When interest rates fall, the primary reason is a lack of inflation – or a deflationary condition. We witnessed this not long ago on a couple of occasions, which you can see in the chart below. In 2011, the benchmark 10-year bond sank from 3.5% to barely 1.5% over an 18 month period. In 2014, it began a decline from 3% and ended up near 1% in 2016. During this time, the Fed was trying its best to stoke some inflation with their many QE programs, and the rest of the world followed.
This approach seemed to work fine, but now the world is awash in debt. That debt is continually being kicked down the road. At some point, it will have the be dealt with, but for now the bandaids are still fresh.
Inflation, Interest Rates and Demand for Bonds
Back to interest rates. When the 10-year bond hit a multi-year high of 3.25%, everyone was scared. Was inflation starting to creep up in earnest? Well, that’s what the Fed has been aiming for, so they get a “mission accomplished” on this goal (so far).
But then the 10-year bond suffered a steep decline, just as an appetite for fixed income increases and supply continues to hit the market (the Fed and Chinese are selling, and the Treasury is releasing record amounts of notes/bonds). Imagine how steep the curve might be if these sellers were not present? We would likely see long bonds once again around 1%.
So, what’s next for rates? The Fed has a big meeting coming up just before Christmas, and all of a sudden there seems to be a debate about whether they will raise rates. Could rates start heading downward again? Never say never!
I think they will raise the rate again but perhaps signal a slowdown. That might soothe the equity markets a bit, which have been in whipsaw mode for a couple of months now. On the other hand, slower growth might not be taken well. It’s a double-edged sword.