Thursday, August 22, 2013

Interest rates in disinflationary vs deflationary environments

- by New Deal democrat

I wanted to follow up on a point I made the other day in my post about "Three ways to look at interest rates." Namely (quoting myself here), I think it is important to keep in mind the difference between inflationary recessions and deflationary recessions. All of the post-WW2 recession through 2000 were inflationary recessions. Inflation increased, the Fed raised short rates to counter it, long rates began to decline as bond investors anticipated weakness, and a recession began. In deflationary recessions, an asset bubble bursts, and/or a debt overhang reaches critical mass, and the inflation rate declines, possibly turning into deflation. Interest rates follow, subject ot the zero lower bound.

The difference in the two types of scenarios is manifest in the different way that interest rates have behaved vis-a-vis stock prices during the disinflationary period of 1982-97 vs. 1998 to the present.

First, let me show you simple graphs comparing the performance of the S&P 500 vs. the 10 year treasury bond. Here's 1982-90:

Here's 1991-98:

And here is 1998 to the present:

It's easy to see in the depictions above that from 1982 through 1997 at least, rising stock prices were paired with declines in bond yields. What is harder to see is that the mirror image of declining yields ands rising stock prices also applies to shorter periods. Conversely, and again it is somewhat harder to see in the depiction above, the period from 1998 on features bond prices declining in much more subdued fashion, and no longer as a mirror image of stock prices, even over most shorter terms.

But fear not, I wanted to show you the above just to give you the raw comparison. The difference in the relationship between stock prices and bond yields becomes much clearer when I measure each by their YoY percentage change. Here's 1982-97:

And here is 1998 to the present:

Now it is much more obvious. During the disinflationary period of 1982-97, the YoY percentage change in stock prices was the mirror image of the YoY percentage change in bond yields. Stocks rose when bond yields fell, and stocks fell when bond prices rose. From 1998 on, however, almost always stock prices and bond yields have moved in the same direction (with the exception of late 2003 through mid-2006).

During the disinflationary period of 1982-97, as interest rates fell, there was continual room for consumers to refinance debt at lower rates. Further, consumers took on more and more debt. When inflation briefly broke back over 6% at the end of the 1980's, the Fed raised rates and inverted the yield curve, and the subsequent recession brought even lower interest rates, and an even lower general rate of inflation in the 1990's. During that period, bond yields fell even with a strong economy.

But that changed beginning in 1998. From that point until the present, bond yields have generally risen with a strengthening economy, and fallen with a weaker economy. As first the tech stock bubble burst, and then the housing bubble burst, there were deflationary moves in asset prices and declining bond yields simultaneously. Several times since then, there have been brief periods of outright deflation. Perhaps a more finely grained assessment is that, since 1998, during periods of a strong economy, bond yields and stock prices behaved as mirror images. But during periods of a weak economy (which has been the vast majority of the time since the turn of the Millenium), the two asset classes have moved in tandem. Since I think it is fair to say that the economy is quite weak, I expect that any decoupling in bond yields and stock prices now to be brief.