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July 18, 1997
Bonds rallied below 6.50% on Wednesday, which pushed the Dow over 8,000, and "zero and zero" mortgages down to 7.625%.
This morning, bonds have retreated to 6.54%, and taken the Dow 100 points below the promised land. This pattern is one more lesson for anyone still in doubt about cause and effect in the financial world: bonds giveth, and bonds taketh away.
New releases of economic data did not resolve the question: is the economy slow enough for lower rates, or too hot for comfort? Retail sales rebounded 5% in June, plenty strong; while industrial production and housing starts muddled along, up .3% and 4.3% respectively.
Next week, Mr. Greenspan testifies to Congress, and there should be some fun as the indecipherable describes the inexplicable to the unspeakable. Clarity will have to wait another week for Thursday-Friday, July 31-August 1, when a special run of data will define rates into the Fall.
The road to financial perdition is paved with convictions that interest rates "should" be at some level, inevitably lower or higher than the market happens to be trading at the time. It's possible to identify trends, trading ranges, and Fed policy; and it's possible to make money by identifying market anomalies; but "should" and "ought to" rest on the belief that markets are reasonable.
Forewarned, it's okay to say that bond and mortgage rates ought to fall. Should, in fact.
One analytical approach to interest rates is to split any given rate into an inflation component and a "real" one. If you think you know the "real", non-inflationary cost of money, you can add the inflation rate to the real rate, and the sum is the level where interest rates should be.
What's the real rate? A matter of some debate until recently, but generally corresponding to the risk of default: not getting your money back. In Treasurys, where default is a low risk, the real rate has been thought to be around 4.0%.
Debate is no longer necessary. The Treasury now sells inflation-indexed bonds, and the rate they pay, absolutely protected against inflation, is therefore the real rate of return. Today, ten-year "I-I" (inflation-indexed) bonds pay 3.67%, and that's the real real rate.
The CPI this year is rising at a 1.4% annual rate. If you add the 1.4% inflation rate to the 3.67% real rate, ten-year Treasurys should be trading at 5.07%. They're not: they're trading at 6.21%, an obviously ridiculous level, as we have just proved. Long term rates ought to fall at least another percentage point, soon, perhaps immediately.
Do I believe that? Should you? Ought you to?
Me? No way. Nice theory, though. If inflation stays at 1.4%, it works. Ought to, then.
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