Interest Rate Confusion

There is a lot of confusion about interest rates and the direction they will go, particularly if the Fed "tapers" its so-called quantitative easing.  While I am uncertain myself about which way interest rates will go, I want to point out a few things so that you can avoid making wrong assumptions.

Some investors think that interest rates will go up when the Fed stops, or even slows down, buying government debt.  In a vacuum, this is a rational thought.  If the Fed, the biggest buyer of bonds, stops buying government bonds, then this should make bond prices go down, if all else stays the same.  Lower bond prices mean higher interest rates.

But the key phrase is "if all else stays the same".  If the Fed slows down or stops its monetary inflation, this will likely strengthen the dollar and lead to a recession.  The demand for money will likely rise.  People will seek safety and will look to lock in guaranteed returns.  In other words, investors are more likely to buy bonds, thus possibly offsetting (or more) the Fed's lack of buying at that point.

On the flip side, many investors assume that rates will stay low or go down if the Fed keeps up its quantitative easing (monetary inflation).  It is possible the Fed could even increase its bond buying program.  When there was discussion of tapering back in June, the 10-year yield went up.  So it would make sense that the 10-year yield would go back down if the Fed keeps up its bond buying or even increases it.

But again, this is only if "all else stays the same".  I think the idea of rates staying low if the Fed continues its monetary inflation is a solid prediction, as long as the perceived threat of price inflation is low.  But if investors start to worry about being paid back in a depreciating currency, then they will start to demand a higher premium.  Investors are not likely going to buy a 10-year bond at 2.5% if they think there will be price inflation of 4% (although this is not impossible if a 1.5% loss per year is the best they think they can do given the inflation).

So if fears of price inflation pick up because the Fed keeps creating new money out of thin air, then it is possible that interest rates could rise to reflect the inflation premium.  It is important to remember that interest rates were going higher and higher in the late 1970's, even while the Fed continued to buy government debt.  But there was also high price inflation during this time, which made investors demand a higher interest rate.

I write all of this not to make any predictions, but just to caution people about different possibilities.  Some people think they can't go wrong in shorting bonds (betting on higher interest rates).  But it is not inevitable that interest rates have to go higher, particularly in the short term.  There are several factors that have to be considered and the Fed's bond buying is just one of those factors.