What are Interest Rates Telling Us?

As we outlined in class yesterday, interest rates and the bond market have a great deal of predictive ability concerning future levels of economic activity. The simple yet very powerful model of interest rates you should use is:

interest rate = f(expected inflation, economic growth, monetary policy)

As I noted, inflation expectations and growth expectations are not necessarily independent of each other, so the time frame you are considering becomes relevant to seeing which matters more. You can use the TIP:TLT ratio in StockCharts.com as one proxy for expected inflation, while a preferable way is to calculate (and track through time) the TIPS spread (= nominal interest rate - TIP rate with same maturity). This is available daily (in real time) from Bloomberg.com. Here is a link to the web page to use for this. As of today (4/21/10), the 10-year US Treasury bond has a rate of 3.79%, while the 10-year Inflation Indexed Security (TIP) has a rate of 1.43%. So:

TIPS SPREAD = 3.79% - 1.43% = 2.36%

Historical data on this is available from the Federal Reserve Economic Data (FRED).

If you want to find a proxy for the level of economic activity and income, you can use consumer cyclicals ($CYC) in Stockcharts.com. Where is support for this? Resistance? Are there any leading indicators from technical analysis that can be of help in the short-term (ex: bullish or bearish divergences based on the RSI)? 

So, you should use the interest rate model above whenever you need to explain interest rate changes or to make interest rate forecasts. To do this, you will need to generate a forecast for each explanatory factor. Possibly, over the time period of your forecast, a factor that usually matters will not matter much. Or possibly, a factor that normally doesn't matter much will be influential. Remember: NOBODY KNOWS THE FUTURE (except CNBC, of course).

For those of you who have taken ECN 327 with me, you can expand the basic interest rate model substantially. Using general macroeconomic models such as the IS-LM and AD-AS, you can identify a fairly large set of factors that determine either economic growth (Ye in those models) or inflation (changes in Pe in the AD-AS model). Basically, those factors are the "other things" of the relevant curves.

Looking at a chart (click to enlarge) of the 10-year rate ($TNX), resistance at 4% becomes readily apparent (note: you must divide the number on the right axis by 10 to get the interest rate). Short-term support is at roughly 3.5%. Why has resistance held over the one-year period covered by this graph? Rates fell twice from 4% (a double top, by the way). What causes interest rates to decline? To answer this question, use the interest rate model.

Rates decline for some combination of declining expected inflation, less expected future growth, or monetary easing. Obviously, we can rule out monetary easing. That leaves us with declines in expected growth and inflation.

Will the 10-year re-test resistance or support? Again, use the interest rate model to answer this question. Anyone doing their forecast on interest rates will have to do this.

Read the relevant chapters in John Murphy's Intermarket Analysis to further help you with an understanding of this topic.

Friday's Employment Report

I had stated in class that the bond market anticipated a bad employment report. THE BOND MARKET WAS CORRECT. In anticipation of a larger-than-expected fall in employment (an actual fall of 263,000 -- much worse than the "consensus" estimate), and thus slower growth ahead, interest rates had been falling during this week. And, the actual number didn't do anything to reverse that trend. Here is a very short summary of the day's 10-year bond performance.


The chart (click to enlarge) shows the ten-year bond rate ($TNX). NOTE: the rate of interest is the listed value on the right axis divided by 10. So, 35 corresponds to a 3.5% rate, etc.  Resistance for the 10-year bond rate has recently been 3.5% -- you can see the rate bouncing off this level several times since August. Focusing only on this past week, we see a noticeable decline in the 10-year rate, in anticipation of a weak employment report.

As interest rates and bond prices are inversely related, note from the RSI indicator above the chart that rates are oversold, so a bond rally (on potentially bad news) has caused bond prices to be overbought.

There is one interesting thing about Friday after the employment release: the 10-year rate rose (and prices fell). And, while the rate hit 3.1% at one point during the day, the close was higher than the open. There was also a lower tail (remember: a possible signal of change of momentum). It is quite possible that the low on Friday may be a 10-year low for the short-term based on Friday's price bar. Keep in mind, though, that mortgage rates tend to be highly correlated with the 10-year bond rate, so it appears that we are going to see lower mortgage rates ahead (below 5% on 30-year mortgages). The real question is whether mortgage applications rise or fall ("other things" are not necessarily equal).

The stock market had a rough couple of days. After class on Thursday, the market dropped sharply. Friday, after the report, another sharp drop occurred until around mid-day when we came off the lows of the day. Here is a story about the stock and bond markets. For extra credit, due at the beginning of class on Tuesday, create a chart of the S&P 500 (daily) using "fill the chart" as the data range. Put the RSI in the same chart (not above or below it), paste this into a Word document. In that document, provide a brief summary indicating how the RSI signaled the recent stock market decline.

You should continue following the bond market throughout the remainder of this semester and beyond, noting what it is forecasting and contrast this with what the stock market is assuming. We will cover the stock market this week.

Moment of Truth for 10-Year

To examine the long-term trend in a variable, it is often advisable to go beyond merely extending the range of daily charts or using weekly graphs. The chart below shows monthly data from 1995 to the present on the 10-year bond. Notice that at the present time, the 10-year rate continues to range within a symmetrical triangle based on resistance from 2002 and support from 2003. The most recent monthly high is touching the upper line (longer-term resistance). Also, the 9-period RSI is not yet in oversold territory.

Examine the graph and analyze it. (1) What is the likely path of the 10-year rate in the next month or two based on technical considerations? (2) Adding economic analysis concerning the way the "pieces" are moving and fitting together (remember our theoretical discussion of interest rates), does this conflict with your technical analysis conclusion or is it consistent with it?

This is the type of thing you need to be doing as you get farther along in the process of writing your forecast paper.