Interest Rates Will Rise Before the Fed Funds Rate Rises….

Good read here from Learnbonds on the likelihood of a substantial jump in interest rates well before the Fed raises rates. This is important for understanding investor psychology and how you have to approach the market like a chess player.  That is, you have to anticipate the many variables that go into cause and effect and then anticipate how the market might respond to various actions.  The more moves you can think ahead the better off you are.

“Stock prices tend to change in anticipation of what will happen, versus on what is happening.  Even though they change on current events, the most important question is:  “What does this mean about 3-6 months from now?”  Interest rates and fixed-income securities prices are similar in this respect.  Smart investors will not wait for QE to be lessened or end, the Fed’s balance sheet to begin shrinking, or the federal funds target rate to be raised.  They will anticipate these things.  You should anticipate these things too.”

Have a read here.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Johnny Evers

    If rates rise, then the interest on the national debt will rise, as we all discussed in here yesterday. At $16 trillion and 7 percent T-rates, the interest alone would be more than $1 trillion.
    We’d have to monetize directly to do that, wouldn’t we?
    Can we issue $2.5 trillion in new debt every year?
    Aren’t we locked into a policy straightjacket?
    I suspect we’re stuck at low rates with the Fed having to buy more and more debt.

  • Steve W

    I think a lot of us are wondering about the policy straightjacket. Having said that, I don’t see ingredients brewing in the USA that would lead to 7% Treasurys. I also keep looking at Japan for clues. I realize the comparison is somewhat apples and pears, but there are similarities — and their rates are still very low.

  • jaymaster

    Johnny, no, it won’t work like that. I missed yesterday’s discussion (and it’s way too deep there to dive in now), but you’re missing one critical point.

    The interest rate on the $16 trillion won’t jump to 7%, or any other value. It’s (for the most part), already locked in at lower rates. The only exception I can think of is for TIPS based debt, which is tiny.

    The increased rates would only apply to NEW debt taken on by the government.

  • Pacioli

    I think Steve W is on to something.

    The ingredients are just not there that would substantiate an appreciable rise in rates, with or without Fed involvement.

    I was very surprised that Cullen characterized the Learnbonds piece as a “good read”. I came across it a couple days ago, and it struck me as a particularly poorly crafted argument, suffering from the fundamental flaw of assuming its own premise.

  • KB

    Oh please! Just look at the proportion of st debt to lt debt, and on maturities schedule! The high rates will hit budget almost immediately by historic standards.

  • KB

    So far, every time the fed stopped QE, rates decreased. So, although we do not know the future, the piece is incorrect connecting end of QE/fed funds rate increase with interest rates increase.
    However, interest rates can obviously rise before the fed fund rates rise/before the fed stops QE. The question is what should be a trigger for this. One would be expected strong and sustainable economic growth. Now honestly answer the question, would it be possible under current circumstances. Another would be loosing trust in the fed and its ability to control situation. Then so-called bond vigilantes would appear. What else can it be? Am I missing something?

  • Johnny Evers

    KB is right. According to what was discussed yesterday, most of the debt is currently being rolled over (5 year duration, $8 trillion in debt issued last year) so it would only take a few years for the interest payments to top 7 pct.
    In this situation, historical comparisons are pointless, because this is a totally new set of circumstances.

  • KB

    right. nothing to add.

  • Cullen Roche

    I didn’t say the argument was entirely right. I said I liked the structure of the thinking….

  • Wells Fargo Must Die

    The Fed always follows the market. The Fed also always tips the market ahead of time so people can get their positions squared away in advance. So this premise is rather obvious.

    Rates rising in an age of financial engineering is another matter. In a low-growth, financially-engineered world, there will be no rise in rates. Higher rates will quash whatever growth can be achieved and lagging or no growth means more of the same.

    Turning Japanese, I think I’m turning Japanese. I really think so.

  • bart
  • Geoff

    Of course interest rates will rise before the Fed Funds rate rises. The bond market always front runs the Fed. The real question is how far will the bond market go? In other words, how steep will the yield curve become? Historically, the curve (10yr less 2yr yield) has never exceeded 300 basis points. It is currently at around 170 bps. So in an extreme front running scenario, 10yr yields are unlikely to rise more than 130 bps (300-170) from here, all else equal. Indeed, the yield curve is already pretty steep at 170 bps, indicating that the bond market is ALREADY front running the Fed to some extent.

  • Kristian Blom

    The piece is well written AND contradicts its own research;

    “Also, notice that these interest rates began rising, versus falling, soon after the federal funds target rate was lowered to near 0%.”

    The bottom line is this; it’s not the Fed that has its hand on the scale, at least not primarily. It is the new paradigm of deflationary dynamics in developed markets and inflationary dynamics in developing markets.
    The output gaps that are of relevance are not national ones but the global one

  • jaymaster

    Well, I guess it some of it depends on what your definition of short term/long term is.

    From the data I’ve seen, there’s $3T due in a year or less, and another $5T due in the 4 years after that.

