Greenspan's Conundrum

On February 17, 2005, Federal Reserve Chairman Alan Greenspan testified before the Senate Committee on Banking, Housing, and Urban Affairs. He noted that despite a recent 150 basis point increase in the federal funds rate, long-term rates had actually trended lower.

Rejecting a variety of explanations at the time, Greenspan called this a “conundrum.”

In his experience, movements in short-term rates typically coincided with similar magnitude and direction movements in longer-term rates. He described the theory behind this as follows:

The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year US Treasury notes even if the more-distant forward rates remain unchanged. Historically, though, even these distant forward rates have tended to rise in association with monetary policy tightening.

But unfortunately, as financial markets often prove, the theory does not necessarily translate into reality, and this relationship, according to Greenspan, had effectively broken down.

Here is a snapshot of the data Greenspan was watching at the time. Notice that the federal funds rate (green line) would eventually move from 1% to over 5% while 10 and 20-year Treasury rates remained essentially unchanged.

While it may have seemed like a conundrum at the time, the relationship between short and long rates has never been one-to-one. Said differently, a move higher or lower in the federal funds rate does not correspond to higher or lower rates across the rest of the yield curve. This is important to understand, especially in today’s financial environment.

If you think about it, this should be evident based on the fact that the slope of the yield curve is constantly changing, and has been one of the best predictors of upcoming recessions.

If changes in short rates always led to similar magnitude changes in longer rates, the slope of the yield curve would stay relatively constant. The chart below, which shows the slope of the yield curve as measured by the difference between 10-year and 3-month rates, demonstrates that this has never been the case. Long rates and short rates have always moved independently of one another.

The reason for this is simply that long and short rates react to different forces. The Fed exerts tremendous control over short rates, as it tries to manipulate the US business cycle, but has little control over longer rates, which are set by global market participants.

In last week’s article, we looked at how the yield on the 10-year treasury has a strong tendency to track the sum of inflation and real GDP growth.

If that’s the case, then I want you to think for a moment about how a potential rate hike (to the federal funds rate) would be interpreted by markets and reflected in the 10-year yield.

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When the federal funds rate moves higher, it doesn’t directly impact rates further out on the yield curve (as we’ve seen), but it does impact borrowing costs for some consumers and businesses. This is because of other key rates in our economy, particularly the prime rate and LIBOR, tend to track the federal funds rate.

With many variable rate loans (such as credit cards, mortgages and some student loans) tied to these benchmarks, an increase in the federal funds rate can increase debt servicing costs, taking money out of consumers’ pockets that could otherwise be used for spending.

This has the effect of slowing the economy and reducing both economic growth and inflation.

Circling back around, if the 10-year yield tends to react to growth and inflation prospects, and higher short-rates put downward pressure on growth and inflation, how would you expect the 10-year to move?

The natural conclusion in this low rate, low growth, low inflation environment is that the 10-year would move lower, not higher, to reflect the diminished growth and inflation prospects. And in fact, that’s exactly what we’re seeing.

This next chart shows the relationship between the federal funds rate and the 10-year Treasury. The blue vertical bar on the right side of the chart highlights how the 10-year Treasury yield has fallen from the point that the Fed last raised rates in December.

The implications of this are interesting to ponder. First, it suggests that this may not be the time for the Fed to be raising rates.

Historically, rate hikes only occur when the economy is showing above trend growth and inflation. These two factors have a tendency to push the long-end of the yield curve up, which allows short rates to rise without flattening out the slope of the yield curve. (Recall that flatter yield curves are indicative of an economy under duress.)

The other interesting implication has to do with the plight of bondholders. Almost everyone makes the implicit assumption (as Greenspan did) that rising rates are bad for all bondholders, as yields across the curve will rise and prices will fall.

But this way of looking at the relationship between short and long rates brings that concept into question. If the dynamics explained above continue to hold, then it’s possible that rate hikes could actually work in favor of long-term bond holders.

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This idea goes completely against much of the advice given to fixed income investors in this environment, which is to stay away from longer-dated bonds because their prices are more sensitive to interest rate changes.

However, if this really is the wrong time to raise rates, and it results in diminished growth and inflation prospects, then long-term bond yields are likely to fall further, making those bondholders richer (and smarter, based on their ability to foresee how this will all play out).

I realize that it’s difficult to take this information and profit from it, but hopefully, it will at least get you thinking differently about the bond market and the various forces that determine yields, and how subsequent rate hikes could possibly play out.

The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

About the Author

Chief Investment Strategist
matt [at] modelinvesting [dot] com ()