Weekly Market Pulse: How High Can Rates Go?

I’ve been getting that question a lot these days. How high can rates go? It is asked in a way that seems to imply that the answer is obvious – not much. Why? The answer is almost always the same; the Fed can’t and won’t let rates go up. If they did it would kill the economy and raise the interest cost of the government. They can’t let that happen so they’ll implement yield curve control and keep long term rates from rising. The Fed is believed so powerful that their mere promise to buy bonds to cap yields would stop the selling by any and all other bond owners.

I suppose that is possible but I have my doubts as to whether the Fed would even attempt to control the yield curve as they have in the past (during WW2 and for six years after the war most recently). The holders of Treasuries back then may have felt some patriotic duty to hold their bonds that today’s holders surely do not. Not only are about a third of Treasuries owned by foreigners but even the ones owned by Americans are not generally owned directly. Americans today surely don’t own bonds because they feel any patriotic obligation to do so. Could the Fed stop a tsunami of determined selling? Well, of course they could but at what cost? I am certain of one thing; if the Fed needed to and did stop long term rates from rising, something else would fluctuate instead. There is no free lunch. In the post WW2 period, after price controls were removed, inflation rose 18% in 1947 and 10% in 1948. And the Fed kept the 10 year pegged at 2.5% until 1951. As I said, something else will fluctuate.

Let’s take a different view of the potential for rates. As I’m sure you’re aware the yield curve has been steepening of late. The 10 year/2 year spread has widened recently to 1.42% from negative in August of 2019. In the past three recessions and recoveries the curve has steepened to at least 2.5%. If the 2 year rate stays at current levels and the curve steepens to 2.5% that implies a 10 year yield of roughly 2.35%. Is that going to happen? I have no idea but I think it makes sense to see that as the potential even though there are significant differences between today’s steepening and past episodes (I’m not going to go into all that in this update but suffice it to say that rates aren’t even going in the same direction as past steepenings).

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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