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.

Assigmnent #3

A number of persons had incorrect answers for the first two questions in Assignment #3.

1. As Md = f(r) but not a function of Y => Md is downward sloping but it does not shift for changes in Y. Thus, there is only one equilibrium r, no matter what the level of Y is. Therefore, the LM curve is horizontal.

2. You need to read the chapter on AD - AS for this. Yf is obtained when labor market equilibrium occurs (where labor demand = labor supply). This gives L*, which when plugged into the production function gives Y* (or Yf).

3. The data you obtained was for the nominal interest rate (the 10-year constant maturity rate) and the real interest rate (the Treasury-Inflation Indexed note). The basic formula to relate these is:

Real r = Nominal r - expected inflation

Solve this for expected inflation:

Expected inflation = Nominal r - Real r

The result is what is referred to as the "TIPS spread." It provides a real-time measure of the value of inflation expectations for the next 10 years (in this case). REFER TO THIS IN THE FUTURE AFTER YOU COMPLETE THIS COURSE -- IT IS VERY IMPORTANT AND OFTEN REFERRED TO.