Why is the market telling the Fed to lower rates?


In the 1980s, high-yield bonds often yielded 13% to 14%, substantially higher than the 10% to 11% yield called for in the recent pricing of Chrysler's debt.

However, the Chrysler debt might be dramatically more expensive than the higher yields of the 1980s. During the decade of Reaganomics, while inflation was coming down, it was still very high. Real GDP growth of 6% plus inflation of 8% brought nominal GDP to 14%. When compared to high-yield bonds of 13% to 14%, the cost of the debt was not too expensive.

In today's market, with real GDP growth approaching 3% and inflation at 2%, this translates into nominal GDP of 5%. With high-yield bond rates of 11%, it is roughly double nominal GDP growth. That is expensive debt.

This means real interest rates in the high-yield bond market are 8% to 9%, which might be too high for an economy that is more mature and has lower inflation. Many bond investors are saying high-yield rates are correcting back to a normal spread. However, when compared to inflation, real interest rates are very high.

The Fed's goal: get real interest rates lower. The first cut should come in September, followed by at least two more rate cuts by year end.

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Last updated: February 13, 2012: 08:58 AM

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