Friday, June 21, 2013

Why Interest Rates Are Rising

There are two theories of why interest rates are rising. In the first, they are rising because of an improved economic outlook, which leads investors to anticipate a swifter exit for monetary policy. In the second, they are rising because of a change in investor expectations of the monetary exit, independent of economic conditions.

Fortunately, statistics has a way of answering these questions: correlation. (Or at least, helping us answer these questions.) I downloaded the daily time series data of the 10-year Treasury note yield and the S&P 500 stock index from June 2008 through the present. If on days that rates are rising, the stock index also rises, then we can assume that both are driven by changes in the economic outlook. If on days that rates are rising, the stock index is falling, then the "economic outlook" story doesn't hold up -- and a "monetary policy" story fits.

I calculated the 90-day correlation coefficient of their daily percentage changes. I find that it has been plummeting since May, which is when interest rates began to jump. See how it's falling off a cliff at the right end of the chart? That means the first story ("happy days are here again") is wrong, and the second story ("the Fed is tightening") is right. Here's the graph.

Oh, and if you're curious, the correlation coefficient is now near the lows of 2009 and 2010. Both of those times were major monetary easings, so rates were falling as stock prices were rising. You might also observe that though the first two big rallies in stocks were amid low correlation coefficients -- i.e. they were Fed-driven -- rallies since the start of 2012 have occurred amid relatively high correlation coefficients. On days that stocks have been doing well, in other words, rates have been rising.

Here's my editorial comment: If the Fed doesn't intend for all of its talk since the start of May to be perceived as pushing forward the schedule for monetary tightening, independent of the economic recovery, it needs to start clarifying its intentions. Now.


  1. run a taylor or mankiw rule-- Fed is simply normalizing policy

    there's little efficacy in mon pol boosting growth here. most of benefits of LSAPs have already occurred

    and one has to look at it from a cost/benefit perspective. dovish guidance + LSAPs have driven sizable excesses in credit markets. look at how spread product and fixed income funds have traded, and retail flows in these products

    the biggest changes were:

    1 fed's optimistic econ projections
    2 fed's dismissal over disinflation worries

    the economy is proving very resilient given fiscal drag. i think fed's projections are pretty in-line with my own, if not a tad less optimistic

    as far as disinflation-- decompose the PCE deflator numbers. even if one looks at core PCE, core commodities/goods & healthcare are driving the disinflation (which are stimulative), while housing and services are strong. i think fed saw the wage growth uptick/cycle low last quarter and is taking the acceleration there seriously

    if corp capex doesn't ramp up and/or wages don't continue to accelerate, fed economic projections will reflect that

    but rates-up are far from sizable enough to impact economy adversely at this stage

  2. fed absolutely meant to signal the hawkishness that's priced into the curve. eurodollars are merely reflecting fed's own policy rate path mean projections.

    now other fixed income is a diff story-- a story that reflects how excessive some of these products were priced to perfection, and how the fed is preempting their normalizations instead of allowing them to become worse

  3. My latest blog post: "The Employment To Population Ratio (EMRATIO) is NOT a good indicator"

  4. Thanks for providing a longer term perspective to this debate.
    I'm eager to read the follow-up on Chinese Treasury holdings you announced over at TheMoneyIllusion. Maybe something else to look at there is the intraday comovement between Treasury yields and the USD/CNY exchange rate between Wednesday & Friday. Chinese selling (and conversion into CNY) puts some upward pressure on the CNY in an environment where EM currencies where falling.
    Probably currency markets are too deep to see anything there. But on overlays of intraday movements may show a little blip somewhere.