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Interest rates are likely to decline markedly in coming months, but not for the reason many on Wall Street are giving.
The real reason to expect rates to comedown is that they are higher than average in inflation-adjusted and tax-adjusted terms. Wall Street, in contrast, focuses on rates in raw, unadjusted terms, and that is misleading.
You might think it doesn’t make a difference whether Wall Street’s reasons are valid or invalid, so long as rates are, indeed, coming down. If they do, of course, bonds should rally — which will be particularly welcome news to retirees and others living on fixed incomes.
But getting the reasoning right is important. A theoretically sound understanding increases our confidence in projecting lower rates. In addition, it focuses our attention on those factors that, should they change, would lead us to give up on that projection.
There are two major problems with Wall Street’s argument that, because raw unadjusted (nominal) rates are higher than average, they are likely to decline. The first is that the conclusion crucially depends on the swath of history to which current rates are compared. Consider how the 10-year Treasury yield
TMUBMUSD10Y,
compares to past averages. At 3.40%, the current yield is higher than the average over the last 5 years (2.11%), 10 years (2.21%) and 20 years (2.91%). But the current yield is a lot lower than the 50-year average, which stands at 6.01%.
There is an even more fundamental reason why the widely accepted argument for lower nominal rates is questionable. The underlying assumption behind that argument is that rates will regress to the mean, with above-average rates being pulled back to average and below-average being pushed up toward that average. But regression to the mean shows up most strongly when interest rates are adjusted by inflation and taxes; the tendency is a lot weaker when focusing on nominal rates.
I owe this insight to a study circulated several years ago by the National Bureau of Economic Research. It was conducted by Daniel Feenberg, a research associate at NBER, Ivo Welch, a finance professor at UCLA, and Clinton Tepper, a senior portfolio analytics researcher at iCapital Network.
Following this study’s lead, the accompanying chart plots the 1-year Treasury yield
TMUBMUSD01Y,
after adjusting for expected inflation and taxes. Notice that, but for a few months in 2005 and 2006, this adjusted rate recently was higher than at any time in the last two decades. (The chart extends backs to 2002 since that is the start date for the inflation-expectations data I used to construct the chart.) Also evident from the chart is the adjusted interest rate’s tendency to regress toward its mean.
The overall message of the chart is that nominal interest rates are likely to decline because inflation is likely to decline.
This message alerts us to what to pay attention to in coming months as we assess whether to continue betting on lower interest rates: Inflation expectations. If expected inflation rises markedly, then lower nominal interest rates become less likely.
One good way of monitoring inflation expectations is a model that the Cleveland Federal Reserve updates monthly. It has a number of inputs, including Treasury yields, surveys of professional forecasters and inflation swaps (derivatives in which one party to the transaction agrees to swap fixed payments in return for payments tied to the inflation rate). Over the last year, according to this model, expected one-year inflation has declined by 157 basis points, even as the Treasury’s one-year yield has increased by 155 basis points.
The bet on lower nominal interest rates is based on the belief that these trends will not continue diverging indefinitely. Unless inflation expectations turn back up, that means that nominal rates will be declining.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
