clearly transferred wealth from debtors to creditors. The US population was asked to bailout the financial system by dramatically expanding the US’s budget deficit and the FED’S  balance sheet reinvigorating both bond  and stock prices but without a commensurate knock on effect on the weakest and largest part of the population. This has meant that the ultimate driver of demand the consumer did not receive any direct help to a healthier balance sheet. He was left to the unforgiving effects of the market forces of adjustment. In other words, the consumer would only return to his usual habits if any or all of the following could take place & in such a magnitude so as to substantially improve his balance sheet and its prospects: A rise in home values, debt deleveraging and forgiveness with its accompanying increase in the savings rate, world growth that would induce cash rich companies to substantially increase investment and employment to meet this growth in world demand.

Will reversing this inequality by pursuing policies aimed at creating the aforementioned conditions drive demand and ultimately consumption? Without doubt the liquidity effect aptly described by Paul Krugman is likely to play an important catalyst. I would in fact call it a wealth effect for it is households feeling good about returning to positive equity that should induce them to spend part of this windfall. This would in turn provide impetus to the cash rich companies to increase the utilisation of their existing factors of production and perhaps lead them to increased investment. The economic textbooks should then take over through the multiplier momentum.   

The above deals of course with wealth and not income inequality a more complex issue worth discussing in a different blog.

My comment on Frances Coppola's blog "Slaying the inflation monster"

Excellent article.

We have been living in an era of deflation since the 2008 financial crisis with inflation vigilantes worsening the situation from central banks to inflationary hawks by not allowing for the cleansing effects of slightly higher inflation/expectations and a redistribution of income from creditors to debtors. The result, historically low long term yields unable to boost economic growth and employment, economies mired in slow growth and a debt overhang which may take decades to write down to manageable levels if policies remain unaltered. The QE embraced by most central banks of indebted countries does help but should be reinforced without half measures and the threatening fear of higher inflation for it is no more than fear for as long as long term bond yields do not predict otherwise and to my knowledge till very recently, they have been showing the exact opposite.

In fact Central Banks should aspire to create market induced sustainably higher long term yields for its this indicator which should lead us to expect stronger growth.