Rates are Rising, Just Not All of Them

One of the hottest debates through 2015, after the Fed said they were going to eventually start removing stimulus and raising interest rates, was whether or not interest rates were going to go up. Every economist predicted that they would. Many traders however suggested that the price evidence said they would not.

In the end the Fed did raise rates, but not until late December. A beautiful merry Christmas gift to the market. And what happened? Short term rates did rise. But long term rates have barely moved. Bond market and interest rate traders will have no problem with this.

The Federal Reserve controls the extreme short end of the market. The overnight risk free rate, Fed Funds. When the Fed says that they are raising rates this is what they mean. And when they say they intend to keep doing so it is to keep raising the Fed Funds rate.

Long term rates are another story. They are, for the most part, out of the control of the Fed in the short run. That is because long term rates are simplistically a combination of a discounted long term risk free rate and inflation expectations. So with inflation expectations falling in the market place long term rates stand a real chance of falling further.

The chart above shows the price of 30 year Treasury Bonds over the last 20 years. Recall that bond prices rise when yields, or interest rates, fall. Clearly prices are continuing to rise. Looking at the far right of the chart prices look set up to head higher in the very short term.

So the Fed has said interest rates are going to rise. And Treasury Bonds are saying that interest rates are going to fall. Which is right? Both can be. So if you have been confused by the debate over rising interest rates, make sure your first question is which rates are you talking about. Short term or long term. It makes a difference.

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