Wednesday, October 29, 2008

Interesting Interest Rate Facts

Today the Fed is expected to announce another formal interest rate cut of at least 50 basis points, down to 1%, you know the level Greenspan decided back in 2003 would create so much benefits through the boost it would provide to the housing market. Yet if you look at the effective Fed funds rate (the one that really matters) it has in fact been close to or below 1% since October 10, meaning that today's announcement will in effect simply be to officially announce what they've already done. Regular readers will remember that this is not the first time the Fed effectively cuts interest rates before formally announcing it. On October 7, I pointed out that the Fed had already cut interest rates, something which the Fed formally confirmed the next day.

Now that we're on the subject of interesting interest rate facts, I should point out that the bond market is now (at least seemingly) pricing in price deflation during the coming 5-year period. The yield for the 5-year regular U.S. government bond was 2.67% this monday. Yet the yield of the 5-year Treasury Inflation Protected Securitys (TIPS) was 3.74%. Meaning that unless the consumer price index fall by an average of more than 1% per year during the coming 5-year period, TIPS will provide better returns than regular bonds. While the current deflationary monetary trends make it basically certain that consumer price inflation will decelerate dramatically in the coming months from its current level of over 5%, consumer price deflation looks less likely. Of course if these deflationary monetary trends continued for a longer period, then consumer price deflation will inevitably follow. But given the determination of the Fed to use all available means to prevent deflation, it seems unlikely that monetary conditions will really be deflationary for sufficiently long time to achieve sustained consumer price deflation of more than 1% for the coming next 5 years.

As TIPS returns have consistently outperformed the return of regular government bonds for a long time, it seems that either bond traders are systematicaly underestimating future inflation and/or that the lower level of liquidity of TIPS relative to regular bonds are creating a liquidity premium for them.


Anonymous Anonymous said...

TLT, an ETF of long term (25 year) US Treasury Bonds have fallen and is falling. It would not have fallen if not the smartest investors had thought there would be a deflation.
We can safely bet on a rising inflation and invest in gold related investments.


8:52 PM  
Anonymous newson said...

i find it rather interesting that in the october rout on the world bourses, the ten and thirty-year t-bonds didn't make new highs, as they would do reflexively in past panics.
the beginning of the end of the foreign love-affair with us long bonds?

2:27 AM  
Anonymous Akbar said...

roubini went on record with the forecast of stag-deflation. somehow it is hard to believe that general level of prices is going to go down, at least, if you lived long enough in NY. dismal science indeed, no clarity even on inflation/deflation point.

3:40 AM  

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