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Economics and Interest Rates Christopher Low, Chief Economist FTN Financial FTN FINANCIAL What Drives the Bond Market • Real yields determined by supply/demand for credit • Inflation premium is best guess about future inflation • In contrast, Fed Funds rate has no market component; It is an attempt to steer growth and inflation • Curve shape is determined by changes in real yields and/or Fed policy • Historically, Fed is 90% of curve shape FTN FINANCIAL Anatomy of a Bond 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Inflation Premium Actual Inflation Real Return TIPS Yield Treasury Note TIPS FTN FINANCIAL 10-yr TIPS Treasury Spread 2.9% 2.7% 2.5% 2.3% 2.1% 1.9% 1.7% 1.5% 1.3% 2003 2004 2005 2006 FTN FINANCIAL 5-yr TIPS Treasury Spread 3.2% 3.0% 2.8% 2.6% 2.4% 2.2% 2.0% 1.8% 1.6% 1.4% 1.2% 2003 2004 2005 2006 FTN FINANCIAL 5-yr Forward 5-yr Spread 3.1% 2.9% 2.7% 2.5% 2.3% 2.1% 1.9% 1.7% 2003 2004 2005 2006 FTN FINANCIAL Policy Lag and GDP 12% 10% 8% 6% 4% 2% 2 qtrs FF Rate GDP 0% -2% 1988 6 qtrs 5 qtrs 1991 1994 1997 2000 2003 2006 FTN FINANCIAL Policy Lag and Core Inflation 12% 10% 8% 6% 4% 2% 0% 1988 FF Rate Core CPI 1991 1994 1997 2000 2003 2006 FTN FINANCIAL Policy Lag and Core Inflation Fed funds Core CPI Quarters Peak FF to peak core CPI 2Q 89 1Q 91 7 quarters Peak FF to trough core CPI 2Q 89 2Q 94 20 quarters Peak FF to peak core CPI Peak FF to trough core CPI 2Q 95 2Q 95 4Q 95 2Q 98 2 quarters 12 quarters Peak FF to peak core CPI Peak FF to trough core CPI 2Q 00 2Q 00 4Q 01 4Q 03 6 quarters 14 quarters FTN FINANCIAL Economic Growth • Inflation falls when the economy grows below potential • Inflation rises when the economy grows above potential • Potential GDP is a guess, based on availability of capital and labor FTN FINANCIAL GDP and Potential GDP (CBO) $14.0tn Recession $12.0tn $10.0tn $8.0tn $6.0tn $4.0tn $2.0tn 1986 Potential GDP Actual GDP Recession Mid-cycle tightening 1989 1992 1995 1998 2001 2004 FTN FINANCIAL GDP Components Consumption Business Fixed Invest Res Invest Inventories Exports Imports Government FTN FINANCIAL Contrib. to GDP Growth Since 2000 Consumption Business Fixed Invest Res Invest Inventories Exports Imports Government FTN FINANCIAL Payroll Employment Growth 600k 500k 400k 300k 200k 100k 0k -100k -200k -300k -400k -500k 1996 Change Trend 1999 2002 2005 FTN FINANCIAL Housing-Related Payroll Growth 80k 70k 60k 50k 40k 30k 20k 10k 0k -10k -20k 2003 2004 2005 2006 FTN FINANCIAL Unemp Rate and NAIRU (CBO) 8.5% NAIRU 8.0% Recession Unemp rate 7.5% 7.0% 6.5% 6.0% Recession 5.5% 5.0% 4.5% Mid-cycle tightening 4.0% 3.5% 1986 1989 1992 1995 1998 2001 2004 FTN FINANCIAL Non-Defense Cap Goods, Ex-Aircraft, Orders, yr/yr% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% Recession Trend Yr/Yr% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 -15.0% -20.0% -25.0% -30.0% FTN FINANCIAL Auto Sales 22.0m Recession Trend Yr/Yr% 20.0m 18.0m 16.0m 14.0m 12.0m 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 FTN FINANCIAL Housing Starts 2400k 