Credit, Interest Rates and Policy Inconsistency in the Post-Great Recession Era: Parte Um

“Gallia est omnis divisa in partes tres”

Interest rates represent the price of credit. The differences in interest rate levels on different financial instruments (U.S. Treasury and corporate debt) or similar instruments over time (the yield curve) are employed as indicators of relative risk. However, what can we say about the behavior of these interest rate differences during the current economic expansion and in an era of administered, not free market-setting, interest rates? Moreover, how can we employ these interest rate spreads as a measure of sentiment, and possibly, speculation or credit revulsion, over the business cycle when such interest rates are significantly impacted by public policy? For example, one puzzle to resolve is the current low level of sovereign interest rates given the perceived risk due to poor fiscal long-term outlooks for these countries. Could these low rates be a byproduct of administered rates along with an upsurge in financial regulation? A second puzzle is the recent weakness in the pace of housing and business investment in the United States, despite low nominal interest rates. 

Traditionally, interest rate spreads vary over the business cycle. Spreads rise during periods of economic weakness and uncertainty, and decline during periods of economic prosperity. Therefore periods of optimism are represented by declines in interest rate spreads while pessimism is associated with increases in spreads. These patterns reflect the dominance of cyclical forces—not secular change, and yet, secular forces may indeed be the more important driving force since 2007. The challenge for analysts is to recognize, or at least question, on a cyclical basis, when interest rate spreads are at extremes and therefore provide a signal of a possible change in the economy or at least sentiment on the economy. Behind the utilization of any cyclical pattern as a guideline is an implicit assumption that spreads may vary, but they will vary about the same mean value over time. Finally, how might we assess changes in sentiment as represented by interest rates if, in fact, the average values and their volatility vary over time? 

I. Identifying Trend: The Anchoring Bias

What has been the trend in five-year and 10-year yields since 1968, the start of rising inflation and interest rates in an activist policy era, and are those trends reliable guides for the future? How permanent is permanent? How normal is normal? Figures 1 and 2 below highlight the problem of an anchoring bias for the period since 1968. For both the five-year and 10-year Treasury benchmark yields, there are two distinct patterns. First, there is a steady rise in interest rates from 1968 to 1979 and then a distinct downtrend thereafter. This highlights the issue that there have been two different economic regimes and indeed we know that since 1979 Paul Volker’s focus on inflation led to a new set of central bank operational goals were in place. Second, there is an equally-apparent steady decline in nominal interest rates since 1982. These two distinct patterns indicate that neither the five-year nor 10-year Treasury rate over this period is mean reverting, and treating the five- and 10-year rates as a coherent series since 1968 is not the correct  approach. Yet many analysts will employ the extended period since the 1960s as their sample set when developing econometric models. In prior work we have found separately that the two-year Treasury rate is not mean-reverting.