Explaining the recent spike in interest rates

There’s been a lot of chatter about the recent enormous “spike” in interest rates. I want to make some comments and observations.

First, this spike, while large in percentage terms over such a short period is really tiny in nominal terms. Take a look:

Once you have a little perspective the “enormous spike” becomes a joke.

Second point:

Rates are anchored by Fed policy and that doesn’t just mean short term rates, it means rates all along the curve. Whatever the Fed funds rate is will be reflected further out. A 10-year yield is nothing more than a reflection of Fed policy over that term. And since the Fed has been very clear about its intention to keep rates low and maintain a “highly accommodative” policy stance out until 2014, there is not going to be some big move up in rates. We’ve probably already hit the upside ceiling for rates.

Third point:

The rise in rates over the past several weeks has been due to a number of things, one of them being an improving forecast for the U.S. economy AND a dissipation of fears of a European meltdown. (In my opinion, the jury is still out on both of these views.)

In addition there has also been a largely unnoticed, but fairly sharp decline, in reserve balances over the past few weeks. (See chart below.) This has been due to the Fed allowing existing positions on its balance sheet to “roll off” (i.e. proceeds from maturing securities are not reinvested) AND a large amount of bond issuance by the Federal Government this month to cover expenditures, which has not been offset yet by Fed monetary operations.

On that last point, notice the recent upturn in reserve balances on the chart below. The Fed is once again stepping in to add reserves. Bottom line, the bond selloff is probably over.