    And maturities are at the longest average they’ve been at in a over a decade, and getting longer every year. I still don’t get what the fuss is all about.

  • Johnny Evers

    Cullen wrote that it would take ‘several years’ for the interest costs to reach $1.5 trillion.
    That would create a fuss!

  • Cullen Roche

    As usual, you’ve taken the argument and veered it off course to meet your ideological preferences. Whether it takes 2 minutes or 2 billion years, the fact is, the deficit will rise if the govt raises rates tomorrow. End of story.

  • Johnny Evers

    No, we’re talking here about what happens if interest rates rise to 7 pct.
    If that happens, I think we’re in agreement that the interest on the debt would top $1 trillion within several years.
    No debating that.
    And you are right that paying $1.5 trillion interest payments would raise the deficit.
    I just don’t see that 7 pct interest rates are a likely possiblity under that scenario.

  • flow5
  • Pacioli

    The ‘structure’ is right, I suppose, in terms of attempting to anticipate upcoming variables. But isn’t that fairly obvious?

    More importantly though, the conclusion, the logic utilized to get there, and the lack of credible evidence, all could not be more erroneous.

  • Pacioli

    I should also be fair in acknowledging that this entry is simply pointing to an outside article, not necessarily reflective of your own thoughts, Mr. Roche.

    Out of 270+ blogs in my reader, yours is easily one of the top 10. I am an avid reader because you stick to facts and reality, and are not beholden to a preconceived agenda.

    I was just a little surprised to see the linked piece referenced at your site, as it seems to be completely at odds with your usual standard of sharp, unbiased observation.

  • Cullen Roche

    Top 10? That’s it? :-)

  • Indignado

    Flow5.. Thanks for posting this article. Great to see somebody else who follows elliottwave. Can somebody please comment on the chart and article in this link. It seems to contradict the argument made on this post of the power of the fed in controlling interest rates. Thanks

  • Alberto

    Average real economic growth in the next 20 years will be around 1%, following the population growth at best. No growth = interest rate will stay as low as today for all the period. We’re also living on extraordinary dangerous times, think about the geopolitical risks in the middle east just to name one. I strongly believe we will see 30y at 2% in the near future.

  • Mirk

    Half correct. Interest rate change will change the value of the CURRENT bond portfolio dramatically. This is where the loss comes from.

  • flow5

    Lawrence K. Roos, Past President, Federal Reserve Bank of St. Louis & past member of the FOMC (the policy arm of the Fed) as cited in the WSJ April 10, 1986 “…I do not believe that the control of money growth ever became the primary priority of the Fed. I think that there was always & still is, a preoccupation with stabilization of interest rates”.

  • flow5

    Interest rates are the price of loan-funds, not the price of money. The price of money is represented by the various price indices.

    But the Fed’s monetary transmission mechanism presumes that a “liquidity preference” curve exists which represents the supply of money. In this system, interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity… All of this has little or nothing to do with the real world – a world in which interest is paid on checking accounts (elimination of Reg. Q ceilings).

    Keynes’s liquidity preference curve (demand for money) is a false doctrine (confuses money with liquid assets). I.e., the money supply can never be managed by any attempt to control the cost of credit.

    The first legal reserve modification in the post-Accord era was in 1959 – when the Fed began to allow vault cash to count towards their reserve maintenance requirements. By confusing liquidity reserves, with legal reserves the FOMC began to lose control of the money stock (i.e., just as the BOG & FDIC raised Reg Q ceiling for the CBs on 5 successive occasions). This induced dis-intermediation (a term applicable only to the NBs), & in due course caused stagflation (business stagnation accompanied by inflation).

    C. 1965, as the CBs began to buy their liquidity (instead of following the old fashioned practice of storing their liquidity), the FRBNY’s “trading desk” switched open market operational guidelines (from using a net free, or net borrowed reserve position), to be dictated by the FFR “bracket racket” – which made the job of legal reserve management impossible.

    I.e., the effect of tying open market policy to a federal funds bracket is to supply additional (& excessive free legal reserves) to the banking system when loan demand increases. Up until interest rate pegs, net changes in Reserve Bank credit (since the Accord) were determined by the policy actions of the Federal Reserve. Afterwards the “desk” accommodated all requests at the pegged rate.

    The fed cannot control interest rates, even in the short end of the market except temporarily. By attempting to slow the rise in the fed funds rate, the fed will pump an excessive volume of legal reserves into the member banks. This will fuel a multiple expansion in the money supply, increase money flows – & generate higher rates of inflation — & higher interest rates, including policy rates.

    By using the wrong criteria (interest rates, rather than member bank legal reserves) in formulating & executing monetary policy, the Federal Reserve has always been, esp. c. 1965- inflation’s engine.

  • Geoff

    “the money supply can never be managed by any attempt to control the cost of credit.”

    Money IS credit. But you’re right that the money supply can never be managed because it is endogenous.

