The document discusses how interest rates have behaved since the financial crisis and makes several predictions: 1) Tapering of quantitative easing by the Federal Reserve is likely to lower interest rates as investors flee to safety in bonds, increasing bond prices and lowering yields. 2) Previous tapers have weakened the economy, pushing interest rates lower, and ending quantitative easing and zero interest rate policies may end the long but fragile economic expansion. 3) Interest rates will remain low due to disinflationary forces like low wage growth and money hoarding offsetting increases to the money supply. 4) The document predicts the Fed's balance sheet will remain above 2011 levels until 2020 and policy rates will

1. Interest Rate Behavior and
Misbehavior Post-Financial Crisis
Joe El Rady

2. FED TAPERING WILL NOT RAISE
INTEREST RATES

3. QE has raised rates while tapering has
lowered them
Source: STA Wealth

4. QE and ZIRP by design support risk
taking
• QE and ZIRP redirect capital from bond markets
to risk markets.
• Conversely, recent tapers have reversed capital
flows from risk assets to the safety of the bond
market, raising bond prices, which lowers bond
yields.
• Therefore, further Fed tightening will likely lower
interest rates again as investors flee to safety,
increasing demand for bonds, which raises their
prices and lowers their yields.

5. TAPERING MAY LEAD TO ECONOMIC
WEAKNESS

6. Without Fed support the economy has
weakened
Source: STA Wealth

7. Economic weakness in the absence of
Fed support has lowered interest rates
• Each time the Fed has withdrawn financial
accommodation, the economy has flagged
pushing interest rates lower.
• Without Fed support, continuation of an
already long economic expansion will prove
difficult given the lack of underlying drivers
that contribute to growth.

8. US economy already has enjoyed 7th
longest expansion since 1879

9. The end of QE / ZIRP may end this
already long expansion
• The Federal Reserve’s programs have
effectively and successfully pulled forward
future consumption to support current GDP.
• The end of these programs may reveal the
void.
• Even small increases in interest rates can
immediately dampen interest rate sensitive
economic activities such as business lending
and real estate purchasing.

10. The expansion, though long, has been
frail
• US economy has not grown as robustly as it
should during the first few years of a post-
recession recovery.
• Reduced average household incomes (which
have actually fallen every year for the past 5
years on an inflation-adjusted basis) have
restrained the recovery.

11. Real GDP growth lagged over the past
several years compared to other cycles

12. Inventory buildup has lagged and
productivity growth has been weak

13. Personal consumption growth has
been dismal

14. Retail sales collapsed during
recession…

15. … and continue to underperform their
long term trend…

16. …especially when adjusted for inflation
and population growth

17. Comparison to other recessions
demonstrates the weakness in retail…

18. …arrested by low personal income
levels starving the economy of fuel…

19. …and hindering personal credit
growth…

20. …lagging confidence…

21. …due to low job growth feeding a
cycle leading to lower job growth

22. The growth that has occurred in jobs is
not only anemic, but also sub-standard
• Almost 70% of jobs created in Q2 2013 and
60% of all jobs in the first half of 2013 were
created in the three lowest-wage sub-sectors:
– Walmart, McDonalds, Janitorial etc.
– These jobs pay an average of only $15.80/hour
– Half of these jobs are part-time

23. THE LIQUIDITY TRAP RENDERS
MONETARY POLICY INEFFECTIVE

24. The Fed may also be caught in a Japan
style liquidity trap
• Cheaper credit through monetary easing
doesn’t yield much when cheap capital is
already abundant.
• For example…

25. Twenty years of low interest rates in
Japan has failed to sustain growth

26. MARKET DYNAMICS MAY
CONTINUE TO COMPRESS RATES

27. As long as the world remains awash in
liquidity, Treasuries will rally
• Higher propensity to save in emerging
economies, coupled with investor preference for
safety, has increased worldwide demand for
bonds.
• Foreign central banks, such as China’s, are buying
US Treasuries in order to gather dollars, thereby
weakening their own currencies in order to boost
exports.
• Financial institutions are also increasing Treasury
purchases to satisfy bolstered regulatory capital
requirements.

28. Supply and demand dynamics also
contribute to the rally
• Higher levels of treasury purchases are
occurring while the supply of you US
government debt continues to shrink due to a
lower budget deficit.
• The US government has enjoyed increased tax
receipts due to higher tax rates, leading to
lower levels of Treasury offerings.

29. PRICE AND WAGE DISINFLATION
WILL KEEP RATES LOW

30. With inflation below target, rates will
not rise

31. Labor costs remain essentially flat

32. Inflation is a rise in the price level
• Prices = Supply of Money * Velocity of Money
• Regardless of how much the Fed increases the
supply of money, the lack of movement
(velocity) of that money, will offset the supply,
preventing an increase in the price level.

33. Money hoarding has offset money
supply

34. PREDICTIONS AND CAUTIONS

35. Predictions
• Expect the size of the Fed’s balance sheet to
remain above 2011 levels until 2020.
– The Fed has stated that it has some tolerance for a
period of inflation in excess of its long-term
targets.
• Expect policy rates close to zero until about
2016.

36. Cautions
• The aging demographic will continue to strain
the financial system, increasing levels of
indebtedness and poor fiscal policy to combat
the issues restraining economic growth.
• Therefore, continued monetary interventions
may create the next boom/bust cycle in
financial assets.
• A potential for phantom inflation caused by bubble
in asset prices remains a serious risk.