Back in December I cautioned that higher rates of interest would not be well-received, and a month later the collateral market shed over 10% of its value in a few days. More recently, nerves have been tested as US-China trade relationships reciprocal and deteriorate tariff hikes are announced. For the time being, as we await news of unusually strong financial activity, a more powerful dollar has accompanied weaker gold and commodity prices, and all have conspired to squeeze emerging market economies, much as I feared.
1 is to show that real yields tend to monitor the real growth rate of the economy. Currently, real produces on 5-yr TIPS (the best market-based proxy for short-term real yields I understand of) are consistent with economic growth of about 2.5% per year. This happens to be only higher than the two 2 somewhat.2% annualized growth the economy has registered since mid-2009, when the existing business cycle expansion began.
If the marketplace (and the Fed) were convinced that real development would be 4% or better, we would very likely see real yields on TIPS trading in the range of 3% or so. 2 demonstrates the hyperlink between market-based real produces on 5-yr TIPS, and the ex-post real produce on the Fed’s target funds rate. The true money rate is the Fed’s true target, since that is the best way of measuring borrowing costs.
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Note that the true money rate has been zero or less for the past decade, and it hasn’t increased much, if any, almost a year for. The red line, the true yield on 5-yr TIPS, is essentially the market’s expectation for what the blue line will average over another 5 years.
The market is not planning on the Fed to do much in the way of tightening, but it is definitely pricing in somewhat tighter policy for the foreseeable future. 2 is that the true yield curve has been steepening within the last year-expectations of future real rates have risen relative to current real rates. Taken together, the form of the nominal and real yield curves tells us not that the economy is being squeezed, but rather that neither the market nor the Fed are very enthusiastic about the idea of a stronger economy. 3 shows that nominal Treasury yields have been unusually low in accordance with the prevailing rate of inflation for the past seven years.
Only before yr have nominal yields begun to catch back up to inflation-and they’re still relatively low. The actual fact that the relationship market has been ready to simply accept only paltry real yields for such a long time is a function, I really believe, of a relatively strong degree of risk aversion and a lack of excitement for real growth prospects.