  • hangemhi

    Yes, what are the other 9? I need to add to my addiction (Not! yes i do. no i don’t, yes i do…). I now also read ReformedBroker, BigPicture, AllStarCharts, MarketAnthropology almost as religiously as PragCap, and less often yet frequent calculatedrisk, onlypricesmatter (free stuff), kimblechartingsolutions, dshort. And then lots of articles that these authors link to in their twitter feeds. But since pragcap led me to each of the above in one way or another i wonder if I’m just reading those that confirm each other in some way (although i definitely get competing opinions, diff subjects, and unique takes). But… just curious what other’s suggest. My addiction knows no bounds

  • hangemhi

    why? and what would that mean for mortgage rates?

  • Aar Bee

    I have seen this chart before. May be market rate changes in anticipation of Fed… I have been disillusioned with Bob Prechter’s Perma bear view. He has been calling tops for almost 4 years now. He is expecting a crash for so long…

  • Cullen Roche

    “The fed cannot control interest rates, even in the short end of the market except temporarily. By attempting to slow the rise in the fed funds rate, the fed will pump an excessive volume of legal reserves into the member banks. This will fuel a multiple expansion in the money supply, increase money flows – & generate higher rates of inflation — & higher interest rates, including policy rates.”

    This is completely erroneous. The Fed is the monopoly supplier of reserves to the banking system. If it wants to set overnight interest rates on reserves it does so by competing with the banks to set the price. Banks, being users of reserves, CANNOT compete with the Fed when it wants to set the price of reserves.

    More reserves also do not necessarily imply any change in inflation. The last 5 years prove this handily. There is no such thing as a “multiple expansion” in the $ supply due to reserve expansion. QE via non-banks can increase deposit holdings and what MR would call “inside money”, but that doesn’t imply an increase in inflation since NFA does not change.

    None of this should be remotely controversial after the last few years.

  • flow5
  • Pacioli

    @ hangem-

    I’d say my top 10 right now are:

    Bronte Capital
    Credit Bubble Stocks
    Economic Musings
    Brooklyn Investor
    A Dash of Insight
    Kid Dynamite’s World
    The Aleph Blog
    The Accounting Onion
    Prag Cap

  • Alberto

    I’m strictly in the Grantham party. Please download its latest letters at GMO. He is much better than me in proving the assumptions about weak growth. Nothing is certain but I found his comments very well grounded. Of course he is not alone, professor Robert Gordon has this paper:

    Doctor Tim Morgan has a much more complete research paper here:

    There are tons of papers about the oil plateau and the end of cheap oil (not to be confused with the end of oil which is not for tomorrow). The thesis of these guys cannot be very popular, expecially in the world of finance, but before rejecting it because “it’s not what I like to listen” is at least worth a reading.

  • flow5

    “If it wants to set overnight interest rates”

    The Oct. 9th, 2008 IOeR policy emasculated the Fed’s “open market power”.

    Even so, the President of the FRBNY’s William C. Dudley: “For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of required reserves, money supply & credit outstanding”


    Quantitative Easing and Money Growth:
    Potential for Higher Inflation?
    Daniel L. Thornton

    Our “means-of-payment” money is designated as transaction based accounts. 93% of all transactions clear thru this deposit classification.

    Contrary to the conventional economic theory reserves are not a tax. And the payment of interest on excess reserves balances is the biggest mistake in economic history. It induces dis-intermediation [not deleveraging] (where the size of the non-banks shrink, but the size of the CB system remains the same). The error can be linked to the General Theory. Keynesian economists don’t understand the difference between money & liquid assets, between money creating institutions & financial intermediaries…

  • Andrea Malagoli

    I am still not convinced. I would have to be convinced that a Japan-like scenario is not possible for the US. I have yet to see convincing arguments of the contrary. This also applies to the opposite scenario of hyperinflation.

    The Fed has the power to keep interest rates low for a really long time.

  • Kurt Shrout

    Sometimes people make unfair judgments regarding an author’s work. The work was good, but the person does not agree with some of what was written; and this clouds or dictates their judgment. I encourage people to read my article and make their own judgment.

  • flow5

    From the “horse’s mouth”:

    “The 1979-1982 period can be well-characterized as saying that the FOMC moving rates farther and faster than “typical,” but still focused on interest rates. Yet the truth is that, in Washington and New York, a large number of talented professional Fed staff did seek to more closely couple the selected rates to likely growth of money and credit. So the emphasis and staff time was devoted, quite honestly, to money and credit aggregates — but underneath movements in and targets for short-term interest rates prevailed. If anything, the experiment proved that finding tight short-term linkages between short-term interest rates and money growth is not empirically feasible”

  • Vincent Cate

    I have a simulation of hyperinflation that people may find educational. It sort of simulates many moves ahead using simple formulas for different things. So you can understand how money supply, velocity, bond holdings, price level, etc all interact. How inflation can get out of control when there is too much debt and deficit. I think this is the best tool yet to help people understand the death spiral that is hyperinflation.