Interest Rate Weekly: Unresolved Issues at Mid-Cycle

Three unresolved issues, among many, are the focus of this note on credit markets. Interest rate spreads, benchmark interest rates and the yield curve may no longer accurately reflect current economic conditions. 

Narrowing Spreads: Chasing Yield at the Expense of Credit?

Interest rates represent the price of credit, not money, and the differences in interest rates on different financial instruments are employed as indicators of relative risk. During the current cycle, spreads have shrunk dramatically (top graph) but, do such spreads represent a thoughtful measure of risk or have we crossed over into the realm of speculation? Interest rate spreads vary over the business cycle. Spreads rise during periods of economic weakness and uncertainty and decline during periods of economic prosperity. Our challenge at present is to begin the questioning process as we know that another recession will come and current spreads may not be adequate protection for risk. As the economy moves beyond, in our view, the mid-point of the current business cycle, we now place less emphasis on these key spreads to indicate inflection points in the economic environment. 

Have Benchmark Interest Rates Changed?

Have the benchmark federal funds, two-year and 10-year interest rates shifted downward since the Great Recession? What factors might account for this shift? In recent years, there appears to have been a downward shift in market rates as evidenced in the middle graph. The question remains, however, whether this shift is permanent or a result of recent monetary policy of keeping the funds rate low and providing forward guidance, suggesting that rates will stay low for a considerable period. Moreover, perhaps there has also been a break in the expected pace of both long-term real economic growth and inflation. Lowered expectations may reflect, in part, the experience of this recovery but also the impact of higher taxes, increased regulation and demographic shifts, most notably the marked downshift in labor force and productivity growth. 

The Yield Curve: Measure of Duration Risk?

The term structure on interest rates, represented by the yield curve (bottom graph) is based upon the view that interest rates on long-term bonds must equal the average of the interest rates on short-term bonds over its lifetime. One big question that remains unanswered, however, is whether a permanent increase in the monetary base, as we have seen in recent years, would reduce short-term rates in the short-run but eventually boost inflation expectations and increase long-term rates over time. There is an inconsistency in monetary policy as it relates to the Fed’s forward guidance, where the Fed talks about allowing an above-target pace of inflation that may alter market inflation expectations. Can inflation and inflation expectations successfully be micromanaged to this extent, and, if so, for how long? The net result should be a steeper yield curve.