Friday, June 05, 2015
Today's employment number illustrates just how sensitive the US stock market is to the prospect of a short term interest rate increase by the US Federal Reserve. The employment number showed a bigger increase than expected and within a few seconds the S&P futures had dropped 10 points on what in other circumstances would be bullish news. Traders figured that bullish news was actually bearish because it made a Fed interest rate hike more likely.
I think this line of thinking is just plain dumb. Take a look a the daily and weekly bar charts of the yield on the 10 year US treasury note you see at the top of this post. Interest rates are already increasing in the US and have been trending upward since the beginning of 2015! In fact the 10 year note yield is now above its 200 day moving average (red lines) which itself is leveling off and will soon turn upward. This suggests that yields are likely to increase during the coming months as well.
Why is the 10 year note yield heading up ??? I think it is because the Fed's quantitative easing program and its readiness to do more should the economy falter has convinced traders and investors that the economic growth in the US over the past 18 months will continue at a steady rate. If inflation comes in at 1.5% over the next few years and real growth is a modest 2% then a note yield of 3.5% (growth plus inflation) is justified. This is where I think the note yield is now headed.
Remember that the Federal funds rate, the only interest rate which the Fed directly controls, is the very last rate to respond to a change in expectations about growth and inflation. This is because the Fed's is always the last float in the growth and inflation parade. Few people seem to understand this simple point.
Another simple point that most people (and, sadly, many economists) don't appreciate: low interest rates are a sign of economic weakness, not a sign of an easy monetary policy. So the rally in the 10 year note yield marks a gradual return to normal economic conditions and is not a harbinger of a tightened US monetary policy.