Kevin Erdmann has an interesting post discussing the evolution of interest rate futures over time. In recent months the date of the first anticipated rise in rates has moved from late-2015 to mid-2015.
But, I expected this to correspond to forward rates for June 2016 Eurodollars of just over 2% and for June 2017 of just over 3%. Instead, rates have trended around a mean of about 1 5/8% and 2 5/8%. If that had been my target mean, it would have been perfect for this trade. (Basically, buying when the price declines and selling when it increases, profiting from random movements over time.) But, the farther the price moves from my target, the harder it is to profit from the position. Why haven’t the prices followed the market expectation?
The reason is that the slope of the yield curve has declined while the expected date of the rise has moved back. Late in 2013, the slope was up to around 33 bp. (Rates would be expected to rise 33 basis points per quarter after the initial rise.) For reference, in the past two cycles, during the rate recovery period, short term rates rose at a pace of 50 to 75 bp per quarter.
So, what’s going on? I think that the market has been surprised by how healthy the economy has remained in the face of the tapering of QE3. This diminishes inflation fears and also signals a hawkish intention from the Fed.
But, I think this reflects the Wizard of Oz view of the Fed’s interest rate policy. I think that there is a systematic underestimation of how much Fed policy chases the Wickesellian interest rate. I think the Wickesellian rate is probably already above zero. This is part of the reason that we have seen an acceleration in economic activity and employment this year. QE3 appears to have been only slightly accommodative, for reasons I don’t completely understand, and so its taper has probably not changed the objective stance of monetary policy that much. But, before QE3, a non-QE zero rate policy was probably disinflationary. The increase in the Wickesellian rate over the past 2 years means that at the end of QE3, a non-QE zero rate policy will probably be inflationary.
This might be right, but let me throw out another possible explanation. Perhaps the markets are reacting to the disconnect between the unemployment data and the GDP data. All throughout the recovery the unemployment rate has done better than the GDP data. Even back as far as 2011 I was doing posts entitled “A job-filled non-recovery.” But the disconnect has recently gotten worse, with NGDP growth coming in at under 4% over the last 6 quarters, and the unemployment rate falling by 1.7% over 18 months, roughly 0.1% per month. That’s a very fast decline in the unemployment rate, which suggests we’ll hit full employment fairly soon. But GDP growth has been really slow.
This pattern has gotten even more pronounced over the past 6 months. You can write off the first quarter due to bad weather, but weather certainly did not affect second quarter GDP. And yet NGDP in Q2 was up only 2.5% (annual rate) over 2013:4. That’s a shockingly low rate of NGDP growth, and yet the rapid decline in the unemployment rate continued. And we recently had the fastest 6 months of job creation since the late 1990s. One thing we know for sure is that job growth must slow at some point. Labor force growth will be exceedingly slow due to retiring boomers, and returning discouraged workers can only do so much. I’ve suggested 3% is the new normal for NGDP, but if you applied Okun’s Law to the recent data (and account for inflation) you’d get even a lower estimate.
So if you look at the unemployment data and the NGDP data together, rather than separately, you are forced to conclude that trend NGDP growth has slowed very sharply. If the markets are gradually figuring this out as more data comes in, it could explain the flattening of the yield curve. The rapid fall in unemployment explains why a rate increase is expected within less than a year, and the declining estimates of trend NGDP growth explain why rates are not expected to rise as far after that first rate increase.
PS. Kevin Erdmann also has a very good post linking school choice, banking regulation, and the right to exit. Highly recommended.
HT: TravisA