Thursday, January 15, 2015

Regulation will be more important than the Fed Funds rate in 2015.

Bond yields have been taking a dive - dropping even more yesterday.  Most of the drop has been from inflation expectations, although some of the drop over the past week has come from expectations of a later rate hike date.  Yesterday, very long term forward rates were stable, but both the date of the first hike and the slope of the curve coming off the hike continued to fall steeply.

The other day, I was thinking about the shape of the distribution of rate expectations, and how different shapes would have different implications for the yield curve.  The short version - a bifurcated expectation would pull the entire yield curve down below the median expected forward rates.  A normal distribution in which the lower tail hit the zero lower bound would push the yield curve above the median expected forward rates.  The slope of the yield curve in the near term suggests bifurcation, but the long end of the curve suggests normal distribution.

Thinking about it some more, and watching recent movements, I think the most realistic interpretation is that expectations have a negative skew, with the negative end of rate expectations hitting the zero lower bound (ZLB) across the entire curve.  So, above ZLB, the mode expectation is above the market rate, the median expectation is below the market rate, and the mean expectation is (approximately) the market rate.  Normally, a negative skew would push the mean below the median, but the ZLB truncates the distribution.  So, both of my explanations were part of the answer.
Here is a graph of this new interpretation.  I suspect that the mode expectations remain fairly stable, and what we see in yield curve movements is increasing negative skew related to increasing uncertainty, which does basically increase the hump at ZLB and decrease the hump at the mode.  So, for the full distribution, higher uncertainty pulls the market price down from the mode.  If not for the ZLB truncation, the mean would be moving down even further, so that we would also expect the market rate to fall below the median expectation.  But, since the increasing uncertainty makes the ZLB more binding, that effect pushes the market price above the median expectation.  Both effects from my earlier post are at work at the same time.

(Caution.  I know I'm spit-balling here.  I'm not trying to get published in an academic model or to change anyone's mind who isn't interested in my analysis.  I'm just trying to get a grasp on the world in real time.  I'm very interested in comments regarding mistakes I might be making here, or basic improvements I could make to the thought experiment.  But, I know that there is a lot of speculation here, and a lot of arguable priors are informing this work.  If you are more than 2 steps away from me here in agreement, or if my priors bother you, then there may not be much for us to discuss.)

Rate Movements in 2015-2016

If rates do rise, I think we can expect a 50-75 basis point move, per quarter after they begin to rise.  This is an interesting situation.  I suspect that in the industrial economy, natural interest rates are already rising above ZLB.  They aren't binding.  What is acting as a governor on market interest rates and NGDP growth is the limit on mortgage credit.  This is not related to interest rates.  Interest rates and the level of monthly mortgage payments for new home buyers are not the constraint on housing markets right now.  This leaves trillions of dollars of savings looking for an outlet, and the industrial economy simply can't utilize all the capital.

So, interest rate movements simply may not be that important.  Rates could rise to 2% by the end of 2015, and industrial credit will probably just keep churning along.  Expansion of industrial credit looks like it is running at the high end of typical potential growth.  This will probably continue.  Interest rates will have little effect until they reach some higher level where they become the constraint.

In the meantime, regulatory issues in the mortgage market and household real estate leverage levels will determine real growth, real rates, and inflation.  If this can loosen, all of those measures will move up.  If it doesn't loosen, then I suspect that the main issue will be whether the Fed stops hiking rates before rates become the binding constraint, or if they hike them enough to further hobble the economy.

In other words, we have 2 important factors to watch, in series.

1) Does the mortgage credit market begin to expand again.  If it does, it's Party in the USA.

2) If not, then the date of the first rate hike is not as important as the level of the last rate hike.  How will we know if it is too high?  Industrial credit will start to decelerate.  But, that can be a lagging indicator.  Likely, the earlier indicator will be a flattening yield curve.

If mortgages can begin expanding at any point before that happens, that will be very bullish.  It will mean higher interest rates, increased employment, higher real wages, and healthy equity markets.

From a speculative point of view, as rates begin to rise, uncertainty about rate levels will begin to decline.  This will reduce the skew of forward expectations, and the yield curve will steepen.  The trick is always in the timing and the details in these types of situations.  There will be a window where a position that gains from rising near-term rates is lucrative.  But, considering the policy inertia of the Fed and their general stance, I would expect them to overshoot, which would call for reversing the position and then speculating on near-term yield declines.

Really, the same pattern will probably play out even if mortgage markets do recover in the meantime, but we will likely see much more growth and higher interest rates in that scenario before the reversal.

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