Deficits, the Fed, and Rates

Forgive us our incredulity. The bond vigilantes were certain that as the Federal Reserve hiked short-term rates, long-term interest rates would barely budge, the yield curve would invert, and the economy would fall into recession.

That theory has been blown to smithereens, so now we hear that it's rising long-term rates that will cause a recession.

According to the vigilantes, which ascribe deep meaning to every move in long-term interest rates, the U.S. has gone from secular stagnation and permanent low rates, to huge (impossible to fund) deficits and rising rates – overnight.

No wonder the average investor is completely confused.

So, let's start at the beginning.

Yes, the Fed drove short-term interest rates to zero and held them there for seven years. And, yes, the Fed bought $3.5 trillion in bonds during Quantitative Easing. And, yes, the Fed is reversing course. It's lifted the federal funds rate five times since 2015, and it's slowly allowing its bond portfolio to shrink.

The federal government enacted tax cuts and spending increases, and the budget deficit ($665 billion in 2017) is now expected to approach $1 trillion or more in 2018 and beyond.

So, how much impact does each of these things have on interest rates?

Here's our list:

1) If the budget deficit were no higher in 2018, than it was in 2017, long-term bond yields would still be higher today.

2) If the Fed had just lifted short-term interest rates, but had not started unwinding QE, longer-term bond yields would still be higher today.

3) When the Fed promises to hold short-term interest rates down, they pull longer-term rates down as well. Long-term rates (say a 5-year bond) are just a series of short-term rates (five 1-year bonds). So, rising 1-year yields mean rising 5-year yields.