Why Short-Term Rates Will Stay Low Longer Than The Market Expects
As a result of improving economic fundamentals, US interest rate products
have been declining in price and yields, which are inversely related to price,
have risen. Although this is a normal occurrence during economic recoveries, as
investors anticipate tighter monetary policy and higher inflation, there is one
important aspect of the current economy which, in my view, suggests that the
market is being overly aggressive with its expectations for future Fed rate
hikes.Â
Capacity utilization, which measures the amount of resources being
used by the economy, is currently at its lowest levels in 20 years. A high number indicates that the available resources are being
stretched, and low numbers indicates the opposite. Typically, when capacity utilization is high, inflation becomes a concern for
the Fed. The reason is that it becomes increasingly difficult for firms to
produce enough to meet additional demand for their goods when they are using all
of their available resources. And when demand exceeds supply, inflation begins
to appear. In order to prevent inflation from taking hold of the economy, the
Fed slows demand by raising rates (higher borrowing costs).
The chart below
illustrates the relationship between high levels of capacity utilization and Fed
tightening cycles. Typically, the Fed raises rates when capacity utilization
rises above 81, as this level is usually accompanied by thinly stretched
resources and therefore higher inflation. But capacity utilization is currently
at a multi-decade low of 74.5, which is significantly below the 81 level, and
will require explosive economic growth before it reaches levels that are
associated with meaningful price inflation.
As can be seen in the chart below, the Fed Funds futures contracts are currently expecting the FOMC to raise rates by 25 basis points in
March 04, which, in my view, is too soon. It is more likely that the Fed will
wait until the 3rd quarter of 04 before it begins raising rates.
