‘Terminal’ funds rate

Screen Shot 2017-04-22 at 11.32.50 AMTake the eurodollar futures strip. Please.

Some interpret it as showing that the “terminal” libor rate might be around 3%, implying a peak in the funds rate of about 2 ¾%.  Maybe that would go with inflation at 1 ¾% and a short real rate of 1%, which would put a top on the expansion.

But that is not really what the futures strip implies, as the peak rate on the futures strip is certainly not the expected peak of the interest rate cycle.

Let’s ignore the probably-small risk premium for simplicity. The reason the strip understates the expected peak of the rates cycle is that the date of that peak is unknown to investors, who must price the mean of the probability distribution for rates, which has to include the idea that rates will fall after they peak.

To see this simplify radically and assume that the peak funds rate is known to be 4% and that beyond 4 years, the only possible alternative is a return to zero.  Looking 5 years ahead, if we figured the funds rate were peaking with 75% confidence, then the forward funds rate would be 3%.  The curve peaks at 3% even though we (for sake of illustration) know the peak is 4%.  Not knowing the date of the peak matters a lot.

This simple point occurred to me while thinking about the fact that credit growth appears recently to have slowed, which seems mostly a lagging indicator of the fact that pent-up demand for durable goods has finally been exhausted and some technical issues, like the bust in the energy patch and the inventory correction.

Looking forward, credit growth should tend to reaccelerate above the pace of durable goods demand growth, following the automatic re-leveraging thesis set out by Jason Benderly.  In brief, Benderly shows that the gap between credit growth and growth in the spending it finances is itself cyclical, favoring spending growth early cycle and credit late in the cycle.  Just look it up.

The problem, though, is that this is actually a negative for spending growth, because the expansion now has less pent-up demand and is more dependent on credit expansion. FWIW, this does not have me in a “panic,” but it represents the disappearance of what had been a comforting positive.

Which brings me to a point Larry Summers has made – or a point that seems analogous to one Larry Summers has made. Summers claims that real interest rates were held aloft by during the mid-2000s by bubble dynamics in housing. From this he infers that his secular stagnation thesis actually applies to before the crisis.

Screen Shot 2017-04-22 at 11.16.04 AM

Summers argues that this differentiates his take from that of, say, Reinhart and Rogoff, as set out in This Time is Different (NOT Growth in a Time of Debt).  R&R claim that economic weakness is enduring but ultimately transitory, where Summers sees it as secular, barring a major policy change.

Applying an analogy to today, I would say that the pent-up demands are largely exhausted, at least outside housing, and that wealth effects have probably also peaked.  I am not sure why the equilibrium funds rate would surge from here.

People expecting the actual funds rate to surge may see it otherwise. I would guess, though, that a big part of the case for higher interest rates is just the continued influence of Taylor Rule type reasoning. As the labor market tightens, it is natural for the real interest rate to rise. But I don’t think we are in an environment where Taylor can work, for reasons I wrote down here quite a while ago.

This does not make me want to go out and buy a bunch of bonds, even assuming I had the dough. I still view bonds as offering return free risk.

Mostly it just reinforces my take that interest rate “renormalization” remains an extremely misleading model of the rates environment. Also it would probably be good for the Fed to allow inflation and expectations of it to rise a bit before risking putting a cap on the cycle.

These thoughts are in the Summer lecture I linked to above, but I have been pushing them a while independently.