Interest Rates in the Driver's Seat

Rates in the Driver’s seat: As I connect the dots amongst the various asset categories, it seems to me that the driver behind the recent counter-trend moves in most markets, is the interest rate markets. The easiest dynamic to understand is why interest rates have risen. From there, it is possible to tie FX rates to an increasing rate differential between US treasuries and a similar maturity sovereign debt of the other currencies. Higher rates also lowers the valuation of precious metals and equities, by using a couple of different arguments. If one combines this fundamental phenomenon, with the over-extended technical readings which have been prevalent for the last couple of months in all of these asset classes, then, at the very least, we have set the stage for a coordinated correction in all these asset categories.


The irony about the recent alignment of interest rates and stocks, is that we had become conditioned to expect interest rates to rise when stocks went up; ie – less fear and less need to own (supposedly) risk-free treasuries. In the recent run prior to QE’s announcement, the prospects of QE2, and the Fed’s outright purchase of treasuries caused stocks and bonds to rise together, which is opposite of the previously observed pattern.


Let me first present to you a chart showing the difference between Japanese Government Bond rates (JGB) and US Treasury rates (UST), and the corresponding Japanese Yen exchange rate, see the first chart on the attachment. I want to credit Julian Brigden, who is a foreign exchange salesman and strategist at CALYON, for bringing this chart to my attention. Although I have paid lip service to this concept, I never knew the relationship held up so well, as the chart vividly shows. (This also works for other currencies, but I am focusing on the Yen for the purposes of today’s blog). On the attached chart, the red line is the difference between 5 year US Treasuries and 5 year JGBs, which has an amazing correlation to the Yen/$ exchange rate. In fact, when I run a regression between the two time series, I get a 90% R-squared correlation coefficient, (2010 data), indicating, that this is a statistically strong relationship. In addition, according to the regression analysis, the beta is 9.14. which means that when the rate difference between the two rates changes, then the currency exchange rates moves by a multiple of 9.14 times. This means that a 0.1% change in rates results in a Yen/dollar change of almost 1 Yen per dollar. Put into the current context, the move in the rate spread from its recent low of 0.73% to the current level of 1.11%, or 0.38% suggests that the Yen’s exchange rate should rise by 3.47 Yen/dollar. In fact, the Yen has risen from a low of 80.20, to the current level of 83.48, or a change of 3.28, which is most of the predicted 3.47. The regression model suggests that the Yen’s exchange rate could rise a bit further to fulfill the average relationship between the two time series.


Another interesting anomaly is that the current sell-off in the Yen is accompanied by a falling stock market, which is counter to the recent observations that when the stock market sold off, the Yen would strengthen, not weaken as it currently has done. This reinforces the idea that interest rate differentials are driving foreign exchange rates, and not stock prices.


This then brings me to see what I can hang my hat on, when it comes to predicting the future course of interest rates (and differentials between rates in various currencies). To that end, I present a modified version of a chart sent around by Dave Zervos (of Jefferies) yesterday. Dave’s main thesis is that when the Fed announces QE/money printing operations, that interest rates drop as the plans are being anticipated, and then announced, since the market is anticipating that the Fed will be purchasing a large amount of treasuries, or MBS. This is bullish for these markets, and interest rates have dropped in anticipation that the 900 pound gorilla, (the Fed), is going to be playing in this sandbox. Subsequently, interest rates rise as the markets begin to anticipate the potential for inflationary outcomes because of QE. This explains the increase in rates over the past couple of weeks. 


Further supporting the idea that each of the Fed’s QE maneuvers increases inflationary expectations, I have included a graph of 10 year treasury rates less the rate on Treasury Inflation Protected Securities (TIPS), which shows that inflationary expectations did in fact increase following the Fed’s QE actions. 


I will end this discussion with the $64 million question: “How much further rates might rise in response to the increase in inflationary expectations, which in turn will influence FX rates, stocks and precious metals?” By the looks of the rate moves in response to each of the last 2 QE acts, we should see at least a 1% move in response to the most recent QE maneuver, QE2. With rates already up 50 bps since the recent lows, that means that half the rate rise could have occurred already. And if this is in fact going to occur, FX, stocks and precious metals could be in for some rough sledding over the next couple of weeks.


* More on QE: NY Fed governor, William Dudley was on CNBC this morning, defending QE2. He specifically said that the Fed was not trying to devalue the dollar, but to improve inflation expectations. He also said that the goal of QE is to remove treasuries from the market and force investors into other assets. Dudley said the Fed was doing QE because they cannot lower short term interest rates any further. 

Clearly the Fed is on the defensive, and it is remarkable to me that all these dissenting voices waited until after the Fed acted, to speak out in protest. I had believed that the reason why the Fed aired the concept of more QE, as long ago as August, was to get feedback as to whether or not this would be a good idea. I guess no one protested the fact that the risk markets were rallying in anticipation of QE, but all of a sudden, everyone is now concerned.


While I do not think more QE will do that much to help the economy, I do acknowledge (and have said so in prior blogs), that inflating our way out of the current deflationary environment is one way to deal with the fact that trillions of dollars of assets are over-leveraged, and under-water. Unfortunately, inflation is a tax on the entire system, not just on those who over-extended themselves.

Here is a funny description of QE, and worth the time to watch:



* And lastly, if you want to gain some insight about the reason why various mortgage foreclosures are being halted, and in some cases over-turned, check out this clip. To save time, you can skip the first 4:45 of this 12 minute video. I only watched the first one, but there are more than just one clip.


All this does not mean that people who default on their debt can’t be evicted, just that the mortgage companies need to evict them correctly.