Does the Fed keep interest rates artificially low?
Dear Steemit community,
we keep hearing it over and over again:
"By keeping rates artificially low, the Fed is blowing up a stock market bubble."
Now the question is, is it true?
Is the Fed responsible for low interest rates?
Can interest rates be artificially low?
Can a central bank control or steer a $40 trillion bond market?
Well, let's find out.
History of US Treasury Yields
The yield on the 10 year US treasury note is the benchmark for interest bearing securities.
So let's have a look at a long term chart to see how the yields have evolved.
click to enlarge
Yields on the 10 year treasury note started climbing in the mid 60's until they peaked in September 1981 at 15.84%.
From that point they started to go lower and lower until they found a bottom in July 2016 at 1.46% and since then they started to climb again.
So did the Fed say in 1965: "Let's sell 10 year treasury notes until our hands bleed, in order to raise interest rates." and in 1981 they said: "Let's start buying bonds until our hands bleed, in order to lower interest rates?
Important note: When bond prices go down, yields go up and when bond prices go up, yields come down.
Well, the Fed did buy huge numbers of bonds during their QE program, but when did it start and how big was its impact?
Let's have a look at the chart again:
click to enlarge
The Fed started QE in November 2008 and ended the program in October 2014.
As you can see, rates started to go down, when QE started, but about a month later, they were even higher than before the start of the QE program. Then they went up and down in a pretty random movement and found a bottom about two years after QE ended.
Yields on the 10 year treasury note have been 2.93% when QE started and they were 2.35% when QE ended.
58 basis points.
Wow, the Fed really had an impact, right?
But what about the drop from 15.84% starting in 1981 to 2.93% before the start of QE?
We are talking about a drop of 1,291 basis points (without QE)!
There are lots of reasons why interest rates go up or down.
As an options trader I know, it is pointless to think about why random markets do what they do, but let's try to find some answers anyway.
What happened from 1965-1981?
In 1960's the US government needed a lot of money (Vietnam War, Great Society program, Apollo program) instead of raising taxes, governments tend to borrow money, since politicians want to get reelected. A high demand for money always drives up interest rates.
Besides that, the population in the US was still relatively young and growing.
Young populations have a high time preference. They have a huge demand for loans, since they are starting families, build homes, start businesses, etc.
Older generations have a lower time preference, their demand for loans is much lower, since they don't borrow that much in order to build homes or start businesses.
Usually older generations already own homes and businesses and besides that have much higher savings.
Another reason for high interest rates is fear and uncertainty, which is priced into fixed income markets.
During the 60's, 70's and 80's there was a lot of fear and uncertainty.
The Vietnam War, two oil crisis, high inflation during the 70's, the Latin American debt crisis, the Savings and Loans crisis in the US, the 1987 stock market crash and the threat of a nuclear war during the whole time.
So lot's of fear and uncertainty to drive up interest rates.
What happened from 1981 - 2018?
In the early 80's technological advance really started to pick up, the Japan economy was a real powerhouse and delivered high quality, but cheap goods to the US and Europe.
All the banking crisis in the 80's got resolved. The Berlin Wall came down in 1989 and all the communist regimes in eastern Europe fell and brought a stop to the Cold War. All in all, a lot of uncertainty and fear went away and that was reflected in lower interest rates.
China opened its economy and started to produce cheap goods for the rest of the world. The internet brought lot's of opportunities to make money. The technological advance during all those years was just mind blowing and I'm sure it will be mind blowing in the future.
Societies in the west grew older and keep growing older, that's also a reason for lower interest rates, like I already stated above.
During all those years productivity did skyrocket and we now have division of labor on a global scale, which is a huge improvement. There is much more credit available nowadays, since we produce much more goods and services on a global scale and where is production, there is also money and credit.
There are probably 1000 of other reasons, why interest rates are much lower now than in 1981, but I hope you see now, that the Fed has nothing to do with it.
Stephan Haller
Please note: I will write a lot more about this topic in my upcoming book, so stay tuned.
While waiting for my next book, please check out my two latest books:
If You Can Order A Pizza You Can Trade - A Mechanical Approach To Options Trading and If You Can Order A Pizza You Can Trade - The Bonus Chapters