Rates Fairly Valued?

As interest rates increased during much of the second quarter, many institutional bond investors believe the price premium from quantitative easing has effectively been removed from Treasury Bonds.  Now, with a greater focus on economic fundamentals, many investors, including SNWAM, consider longer-term Treasuries to be fairly valued.  A major determinant in the level of interest rates is inflation. By most indicators, including the Federal Reserve’s preferred measure, the PCE Deflator, core inflation is currently running just over 1%, which does not argue for a continued rise in interest rates.  One way in which economic growth and inflation could begin to rise is with an increase in the velocity of money, which occurs when banks make loans to corporations and consumers, who then spend that money and start a chain reaction of money changing hands.  Velocity of money has been falling consistently since the US entered the most recent recession in 2008, and precipitously since the Federal Reserve engaged in the practice of paying 25 basis points to banks on the excess reserves they hold at the Fed.  While the Federal Reserve has increased the money supply significantly, if that extra money continues to sit in reserves, it will not flow through the economy and create growth or put much pressure on inflation.  If there were to be a change in this policy, or if fundamentals in the economy were to turn more positive than what we’ve seen, our outlook for rates would likely adjust.