The rise in interest rates in the last couple of years has caused both anger and agony among Americans. Mortgages and car loans have gotten more expensive, as have credit cards and other forms of consumer credit.
With rising costs of housing adding to the general increase in the costs of living, it is understandable that families across America wish for a return to the days when the federal funds rate was near zero and the yield on Treasury securities was less than 1% per year. Unfortunately, those days are gone, and—I have to add—that is good.
We need high interest rates to stabilize the financial system, to keep inflation out of the economy for the foreseeable future, and to return the federal government to at least a modicum of fiscal responsibility.
To be clear, the rise in interest rates, which began in 2022, did not mark a departure from some kind of long-term normalcy. The higher interest rates returned the U.S. economy to a more normal state of monetary policy. As Figure 1 explains, the period of very low interest rates—between the red arrows—that people now compare our higher rates to, was an exception by historical comparison; there was a brief return to very low rates during the pandemic, but that was also an abnormal period for U.S. monetary policy:
Figure 1
There are two reasons why we can expect high interest rates over the long term. The first reason has to do with inflation. The Federal Reserve itself now admits that keeping the policy-making federal funds rate close to zero for several years was not the best of actions. In a speech on May 28th at a monetary-policy conference in Tokyo, Michelle Bowman, a member of the Federal Reserve Board of Governors, explained that the pandemic-related money printing—and the Fed’s purchases of government debt—was too excessive from an inflationary viewpoint.
In short: Bowman acknowledges that there is an upper limit to how much money a central bank can print before the flood of cash ignites a bonfire of inflation. She is muted in her form of institutional self-criticism, but she does effectively admit that especially the pace of the pandemic-related monetary expansion was irresponsible.
For reference, there is solid academic evidence that a monetary expansion that is used for the purposes of buying government debt is the absolute best way to set prices on fire in the economy.
It is refreshing to see these admissions by Governor Bowman. It means that the Federal Reserve is solid in its determination to prioritize low inflation over any other policy goal. Since inflation remains elevated—the average over the past 12 months is 3.36%—this means that the chances of lower interest rates have weakened considerably in the last few months.
However, this does not mean that the Fed will cut its federal funds rate when inflation returns to the 2% neighborhood. The other reason for them to keep the funds rate high is unsurprisingly related to the U.S. government’s enormous indebtedness. The total government debt increased by $50.1 billion in May, a low number by comparison, though higher than the $30.5 billion in April. However, the relatively modest monthly increase is not the result of an improvement in U.S. fiscal policy; the $190.7 billion monthly average debt increase from the period October-March is far more normal. The low April and May numbers are due to tax filing season, which always comes with a spike in tax revenue.
We can safely expect the U.S. government to be back to more ‘normal’ borrowing figures in June and July. As this happens, investors will reinforce their demand for risk-premium mark-ups on Treasury securities.
Earlier this year, we saw a risk premium trend in yields on Treasury debt. Figure 2 reports the yield curve for the United States government, from January through June. After a brief drop in long-term interest rates (1) the market for sovereign debt produced a series of rate hikes (2) which added about 0.5 percentage points to the yields on the longest Treasury securities. It was not until May that this rise in yields was broken (3):
Figure 2
The small decline in long-term rates last month is likely explained by increased purchases of U.S. debt by large institutional investors. According to FINRA’s database over daily trade volumes in Treasury securities, the value traded in the last four days of May, from the 28th through the 31st, was almost 83% higher than the value traded on the same days the week before.
This suggests a market intervention by large institutional investors whose interest in buying U.S. debt is likely speculative in nature: as expectations mount that the European Central Bank will cut its policy-setting rates at its June 6th meeting, yield-seeking investors take their money out of the euro zone and buy high-yielding U.S. debt instead.
Over the past three months, the market for sovereign debt has gone from planning for two, maybe three rate cuts by the Fed, to planning their portfolios based on the premise that there will be no rate cuts for the remainder of 2024.
With all that said, I would caution that the market’s expectations of a high federal funds rate also reflect their demand for risk premiums for holding U.S. debt. There are a few solid indicators of this risk-premium demand, among them an often overlooked pair of data from the auctions of new debt that the U.S. Treasury holds almost daily. This is the so-called tender-accept ratio, which consists of the money that investors offer (or tender) at the auctions, and the total volume of debt that the Treasury will sell (accept).
Figure 3 reports an aggregated T/A ratio for the entire stock of U.S. debt. It shows that the ratio is in long-term decline, and has fallen sharply two months in a row. The decline is not major from a numerical viewpoint, which is probably the reason why no other analyst is taking it into consideration. However, the trend of decline is consistent—and worrisome:
Figure 3
The T/A ratio is a good early-warning indicator of a fiscal crisis. So long as the T/A ratio remains above 2, i.e., there are two dollars of investor money tendered for every dollar of debt the Treasury sells, there is no real worry about investors abandoning U.S. debt. However, when the ratio falls below 2, market psychology kicks in and points to the next big and outright catastrophic threshold: when the T/A ratio falls below 1.
At that point, the Treasury will not be able to sell all the debt it auctions off—unless it rapidly raises its federal funds rate. That is when a fiscal crisis breaks out. The territory where the T/A ratio runs between 1 and 2 is to be interpreted as a ‘crisis warning’ state.
We still have a way to go before we get there. However, most of what is happening on the U.S. debt market right now is conditioned on the expectations that at some point, the United States government could indeed find itself in a position where investors are no longer interested in offering $1 for every $1 of debt it wants to sell.
For this reason, plan your personal finances on the premise that interest rates will remain high for the long haul.
