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US 10 Year Interest Rates

Summary:
Why have they increased so much. The US Treasury constant maturity 10-year interest rate has increased dramatically since the FED started fighting inflation (after falling dramatically during the Covid 19 epidemic). The increase is not unusual — Monetary policy effects GDP and employment through medium and long term interest rates, especially including the interest rate on 30 year mortgages. But I think it should be surprising. Before going on, I have a bit of very useful investment advice: do not take investment advice from Robert Waldmann. WIth that disclaimer posted, I have to say that I have the impression that long term treasuries are a good buy when the Federal Funds rate is high — that is I think the price drops too much so the return

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Why have they increased so much. The US Treasury constant maturity 10-year interest rate has increased dramatically since the FED started fighting inflation (after falling dramatically during the Covid 19 epidemic).

The increase is not unusual — Monetary policy effects GDP and employment through medium and long term interest rates, especially including the interest rate on 30 year mortgages. But I think it should be surprising.

Before going on, I have a bit of very useful investment advice: do not take investment advice from Robert Waldmann. WIth that disclaimer posted, I have to say that I have the impression that long term treasuries are a good buy when the Federal Funds rate is high — that is I think the price drops too much so the return increases too much). The 10-year rate should be the average 3-month rate over 10 years plus a roughly positive constant reflecting risk and the extreme liquidity of 3-month bonds. It looks as if investors expect the (overnight) Federal Funds rate to remain elevated for a significant part of a decade. This would be unusual except for during periods of persistently elevated inflation (that is the 70s and 80s).

One reason for a high nominal interest rate is that investors expect high inflation, so the expected real rate is not high. However, the 10 real interest rate paid on Treasury Inflation Protected Securities also increased dramatically

The difference (TIPS spread) which reflects expected inflation (and again a liquidity premium) changed little. Also surveys of ordinary people and experts all showed little change in medium term inflation expectations. Dramatically increased expectations of inflation over 10 years are not the explanation.

A third possibility has to do with the strangeness of investing and especially of people managing other people’s money. The argument that 10-year rates should be the 10-year average of 3-month rates plus a roughly constant premium relies on treating revenue (interest yield) and expected capital gains equally. Interest is in the bank. It is possible that interest and capital gains are treated very differently not just because of normal risk aversion, but because of the special risk aversion of a money manager who does not at all want to be explaining how the strategy worked in expected value, because there were probably going to be capital gains which did not happen to materialize.

This distinction between the second (new normal) and third (asset prices are strange) explanations matters a lot. In particular if one wishes to know if the US Federal Debt is sustainable one wishes to forecast future long (and short and medium) term real interest rates which determine whether the debt can be rolled over forever or not. This is a topic of great interest to me and will be the topic of another post.

Robert Waldmann
Robert J. Waldmann is a Professor of Economics at Univeristy of Rome “Tor Vergata” and received his PhD in Economics from Harvard University. Robert runs his personal blog and is an active contributor to Angrybear.

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