2200k 2000k 1800k 1600k 1400k 1200k 1000k 800k 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 FTN FINANCIAL New Home Sales 1400k 1300k 1200k 1100k 1000k 900k 800k 2003 2004 2005 2006 -23.2% FTN FINANCIAL Existing Home Sales 7,500k 7,300k 7,100k 6,900k 6,700k 6,500k 6,300k 6,100k 5,900k 5,700k 5,500k 2003 2004 2005 2006 -15.0% FTN FINANCIAL Single-Family House Listings 4.5M 4.0M 3.5M 3.0M 2.5M 2.0M 1.5M 1.0M 1989 +82.2% 1991 1993 1995 1997 1999 2001 2003 2005 FTN FINANCIAL New Single-Family Listings 600k 550k 500k 450k 400k 350k 300k 250k 200k 150k 100k 1963 1968 1973 1978 1983 1988 1993 1998 2003 FTN FINANCIAL Median Home Price, yr/yr% 20.0% New (smoothed) Existing 15.0% 10.0% 5.0% 0.0% -5.0% 2003 2004 2005 2006 FTN FINANCIAL Home Equity Withdrawal $800bn $700bn $600bn $500bn $400bn $300bn $200bn $100bn $0bn 1991 1993 1995 1997 1999 2001 2003 2005 2007 FTN FINANCIAL House Completions vs Sales 2100k 1900k 1700k 1500k 1300k 1100k 900k 700k 2000 2001 2002 2003 2004 2005 2006 Housing completions Home Sales Adjusted for cancelations FTN FINANCIAL Inflation • Containing inflation is the primary goal of Fed policy • The bond market (usually) trades independent of the Fed • Bond investors like it when the Fed is right. But, they really like it when the Fed is wrong, as long as it means too much tightening FTN FINANCIAL CPI and CORE CPI, yr/yr% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 2003 2004 2005 2006 CPI Core CPI FTN FINANCIAL PCE and CORE PCE, yr/yr% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 2003 2004 2005 2006 PCE Core PCE FTN FINANCIAL Core CPI, 3mo/3mo% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 2003 2004 2005 2006 FTN FINANCIAL PPI and CORE PPI, yr/yr% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% 2003 2004 2005 2006 PPI Core PPI FTN FINANCIAL Silver and Gold, (yr/yr%) 100% 80% 60% 40% 20% 0% -20% -40% 2000 2002 2004 2006 Silver Gold FTN FINANCIAL Crude Oil, (yr/yr%) 200% 150% 100% 50% 0% -50% -100% 2000 2002 2004 2006 FTN FINANCIAL GSCI Index, (yr/yr%) 80% 60% 40% 20% 0% -20% -40% 2000 2002 2004 2006 FTN FINANCIAL Fed Policy • Fed Policy artificially sets the short end of the curve. • Balancing act between growth and inflation. FTN FINANCIAL Fed Funds Target Rate 7% 6% 5% 4% 3% 2% 1% 0% 2000 2002 2004 2006 FTN FINANCIAL Real Fed Funds Rate 6% 5% 4% 3% 2% 1% 0% -1% -2% Real FF (Core CPI) Real FF (Core PCE) 1995 1997 1999 2001 2003 2005 1987 1989 1991 1993 FTN FINANCIAL Yield Curve 6% 5% 4% 3% 2% 1% 0% FF 2 3 5 10 30 Now June, 2004 FTN FINANCIAL Fed at Turning Points • The first tightening is usually a surprise to the market. • The first ease is usually a surprise to the Fed. • Fed tends to tilt against inflation • Fed doesn’t trust the curve as an indicator because it implies the Fed causes recessions. FTN FINANCIAL Bond Market after a Tightening • Bond market leads from the long-end • 10-yr yield often rallies as much before the first cut as after • The eventual low in 10-yr yields comes before the last cut FTN FINANCIAL
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