Following our previous article "Some Thoughts on the Inflation Problem," we have attempted to research and reflect on another headache-inducing issue: the pricing of interest rates, for your reference.
What determines the level of interest rates?
If we look at the chart of long-term interest rates in the US over the past 50 years, the terrifying version of the story seems to be overly sensationalized (once the trend of continuously declining interest rates that began in 1980 starts to reverse and go up, we are still at relatively low interest rate levels...this is what Dalio has been warning about), which is also why there has been recent nervousness in the US capital markets.
First of all, please forgive my shallow economic theory background: I have read many analyses of the reasonable interest rate by economists, there are many methodologies and many of them I may not fully understand, so here I will write only my own understanding.
First of all, the most important thing is: interest rate is the time cost of funds (whether or not there is a central bank), the effective interest rate should make the resources reasonably allocated in society, for example, in economic depression and insufficient investment, the interest rate should be at a low level, which helps promote the economy to recover to a reasonable level (the so-called reasonable is a relatively ideal state between employment and inflation). Therefore, from this point of view, the reasonable interest rate level should indeed have some stable relationship with the relative long-term economic potential growth rate of the economy. From the perspective of all participants in society, this relationship should be more related to nominal value rather than actual value (after deflation), because corporate income, profit, and investment decisions are based on nominal value. The long-term trend of interest rates is basically consistent with the trend of inflation, but it is not the only factor affecting it. The inflation level in the United States has been basically stable in the 2-4% fluctuation range since 1980, but the interest rate in 1980 was still as high as 8%, or even higher, and as high as 6% in the 1990s, until it dropped to within 4% after 2010.
If we combine it with the nominal GDP growth rate of the United States, it may be easier to understand. Generally speaking, interest rates need to be consistent with nominal values in order to price the cost of capital in economic activity more appropriately. The intrinsic reason is relatively easy to understand. The nominal growth rate can be considered as the average income growth of society as a whole. If the interest rate is higher than or equal to this value, there is no investment motivation for society as a whole, because the increase is lower than the interest rate. If the interest rate is far lower than this value, then the average investment impulse in society will increase significantly, which may result in inflation and other social pressures.
So in the long term, it's probably difficult for the potential growth rate of the US economy to trend breakthrough the level of around 2% after 2010 without special breakthroughs in population, capital, technology, and other factors. Therefore, the level of long-term interest rates will be more determined by the future long-term inflation level.
If the long-term inflation level can return to around 2% as expected by the Consumer Expectations Index or the Federal Reserve, the long-term interest rate level in the United States should generally be around 3% (slightly lower than the nominal GDP potential growth rate of 2%+2% = 4%, because the cost of capital should be lower than investment returns in the long run, otherwise it cannot promote economic activity).
Similarly, short-term interest rates are more affected by short-term factors related to the two factors mentioned above. For example, the current short-term inflation expectations are relatively high (although they are expected to have peaked), which may keep short-term interest rates high.
Of course, economists have many more sophisticated calculation models, but here I am just briefly explaining the logic, which should contain some basic economic principles.
Of course, the legal interest rate level of a country has other practical implications. For example, the current level of US government debt cannot be compared to that of 50 years ago, and the high interest burden caused by high interest rates is also a concern for a country's monetary authorities.
Therefore, overall, it is probably too pessimistic to think that the long-term interest rate level will trend upward and reverse the previous situation.
The plan of the new debt king Gundlach
Recently, the new Bond King Gundlach has been saying that long-term US Treasuries are undervalued, and has been buying them accordingly. His view seems to be consistent with ours, and we will briefly analyze his investment analysis logic.
The Federal Reserve’s dot plot guides interest rate trends:
We believe that the main reason why Gundlach advocates buying long-term US Treasuries is actually more from a mathematical perspective, as the current interest rate curve cannot support higher interest rate levels.
The current trading prices of various term interest rates in China and the United States:
Based on the current Federal Reserve dot plot, if the Fed's expectations can be achieved on time (such as starting rate cuts in 2024 and maintaining the long-term target rate of 2.5% after 2026), the theoretically calculated 10-year US Treasury bond yield can only support 2.9%. Even considering other factors such as trading costs, it is unlikely to exceed 3.0% by much. Because US Treasuries are risk-free assets and do not involve fluctuations in risk premiums, this yield is theoretically well-supported and can be locked in.
However, the yields on relatively short-term US Treasury bonds will be significantly higher, as they are more affected by short-term interest rates. For example, the theoretically calculated yield on 5-year US Treasury bonds is 3.6%, but it is still lower than the current market trading price.
The market expectations reflected in this situation indicate that the market does not actually believe that inflationary pressures will disappear after 2025 and return to the era of low inflation. The market believes that inflation will remain above the Fed's target of 2% for a relatively longer time, or that the Fed will not be able to reduce the 10-year yield to 2.5% by then.
Gundlach clearly believes that inflationary pressures are more short-term, and that they will eventually decline significantly, and long-term interest rates will approach the long-term target rate. As to who will be proven correct, only time will tell (as discussed in our previous discussion on inflation). At least, Gundlach believes that current pricing is sufficient.
We have done some simple calculations, and if the market prices 10-year bonds according to the interest rate curve given by the Fed, Gundlach's investment in Treasury bonds may provide a high IRR (if the market quickly converges to the Fed's target direction, the IRR could even be double-digit). Even if the market takes a very long time to achieve convergence between the interest rate curve and the long-term interest rate trend, Gundlach may still believe that a 4% yield on US Treasuries is sufficient.
Of course, there are many factors that affect the short term, including trading restrictions.
It cannot be denied that even in the long run, the pricing of the 10-year bond may be undervalued, but various trading restrictions may still exist in the short term, especially when such convergence requires a severe inversion between the short and long ends, which may cause many investors to have to sell long-term bonds. For example, many investors may be short-term borrowers investing in long-term bonds (such as banks, insurance companies, funds, etc.), and such inversion will force them to deleverage. The recent turmoil in the bond market is probably related to this.
One cannot help but marvel at the fact that during the transition period of investment market and investment mode (especially when the previous investment paradigm is widespread and persistent, investors tend to take it for granted and adopt increasingly aggressive investment strategies, and even leverage it), there are often many turmoil events. For example, if it is assumed that house prices will always rise and never fall, it may trigger many hidden overdrafts and leverage (even if it is not an increase in the surface debt ratio); in addition, investors who do interest rate arbitrage may be accustomed to the long-term reality of RMB interest rates being higher than USD interest rates, but this may reverse due to the rare opposite trends of the two countries' interest rates in recent years, and so on.
We will continue to explore this topic more deeply in the future.
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