Everyone Anticipates "Normalization" Of Interest Rates, Except The Bond Market

Starting in 2012 the FMOC referenced the need for normalizing interest rates, by setting out its expectations for the Fed funds rate in the “ longer run”. The FOMC was careful not to specify how long is the longer run, but it was very clear that it expected a return to “normalcy” (Figure 1). Normalcy is how things were before the 2008 crisis. Inflation would be at 2 %, the Fed funds rate would be at 4.25 % and the real rate of interest at 2.25%, conditions that prevailed on average for more than 20 years prior to the 2008 financial crisis. To be fair, this expectation seemed to reasonable at the time, since the economy had made a respectable recovery from  the  Great Recession of 2008, employment was growing and GDP started to expand, albeit slowly. Only inflation remained the laggard.

Figure 1 Federal Reserve Targets set In January 2012

However, the bond market never really bought into the narrative of the return to normalcy and, in effect, bet against the Fed. How do we know this? The nominal and real yields on 10-yr Treasuries indicate what the market expects from the Fed funds over time. In other words, the 10-yr bond is just a succession of the expected 1 yr interest rate in each of the next 10 years. Of special note are the Treasuries Inflation Protected Securities (TIPS) whose principle is tied to changes in the CPI. If inflation picks up, the TIPS yield increases and if inflation declines the yield falls. As Figure 2 illustrates, with the exception of the “taper tantrum” in mid-2013 and the deflation scare of the summer of 2016, nominal 10-yr rates were held to between 2-2.5% and real interest rates were around 0.5%. Bond investors never bought into the inflationary expectations held by the Fed and most importantly never accepted that the real rate should be back to “normal” of 2.25%.

Figure 2 Nominal and Real Rates for 10yr UST

Since 2012 the Fed stuck to its guns and insisted, at every policy announcement, that inflation would return to the 2% level. Over the 5 year period, the PCE (the Fed’s preferred measure of inflation) averaged 1.5 %.  More importantly,  the TIPS revealed, inflationary expectations were well anchored in a range below the Fed’s target of 2%. The bond market heard what the Fed was saying, but held a very contrary view of the future. It looks as if the bond market challenged the Fed and won. I say ‘won ‘because the bond market correctly forecast inflation so that investors did not suffer a loss--- both nominal and TIPs protected participants from any erosion due to inflation.

Now that the Trump-induced boost in yields has subsided and started to reverse itself, the 10 yr yield has fallen 35 bps since its high in March this year. The road towards a “normal “ Fed funds rate now seems even longer and more arduous. It may be that what we are experiencing now is normal.