On the QT

Whatever happened to rising interest rates? The newswires were hot with stories of hyper inflation and soaring interest rates. The stories stoked fear from two angles. One school of thought said that if the Fed kept QE2 rolling it would foster inflation, and therefore, higher interest rates. The second school of thought believed that if the Fed ends QE2, there would be little support for treasury price and long-term interest rates would rise. In other words, no matter what actions the Fed took, long-term interest rates were heading higher. Not so fast Sparky. There appears to be much misunderstanding regarding how QE2 (and QE1 for that matter) affected the bond market.

When the Fed ended QE1 last year, long-term interest rates declined (helped by Euro troubles). When the Fed announced the possibility of QE2, long-term rates began to climb. Long-term rates hit their highest levels since early 2010 last December following the launch of QE2. Now, with the Fed’s announcement that QE2 will end on schedule in June, but that the Fed will reinvest maturing assets, long-term U.S. treasury yields have fallen. The yield of the benchmark 10-year not dropped to 3.16% the other day.

The recent fall of long-term interest rates is not as counterintuitive as it may appear at first glance. When the Fed halted QE1 it was considered to be disinflationary. Many market participants took off their risk trades and headed into U.S. treasuries. When the Fed moved toward QE2, risk trades went back on and really took off when QE2 was launched. Risk trades include speculating in equities, commodities and junk bonds. Now with QE2 likely coming to an end, but with the economy showing a bit more life than last year, long-term rates have fallen, but have not plummeted as in 2010.

This does not mean that long-term rates will not trend higher. However, they are more likely to creep higher rather than experience a spike. The street consensus as per a Bloomberg Survey indicates a consensus opinion of below 4.00% for the yield of the 10-year U.S. treasury note for year-end 2011.

The street consensus forecast for Fed Funds indicates no change to the Fed Funds rate this year with the first Fed action coming in Q1 2012. Three-month LIBOR, which is greatly influenced by the Fed Funds rate, has fallen from .33% to .26% during the past month. The one year forecast for three-month LIBOR is in the .75% to 1.00% area. Investors buying floating rate paper may be very disappointed with their investment choice.

Why may the rise of short-term rate be modest? This is because growth is not expected to be strong enough to move above the U.S. historical trend rate of 3.1%. Also, it must be remembered that QE is a form of easing (lowering rates in alternative fashion). Therefore, the removal of QE stimulus must be regarded as QT or Quantitative Tightening. When QT and rate increases are factored in together, it appears unlikely that the Fed will have to raise the Fed Funds rate very high during the coming interest rate / economic cycle, possibly not higher than 2.00%. I think we may be in for a few boring years as the economy adapts to new realities and housing prices languish until population growth provides the market with QUALIFIED buyers.