In a way, this blog entry is a follow-up to my blog Why the Fed Hasn't Created Inflation Yet. I mention this because there is a general relation of interest rates to inflation rates.
Below is a graph of 10 and 20 year US Treasury yields in recent years (2005 to Present). The blip upwards on the right hand side of the chart is what recently happened when the Federal Reserve began talking about removing it's interest rate suppression program (it's bond buying program called quantitative easing). Since we've gotten used to extremely low interest rates, including historically low mortgage rates, the natural question is high how will rates go if and when the Fed exits it's bond buying program.
|US Treasury Yields (Green Line is 7 year note, Blue is 20 year Bond, Grey is the difference)|
Here's a really long term picture of interest rates. I find it, well, depressing that long term interest rates today are back to levels similar to those during the Great Depression.
How High Might Interest Rates Rise?
Nobody knows how high interest rates will rise, but you can make some guesses based on inflation expectations and history.
Scenario 1: It's possible that rates will revert to levels prior to the financial crisis starting in 2008. If so, then expect about 5% rates on the 10 and 30 year Treaury bonds, respectively (compared to 2.7 and 3.8% now). See the first chart above. This is highly unlikely as inflation was much higher in 2008 than now. Inflation expectations were also higher as asset bubbles were really "bubbling." The housing bubble burst in that year. See charts below.
CPI inflation was spiking just prior to the financial crisis. See the charts below. CPI inflation was spiking to about 4 or 5% before the bust in early 2008 meaning that inflation-adjusted interest rates were 0 or negative. Now CPI inflation is running less than 2% and trending down slowly. That's a big difference.
Scenario 2: The level of interest rates should give about 1 to 1.5% of 'real' returns after taking into account inflation (and inflation expectations). This is good generalization from history. Since CPI inflation is about 1.5 to 2% today (see the graph below for CPI inflation chart), then interest rates should be 2.5% to 3.5%, which is about the level that we are at today! In this scenario, it appears interest rates may not rise further, or maybe even fall. Afterall, bond yields have been falling for 30 years now---ever since Paul Volcker crushed inflation early in the Reagan years.
The Real Question Might Be: How Low Will Interest Rates Go?
Just judging by the charts (below) of CPI inflation, I think I can see a volatile but dis-inflationary trend since 2011. Compare this chart with the chart showing world economy growth. World growth has been slowly sinking since 2010. It would appear that this downward trend in growth will continue because monetary and fiscal stimulus programs are being (or going to be) slowly unwound both here and in China. In places like China, where government debt levels have rocketed in recent years to levels that are associated with financial crises, stimulus spending must necessarily decline. Chinese GDP will decline too since government "investment" is some 50% of the GDP. The US Federal Reserve will almost certainly back off on it's QE program in the year ahead. There's a good chance of another financial crisis in the years ahead and a good chance of depression conditions.
This trend of CPI inflation and world growth seems to indicate that yields will continue to fall from today's levels.
Here's the graph showing world-wide GDP which is declining since 2010. The worldwide trend toward lower GDP growth continues to this day. See my blog Jeremy Grantham's Personal View of the Stock Market. Lower growth implies lower inflation.
|World Growth Since 2007|
Graphs of CPI and Core inflation rates (both graphs from Nordea Market Research):
|Recent CPI and Core CPI Inflation Rates Since 2008 (Blue Line is US Data)|
I think there's a good chance that interest rates are fairly valued today. I think the 10 year Treasury bonds will vary from 2.5% to 3.5% in the years ahead. Today, we're at 2.8%. There's also a good chance that the world-wide growth trend downwards might drive interest rates generally lower. If so, then you will make money in bonds in the years ahead.
My investment advice is to buy bonds hand-over-fist if rates rise to 3.5% on the 10 year treasury bond. (I think you can start buying at 3.0% since rates may never rise to 3.5%). I think that will occur in an upcoming short term reaction to the start of QE tapering by the Fed. Buy a good variety of bond funds (corporate, treasuries) in various maturities but lean toward intermediate and longer term maturities for capital gains and better yields.