Direction of Interest Rates During Inflation

Neo: Why do my eyes hurt?
Morpheus: You've never used them before
--The Matrix

Many people associate deflation with falling interest rates. However, a quick look at T-note yields over the past 30 years suggests a secular decline in rates.

Few would suggest that the past three decades have been deflationary. A better case can be made that we've seen more inflation (i.e., expansion in the supply of money and credit) during this period than at any time in US history.

So what gives? The first thing to keep in mind is that the current state of markets cannot be described as free. Instead, they are subject to perpetual manipulation by policymakers. What this means is that any behavior and its expression in prices has been distorted. Risk/reward perceptions in free markets differ significantly from risk/reward perceptions in hampered markets. Indeed, this axiom is one of the key reasons that policymakers intervene.

Since the early 1980s, the Federal Reserve has been pressing interest rates lower thru FOMC monetary policies. Lower credit costs have created an orgy of borrowing and debt. This leverage has been deployed into asset markets, stocks, real estate, and bonds. Yes, debt assets have been bid up along with stocks.

Parenthetically, this situation has been exacerbated by the fact that the dollar has enjoyed reserve currency status during this period. We can be confident that buying of US Treasuries would have been less over the past 30 yrs had the dollar not enjoyed reserve currency status.

What we're saying here is that the correlation between stocks and bonds has been positive over this 30 yr period. It has not been negative as is often suggested by pundits.

In times where credit is made artificially easy, all financial assets are likely to go up in correlated fashion for a prolonged period of time. The somewhat counterintuitive proposition reads like this:

When interest rates are artificially suppressed, a significant portion of the borrowed funds will go into government bonds, which pushes interest rates still lower.

In periods of secular, credit based inflation, interest rates decline rather than rise.

It is interesting what should occur when this secular trend reverses. Something for a future missive...